Like a Pilot in the Fog Not Revealing the Flight Plan

A key lesson of modern monetary policy theory is that managing expectations is central to optimal inflation control. Facing a supply shock (unless purely temporary), optimal monetary policy theory prescribes a commitment about future actions. Let's suppose a jump in the price of oil or the price of energy hits the economy. Then the policy authority should announce that it will undertake a restrictive monetary policy for a period that extends beyond the foreseen duration of the shock. Through this persistence the policy authority aims at dampening inflation expectations today, and therefore also current inflation.

Throughout the post-Covid inflation fight, originally due to a surge in energy prices, the ECB has shown a unique way of managing inflation expectations. In a nutshell, very different from the commitment approach prescribed by theory. President Lagarde has always insisted that monetary policy decisions be taken "meeting by meeting", i.e. one step at a time. In other words, the ECB has deliberately avoided making commitments about its future actions. It has therefore opted for a discretionary rather than a rule-based approach, contrary to what standard economic theory suggests about optimal monetary policy. The ECB has always justified this approach citing the great uncertainty weighing on the economy of the euro area: for example, uncertainty about a possible future slowdown in economic activity. But this uncertainty did not land from Mars, it has largely depended on what economic operators expect the ECB itself to do. In other words, the central bank has behaved like an air pilot who, in the fog, refuses to reveal his flight plan. Instead of helping decrease the level of uncertainty, the ECB has helped to fuel it. It has effectively given up on activating one of the levers that affect inflation, i.e. expectations. It acted based a sequence of ad hoc moves, and not on a pre-announced schedule of actions.

This conduct has set a new template for the conduct of monetary policy in the face of persistent supply shocks. A template, however, which is still in search of a cogent theory. The principle that the ECB has established is that a forward-guidance approach (committing itself to future actions today) is important only during periods of deflation and stagnation, and in particular when monetary policy is stuck at the lower bound of zero nominal interest rates. In that case what the economy needs in order to reflate is lower real interest rates, which can be achieved only via higher inflation expectations (and not via lower nominal interest rates since the latter cannot be negative).

Outside zero lower-bound periods, however, the ECB has stated that a strategy of commitment to future actions is not necessarily warranted. Interestingly the ECB has taken this stand without the backup of explicit and established economic theory. A clearer and more effective alternative, which could have distanced the ECB from a purely discretionary approach, would have been to adopt an approach technically defined as Inflation Forecast Targeting (IFT). IFT involves making a commitment today to continue raising interest rates in the future until medium-term inflation forecasts are consistent with the two-percent target. Relaxing the nature of discretion in one's actions, and putting one's credibility on the line by making commitments for the future, is the most effective way to counter the persistence channels of inflation described above.

The fact, however, that the ECB has insisted on a purely discretionary approach could be the main explanation why inflation has continued to be so stubbornly high, despite energy prices having returned to historical normal values fast enough. In other words, the "meeting by meeting" approach pioneered by the ECB remains an empirical monetary policy conduct still in search of a theory. Time will judge whether it proves successful.