Steady as she goes: The ECB keeps policy rate unchanged again

After having raised the key policy interest rate in April (from 1 to 1.25 %), the ECB kept it unchanged on June 9, thus repeating their “non-action” of May. This is a somewhat bold and perhaps unconventional move by a central bank whose overriding legal mandate is price stability. Given their own definition of price stability as meaning an annual Euro-wide HICP-inflation rate not above 2%, you would have thought that the increase in April would have been followed by further increases. After all, HICP-inflation is currently above 2.5%, and unemployment is falling slightly (continuing the downward adjustment, which I have argued earlier could have been the trigger for the April increase in policy rates).

Both factors would under conventional Taylor-rule thinking call for a policy increase, but I suspect that the ECB is being a bit more subtle here. They known that credibility is of essence, and a central bank which manages to anchor inflation expectations need in theory not respond to inflation at all (and the ECB doesn’t appear to have reacted to HICP inflation at all during the past 11 years, as I have discussed previously). In the press conference following the decision of an unchanged rate, Governor Jean-Claude Trichet indeed emphasized that inflation stabilization is of utmost importance:

On balance, risks to the outlook for price stability are on the upside. Accordingly, strong vigilance is warranted. On the basis of our assessment, we will act in a firm and timely manner. We will do all that is needed to prevent recent price developments giving rise to broad-based inflationary pressures. We remain strongly determined to secure a firm anchoring of inflation expectations in the euro area in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term.

He is clearly engaging in signaling here. And this, of course, only succeeds if on has credibility. In that respect, a recent study by Meredith J. Beechy, Benjamin K. Johannsen and Andrew T. Levin is of interest. In their paper “Are Long-Run Inflation expectations Anchored More Firmly in the Euro Area that in the United States?”, American Economic Journal, Macroeconomics 3 (2011), 104-129, they answer (in the briefest possible version of their results) “yes”. So relative to the US, the ECB seems to being doing quite well in terms of anchoring inflation expectations.

But irrespective of this, unemployment is falling (from an absurdly high level), which in itself could be a reason for a rate increase (from an absurdly low level). Here I think the ECB shows, contrary to popular perceptions, that they are not as hawkish as often portrayed in the short run (I mean that as a compliment although it will probably not be taken as such). They mention that the decline in unemployment is not as strong as previously expected (“continued expansion of economic activity in the euro area in the second quarter of this year, albeit at a slower pace“), so they probably do not except much inflationary pressure from that account. And eventually, they keep emphasizing that they picked a wrong inflation measure to focus monetary policy on; namely one that fluctuates with energy prices (which are really not controllable in any sense by the ECB):

The relatively high inflation rates seen over the past few months largely reflect higher energy and commodity prices

I.e., imported, and highly volatile components, which are outside of the ECB’s control.

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