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I don’t know if Christine Lagarde is a fan of Giuseppe Tomasi di Lampedusa. But the Italian writer’s most famous line — “everything must change so that everything can stay the same” — could stand as inspiration for what the European Central Bank is achieving on her watch.
The ECB used to be the central bank that could only be relied on to do what was needed at the last minute, if at all. Disagreement within its governing council meant its detractors had to be dragged kicking and screaming along with the majority.
Times have changed. A series of manoeuvres has quietly shifted the euro’s central bank into a position where it can do what needs to be done with minimum controversy. The onetime sound and fury have been replaced by a natural, but contained and manageable, range of opinion.
In July, the ECB governing council unanimously adopted a new policy strategy, formally adopting a symmetric two-per cent inflation target and committing to extra patience and persistence when interest rates are at rock bottom. The review gave solid foundations to a policy approach the ECB had increasingly already been practising, and represented a moderate but clear dovish shift for the future.
The bank then confounded sceptics by giving patience and persistence a hard definition. It will not raise rates until inflation is expected to hit or exceed the target in at most 18 months and then stay there (formally, from the midpoint to the end of the ECB’s two-to-three year forecast horizon). If you want a technocrat’s paraphrase of waiting to see the white in the eyes of inflation, you don’t get better than this.
The most hawkish voices could only give muted resistance to the tolerance of short-term inflation that this framework logically entails. Those who thought it meant no change in practice have been shown that the ECB’s new test raises the hurdle for tightening policy.
It was against this background that the ECB announced last Thursday it would slow its purchases of government bonds. This was widely expected, and it was a “taper” in all but words. Literally so: channelling her inner Margaret Thatcher, Lagarde bristled that “the lady isn’t tapering”, preferring the world “recalibration”. But this is a distinction without a difference. The rate of asset purchases will fall.
What matters is not the label but the justification. A “moderate” slowdown was consistent, the ECB said, with maintaining “favourable financing conditions”. This gives something to everyone. The hawks see asset purchases slow. The doves see undiminished monetary support for growth.
The ECB has, in short, secured a taper without a tantrum. That sets it up to nudge asset purchases further down in December if financial conditions remain favourable — or postpone or reverse in the opposite case — all without drama. Jay Powell and the Fed will consider themselves lucky if they can pull off the same feat.
Many observers expect that as the pandemic-related bond-buying nears its programmed end next year, the smaller regular programme may be boosted and made more flexible. There will no doubt be fierce discussions on the governing council. But the beauty of the ECB’s careful manoeuvring is that the eventual landing zone is obvious.
The hawks will get a continued taper in total purchases. The doves will get their boost in regular purchases to make the transition smoother. Some predict the link in the ECB’s guidance between ending purchases and raising rates will be broken, allowing the hawks to push for an earlier end to quantitative easing — but that will also allow doves to push for rates to stay low well past when the bond-buying stops. It will all be calibrated to the state of financial conditions — as near as you get to targeting long-term interest rates without formally doing so.
A central bank could not hope for a more comfortable place to be. Yet Lagarde was defensive when asked about the “five-year five-year forward” rate of inflation — a swaps-derived measure of what markets think inflation will be five to ten years from now — which has risen by half a percentage point this year to stand above 1.75. She acknowledged the rise, but said “we don’t want to be data slaves”.
Surely expectations homing in on the ECB’s target is a mark of success. Lagarde could have said she would have preferred to see the 5y5y rate at precisely two — but that getting two-thirds of the way to the target in so little time is a vindication of the ECB’s credibility.
Markets largely taking for granted that the ECB will do what it says it wants is a change that even its president finds unfamiliar.