Today, the European Central Bank decided to keep its policy rate unchanged. I am not particularly surprised. In recent empirical work, Morten Aastrup and I estimate what determines the ECB’s interest-rate changes. It turns out that inflation or expectations thereof play no role. Instead, changes in economic activity as measured by Euro-area unemployment is an important determinant. Americans who cling to the idea that good monetary policymaking is characterized by an adherence to a variant of John B. Taylor’s rule that carries his name, may find this surprising.
However, consistent with modern New-Keynesian theory (cf. Michael Woodford’s Interest and Prices, Princeton University Press, 2003), a credible anti-inflationary central bank can keep inflation in check by managing inflation expectations. The correlation between interest rates and actual or expected inflation will therefore weaken. For example, if inflationary pressures are building up, and the central bank raises interest rates, then if the bank is credible, inflation expectations will move little. Instead, one may observe a significant response to business cycle indicators like the current unemployment rate, as this provides information about future inflation.
The ECB seems to have figured this out, as they state in their press release for today’s decision of doing nothing:
Taking into account all the new information and analyses which have become available since our meeting on 13 January 2011, we continue to see evidence of short-term upward pressure on overall inflation, mainly owing to energy and commodity prices. This has not so far affected our assessment that price developments will remain in line with price stability over the policy-relevant horizon. At the same time, very close monitoring is warranted. Recent economic data confirm the positive underlying momentum of economic activity in the euro area, while uncertainty remains elevated. Our monetary analysis indicates that inflationary pressures over the medium to long term should remain contained. Inflation expectations remain firmly anchored in line with our aim of keeping inflation rates below, but close to, 2% over the medium term. The continued firm anchoring of inflation expectations is of the essence.
Indeed, if you anchor inflation expectations, your policy changes will reflect changes in real economic conditions that may pose threats to price stability. And the ECB currently sees no threats from the slow recovery of the Euro-area economy.