A decision that lacks transparency

The ECB has decided to leave interest rates unchanged. In a phase of great uncertainty such as the current one, it is a decision that lacks transparency, as it appears inconsistent with the specific policy framework that the ECB itself has decided to embrace.

The ECB statement is clear: inflationary pressures are mounting. In November, the growth rate of the HICP index (Harmonized Index of Consumer Prices) has been around 3 percent, the highest in the last few years. The staff projections indicate an inflation rate between 2 and 2.2 percent in 2007, but between 2 and 3 percent in 2008. This is hardly surprising. With real oil prices as high as in the seventies, it would have been difficult to avoid any inflationary effect, despite the fact that we live in a world with lower oil intensity.

Can the ECB publish inflation forecasts between 2 and 3 percent and decide not to raise interest rates? Given that its explicit mandate is to keep inflation below but close to 2 percent, what type of signal is the Bank sending to the markets, especially as regards its own credibility?

The second pillar of the ECB policy strategy, the so-called monetary analysis (an unicum among the Central Banks in the world) is even more compelling. It points to a vigorous expansion in the monetary base and in the credit aggregates in the Euro Area. Not quite a credit-crunch scenario, as many currently fear in the US In light of the ECB orthodoxy on the fundamental role that monetary aggregates exert for inflation, there would be plenty of reasons to be worried: more specifically, plenty of reasons to raise inflation expectations.

Rarely in the recent ECB history has the monetary pillar sent a more contradictory message than the one in the current situation. If there were a reason for the markets to anticipate constant interest rates it lies essentially in the fear of a forthcoming credit crunch extending from the US to the Euro Area. Yet there seems to be no trace of that, at least according to the ECB data. In its statement, in fact, the Bank limits itself to vaguely refer “to uncertainty in financial markets” as a background for its decision.

In this mounting inflation context, more than ever, the lack of transparency in the ECB policy points to the need of a more rigorous (arguably “scientific”) framework in which its policy decisions can be rationalized. Much of the recent literature describes the optimal conduct of monetary policy in terms of ‘inflation forecast targeting’. Two are the basic ingredients. First, a numerical target for inflation (as it is well-known from the experience of many countries in the world that have adopted inflation targeting, including emerging-market economies). Second, and more importantly, a management of the path of interest rates such that in each period the inflation forecast at some horizon, and conditional on that same instrument path, are in line with the inflation target.

This second “pillar” is necessary because the effects of monetary policy variations take time to materialize (on average, a rise in the short term rate displays its peak effects on inflation after 18 months). Hence it is not feasible to require a Central Bank to be on target in each instant of time. What matters is that the projected interest rate path is such that that today’s inflation forecast looks close to the target. Two basic principles follow. First, it is not the short term variation in interest rates that matters, but their expected future path. Second, transparency in Central Banks’ actions is critical.

The recent ECB decision is a prototypical example of the usefulness of inflation forecast targeting. Suppose the ECB had adopted it. Then, it would have certainly published its two/three year inflation forecasts in its official statement, making that the central focus of its message. Most importantly, however, the ECB would have tried to convince the markets that unchanged interest rates today belong to a projected future interest rate path which is totally compatible with inflation forecasts (as of today) in line with the numerical target. Even better: the ECB would have published the expected future interest rate path, with reasonable, and well-explained, confidence intervals. In such a context of transparency, the decision of leaving interest rate unchanged could have comfortably co-existed with the mounting inflationary outlook described by the ECB itself.

On the website announcing the decision of December 6 there is a short document reporting the staff inflation forecast: in 2008, they lie between two and three percent. How should we interpret those forecasts in light of the ECB mandate? What should prevent agents to raise inflation expectations based on such forecasts? Most importantly: conditional on what path of future interest rates have those forecasts been computed? Reading carefully through the technical notes in small print (not really an example of transparency), one observes that the staff projections are based on the markets’ expectations of future interest rates. Hence they are conditional not on the future interest rate path that the Bank itself foresees as most likely, but on the interest rate path that the markets foresee as most likely.

Why would the ECB publish inflation forecasts (at least for 2008) that: (i) are not in line with their mandate, and (ii) are conditional on what the agents expect that the Bank will do, and not on what the Bank wishes that the agents expect that the Bank will do (although with a margin of uncertainty)? Is this the best way to manage inflation expectations, especially in this phase of great uncertainty? Some observers have pointed out that, since Euribor rates are currently on the rise in the inter-bank market, monetary conditions are anyhow turning tight, and this would justify the ECB decision of leaving interest rate unchanged. This concept is misleading. A rise in Inter-bank rates today does not (and cannot) provide any useful information regarding the future path of interest rates. Only the Central Bank can meaningfully and effectively manipulate those expectations, and this is what essentially matters for inflation.

One cannot rule out that one consequence of the recent financial turbulence will be to reignite the debate on the optimality of the ECB monetary policy framework. After all, a correct move taken in the wrong framework can sometimes be as detrimental as a incorrect move taken in the right framework.

This column first appeared in Italian on our Consortium partner’s site www.lavoce.info.