In times of trouble, financial markets look to central banks for reassurance. The markets need to know what central bankers are thinking about the state of the economy, so they can better predict when official interest rates are likely to change. Reliable information helps to keep the cost of borrowing down, because in an uncertain world lenders tend to put a risk premium on loans, forcing interest rates higher. For these reasons and many more, good channels of communication between the central bank and the markets are crucial. So how well is the European Central Bank doing in this respect? Can we detect any signs that the ECB is being too strict over inflation and damping down eurozone growth unnecessarily, as some politicians complain?
Of all the European institutions, the ECB is the most transparent – for economists, that is. Every month the Bank’s bulletin re-assesses the economic situation on which short-term monetary decisions are based, giving financial institutions the clues they need to predict the outlook for interest rates. The bulletin also explains the Bank’s longer-term strategy on other topics, such as why it does not follow predetermined rules. Members of the Bank’s council frequently talk publicly on policy issues and are impressively united when compared with their counterparts in other EU institutions, or with European politicians in general. This degree of transparency is wholly appropriate, given the ECB’s independence from governments.
Several points about good communications are worth stressing. First, transparency is a pre-condition for money market institutions, and banks especially, to form sound expectations about the future direction of interest rates. Second, the ability of financial markets to make accurate predictions improves the functioning of monetary policy; it allows the central bank to achieve price stability at a reasonable cost. Third, political interference in the Bank’s decision-making would spoil this system.
The effectiveness of the ECB’s day-to-day communications can be judged by results. Nearly all eurozone interest rate changes since December 2005 have been correctly anticipated by European banks and discounted on the money markets. One of the rare exceptions was in August 2007, when comments by ECB president Jean-Claude Trichet were interpreted to mean a rate increase was on the way despite problems on the inter-bank market. This episode proved a brief – if significant – hiccough. There are also questions raised over the value of the ECB’s press conferences, as Jean-Claude Trichet – like all central bankers – tends to manoeuvre around direct questions about future monetary policy.
Some economists would also prefer the ECB to publish its own forecasts on the direction of interest rates. While this may be tough for central bankers, it’s not impossible; Norway, New Zealand and Sweden all manage it. However, it is difficult to imagine how all the members of the ECB’s governing council could agree on a single rate forecast as it would require so many independent members from different countries to reach a consensus.
Recently, the US Federal Reserve improved transparency by publishing its own macroeconomic forecasts quarterly, instead of twice a year. The Fed also extended the time horizon for these forecasts from two years to three years, and started to document any internal disagreement over economic estimates. Members of the Federal Reserve Board base their forecasts on the assumption that future monetary policy will be appropriate to achieve the right balance between economic activity and inflation. These assumptions rest upon the board members’ own interpretation of the Fed’s dual objectives of maximum employment and price stability. This ensures an internal logic to Federal Reserve predictions: macroeconomic forecasts are compatible with board members’ monetary policy expectations. So, while the Fed – like the ECB – avoids forecasting its own monetary policy, its chairman, Ben Bernanke, does expect the markets to be able to deduce the specific monetary policy that is compatible with the Fed’s projections on growth and inflation.
The ECB also regularly publishes forecasts – but these lack the Fed’s internal logic. That is because ECB projections are based on market expectations over interest rates, rather than the Bank’s internal views about appropriate monetary policy. This leads to an annoying situation: ECB macroeconomic projections for variables like inflation and Gross Domestic Product may be incompatible with market expectations over future interest rates. This may seem a rather technical point but it is important. It is another bump on the otherwise smooth communications between the markets and the central bank in Europe.
So, the overall verdict on ECB communications is that they are good, but not yet perfect. The importance of good communications can be looked at another way, i.e. the practical implications for borrowers. When European householders take out a mortgage to buy a home, or investors borrow money from a bank to purchase investments, the interest rates they pay reflect long-term market rates. These are not the same as the very short-term rates fixed by the ECB. However, long-term and short-term rates are linked via market expectations. If the markets expect short-term rates to be high in future, they factor this into long-term rates. Furthermore, if lenders are also uncertain about future trends, they put an additional risk premium on the cost of credit in the form of even higher rates. Poor communications between the ECB and the markets would be one major cause of uncertainty and therefore of higher risk premiums. Even at an auction of government bonds, if buyers are very uncertain about the future of short-term rates, they will demand compensation in the form of a higher risk premium. So the cost of government debt rises too. It is, therefore, clear that good communications is one vital tool for managing market expectations. In fact, in many respects monetary policy actually operates through market expectations over future interest rates; when good communications reduces uncertainty, expensive risk premiums can be avoided to the benefit of all – including governments.
No wonder then that during the last two decades, central banks have improved communications with financial institutions and the public, thereby moderating the volatility of markets, business cycles and inflation. One pre-condition for these achievements has been the independence of central banks. If politicians had leverage over decisions of the European Central Bank, for example, then effective communications would be frustrated. It would then be impossible to forecast monetary policy accurately, volatility would increase and risk premiums would rise. Eventually investment would fall and growth would slow. This would result either from direct political influence over the central bank’s monetary decisions, or the implicit threat of interference which could weaken the bank’s resolve.
Central banks should not be entirely sacrosanct, of course. But the bar for political interference should be set very high. The temptation for governments to dilute the value of money by printing more of it or by keeping credit artificially cheap has been omnipresent in history, and remains acute today. The ECB cannot solve structural economic problems in the eurozone, nor is it mandated to help politicians to fulfil election promises. If certain countries lose competitiveness due to the slow pace of economic reform, they should speed up these reforms, not look to the ECB to cut interest rates or massage the exchange rate down. When the European Central Bank holds interest rates steady – and thereby supports more moderate growth – it is delivering a plain message: sustainable growth will only be possible once errors made in the financial sector have been resolved.
This leads us into the politically-sensitive debate about the ECB’s stance on inflation, particularly during the current financial market turbulence. There is no evidence that the monetary policy pursued by the European Central Bank has ever been, or currently is, over-cautious on inflation. According to our estimates, ECB interest rates accommodated growth for most of the period since 2001 and only recently became neutral. If anything, the ECB promoted growth in the past. Indeed, the enormous increase in money supply, the fast growth of credit and the increases in house prices in some eurozone countries all suggest that the central bank was too lax – albeit less lax than the Federal Reserve. Given the latest data on inflation, oil prices and the growth rate of the money aggregates, there are still reasons to raise interest rates. So, given the current uncertainties about the business cycle, the ECB decision to hold interest rates constant is balanced, not restrictive. Those who demand lower eurozone rates are simply inviting Europe to replicate the errors seen in the US. There is now evidence that the current turbulence across the world’s financial markets is at least partially caused by the US having kept interest rates too low for too long. Yes, the sub-prime credit crisis will have some effect on economic growth. It is naïve to believe though, that if central banks simply printed more money, all the errors of the past would be solved. It would only cause future problems.