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The European Central Bank is set to scrap its focus on using the latest economic data to determine whether to cut interest rates, sounding the knell for one of the core strategies deployed by the Eurozone’s rate-setters to bring under control the worst bout of inflation in a generation.
Philip Lane, the ECB’s chief economist, told the Financial Times’ The Economics Show with Soumaya Keynes that monetary policy decisions at some point in the future needed “to be driven by upcoming risks rather than being backward-looking” once the central bank was sure inflation was in line to hit its medium-term goal of 2 per cent.
Before the post-pandemic surge in inflation, the ECB and other major central banks put a lot of weight on their forecasts for where inflation would be two years from now when deciding interest rates.
But their inability to spot that price rises in energy markets — sparked by supply chain snags and the impact of the war in Ukraine — would stick around left rate-setters struggling to maintain their credibility.
Their encounter with the first bout of persistently high inflation for decades led central bankers in Frankfurt and elsewhere to focus less on their forecasts and more on monthly inflation and survey data, along with quarterly GDP figures.
While inflation in the Eurozone has fallen sharply from a peak of 10.6 per cent in October 2022 to 2.3 per cent as of November, short-term data continues to carry more weight than the central bank’s projections of where inflation will be two or three years from now.
Lane stressed in the podcast that while inflation had fallen close to the ECB’s target of 2 per cent, “there is a little bit of distance to go”. Services inflation needed to come down further, he said.
After the podcast was recorded, Eurostat reported that annual services inflation came down to 3.9 per cent and was slightly softer than predicted.
“Once . . . the disinflation process [is] completed, then I think monetary policy needs to be essentially forward-looking, and to be scanning the horizon for what are the new shocks that might lead to less or more inflation pressure,” Lane said.
As the ECB expects to hit its 2 per cent goal over the course of 2025, this implies that next year could be the point when the central bank could revert to its pre-2022 mode.
“At some point, we will make the transition from having been driven by [the] very important disinflation challenge to the new challenge of keeping inflation [at] 2 per cent on a sustainable basis.”
He declined to comment on exactly when this point would be, but said that over the course of next year, “there’s going to be a transition to a more sustainable neighbourhood of 2 per cent”.
Some analysts hope that the ECB will start to change its wording about its future stance at its next policy meeting on December 12, when it is widely expected to lower its key deposit rate by another quarter-percentage point to 3 per cent — a level generally still considered as restrictive.
Lane implied that the ECB might not completely dump its focus on the short-term data. While the “data dependence falls down in priority”, the new challenge would be “assessing the incoming risks” on a “meeting by meeting basis”, he said.
The governor of the Bank of Italy, Fabio Panetta, in November called for an end of the meeting-by-meeting data-driven approach, urging the ECB to commit to future interest rate cuts in advance to avoid falling back into an era of subpar inflation.
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