The European Central Bank (ECB) attaches great importance to the credibility that people have in its ability to achieve its primary objective of price stability in the medium term. In the ‘Introductory Statement’ to the monthly press conference the Governing Council has repeatedly expressed its “strong determination to keep medium and long-term inflation expectations firmly anchored in line with price stability”. However, ECB credibility has steadily eroded during the last years and has now reached worrisomely low levels.
Measuring market inflation expectations
It is common to consider market expectations of inflation, in particular the ‘break-even’ inflation rate extracted from yield curves. But this indicator reflects many things: inflation expectations, inflation risk premiums, and liquidity and term premiums. These make this measure especially difficult to interpret during the current turmoil in financial markets.
To avoid this problem it is useful to investigate inflation expectations based on the ECB’s Survey of Professional Forecasters (SPF), which has been conducted every quarter since 1999. Figure 1 shows that SPF expectations for euro area HICP inflation two years ahead have increased markedly over time from 1.5% in the first quarter of 1999 to over 2.1% in the third quarter of 2008. Even five-year ahead SPF inflation expectations have gradually inched up from about 1.8% to over 2.0% (the upper ceiling of the ECB's definition of price stability of "below, but close to" 2%).
Figure 1: SPF inflation expectations
ECB credibility looks even more troublesome when taking into account not just the point estimate but also the uncertainty expressed by the SPF panel. Figure 2 shows how likely the SPF respondents consider an outcome of euro area HICP inflation consistent with the ECB’s quantitative definition of price stability (0-2%).
The two-year-ahead SPF probability of 0-2% inflation has declined from over 80% in 1999 to less than 40% in 2008. Admittedly this could be influenced by the current high level of inflation. But even at a five-year ahead horizon — a horizon over which the effect of oil prices would linger only if the ECB had been unable to curtail second-round effects — the credibility measure has gradually eroded from over 60% in 1999 to only 43% in the third quarter of 2008.
In short, these professional forecasters believe that there is a less than even chance that the ECB will manage to achieve its definition of price stability in five years’ time. This is worrying.
Figure 2: ECB credibility (SPF probability of 0-2% inflation)
Decline in ECB inflation credibility
The decline in ECB credibility appears to be significantly correlated with the inflation performance in the euro area.1 But the loss of confidence in the ECB’s ability to deliver price stability in the medium term is not surprising considering the ECB’s befuddling communication practices.
First of all, its qualitative definition of price stability of “below but close to” 2% is fuzzy. Furthermore, the explanations the ECB provides for its policy decisions are inadequate. For instance, the Eurosystem staff projections published in June showed a range of HICP inflation between 1.8% to 3.0% for 2009, assuming a three-month Euribor rate of 4.9% for 2008. Although the midpoint of this inflation projection range is uncomfortably above the 2% ceiling, the ECB left its main refinancing rate constant at 4% and merely expressed that the Governing Council is “in a state of heightened alertness”. The ECB’s inaction was surprising and its (lack of) explanation left journalists at its press conference puzzled over why rates had not been increased. Although the ECB raised the refinancing rate to 4.25% in July, this was insufficient to prevent a further drop in ECB credibility to well below 50% in the latest SPF.
A challenging environment
The ECB faces a very challenging economic environment with a large degree of uncertainty and potentially difficult tradeoffs; the optimal interest rate decisions are far from obvious. But this means that now more than ever, the ECB would benefit from properly explaining its monetary policy actions.2 In particular:
- It should provide the medium term macroeconomic projections of the Governing Council, especially when it appears that they differ from the staff projections.
- The Governing Council should publish the balance of votes to enhance short-term predictability and allow the private sector to better understand the monetary policy reaction.
- The Governing Council should publish un-attributed minutes of its monetary meetings.
This would not only clarify the ECB’s thinking but also give it the opportunity to show that its monetary policy decisions are solely based on euro area considerations, in line with its mandate, and are not beholden to national interests.
- Finally, the ECB should publish its policy rate projections and use scenarios to explain how it intends to act depending on economic developments.
For instance, it could show how it would reduce rates if economic weakness removed inflationary pressures. But at the same time, it could indicate how it plans to react if wage demands get out of hand, thereby displaying its ‘strong determination’ to anchor medium term inflation expectations.
Regardless of what the ECB’s upcoming decisions will be, it would greatly benefit from improving its communications to help stem the precipitous decline in its credibility to unprecedentedly low levels.
Petra Geraats, Francesco Giavazzi and Charles Wyplosz (2008). “Monitoring the European Central Bank: Transparency and Governance”, CEPR.
1 See Petra Geraats (2008), “ECB Credibility and Transparency”, European Economy Economic Paper 330, European Commission, Economic and Financial Affairs.
2 The need for improvements in ECB transparency and communication is discussed more extensively in our report “Monitoring the European Central Bank: Transparency and Governance”, CEPR, 2008.