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What does the ECB think right now?
When consensus building in policy risks surprising markets
The accounts of the ECB’s July policy meeting revealed an agreement amongst the Governing Council not to hint in public about the likely next policy move—creating a dearth of information on voting intentions where once there was a cacophony of noise.
In an interview with the Financial Times earlier this year, Pierre Wunsch, Belgian central bank governor and ECB Governing Council member, remarked on the dangers of consensus building in the context of central bank rate decisions—something President Lagarde has made a priority for her tenure.
As the Financial Times framed it, Wunsch:
“very much appreciates” Lagarde’s approach, but added: “Where there is room for discussion is if there is too much consensus. I think it removes relevant information from the market.” Hiding divisions between rate-setters risked surprising the market, as has happened several times already, he added.
This observation appears particularly pertinent as the ECB’s September meeting draws closer.
For as a wise owl once might have said: there are risks inherent in hiding information.
The consensus candidate
Lagarde’s focus on consensus building as ECB President was underlined in her inaugural press conference. When asked about emerging disagreement amongst the Governing Council on policy, Lagarde emphasized: “I will certainly try to bring the best out of the members of my Governing Council in order to arrive at monetary policy decisions and use of instruments that will be as consensual as possible.”
Indeed, prior to this commitment, though behind closed doors, Lagarde was urged by Governing Council members to make policy decisions in a more democratic way—unlike her predecessor Mario Draghi, who was said to push through decisions with minimal consultation.
Thus was a compromise struck, according to Reuters; Lagarde would listen, but would insist on discipline in return:
Lagarde pledged to spend more time listening, and not to front-run decisions before policymakers had weighed in… In return, she asked for discipline from the Governing Council, the ECB’s top policymaking body… Governors had to stop trashing policy decisions once taken and keep internal disputes out of the media, presenting a common external front…
The July agreement
It’s fair to say that this has approach as been successful—up to a point.
The Governing Council has been united, once decisions have been taken, in support of policy despite the most aggressive rate hiking cycle since the single currency was formed—not to mention the variety and contrariness of views on the Governing Council.
Put another way, ex post discipline on policy has been a success.
But prior to major decisions there has been less discipline—described earlier this year as “a cacophony of voices” that has at times made the policy message and reaction function difficult to discern.
Curiously, therefore, under Lagarde there has been something of a reversal of roles.
Instead of the ECB President front-running major policy decisions, as alleged under Draghi, more recently it has been Governing Council members doing the front-running—before policy discussions between the group have occurred—by pre-announcing their bias for the coming meetings. And not only, but especially, Knot.
Forward guidance or no forward guidance, central bank governors are apt to talk.
But the September policy decision, to pause or to hike, will be the most difficult for some time—as the hawks and the doves face off. Mindful of the fireworks this might trigger, this may explain the “broad agreement” during the July meeting, per the minutes published this week, that:
ahead of its September meeting, the Governing Council should neither hint at further rate increases nor signal that it would pause in hiking rates or that it had reached the peak rate. It was emphasised that any further tightening had to be assessed meeting by meeting, on the basis of the incoming data and a “risk management approach” that carefully weighed up the relevant risks.
In other words, Governing Council members, for the most part, agreed to refrain from steering the market on the upcoming decision, focussing instead on the data dependency and the need to weigh various risks.
And except for the hapless Holzmann, Governing Council members have stuck to the script pretty rigidly. Most have emphasized the decision is wide open and depends on data. Few have guided the market on how they will vote.
What’s the mandate?
The decision will be fascinating, of course—not least because it gets to the heart of how the ECB’s mandate should be interpreted, and the weight that should be placed on inflation versus activity in guiding policy.
Also in the July minutes was a rehearsal of the positions that will likely be taken in a few weeks. For the doves:
the Governing Council needed to take into account the “secondary objectives” assigned to it in the Treaty on European Union and contain unnecessary side effects on output and employment when pursuing its price stability mandate over the medium term… the ongoing transmission of past monetary policy actions could lead to a more pronounced deceleration in economic activity than was necessary to achieve price stability…
The hawks countered:
concern was also raised that the economy might be entering a phase of stagflation, in contrast to a more benign scenario of a soft landing. It was underlined that the Governing Council’s mandate was price stability and that institutional independence had been granted to allow central banks to focus squarely on price stability.
The playbook for policy over the past two-decades has largely been adjusting to rates in the face of negative demand or positive supply shocks.
Stagflation due to negative supply shocks, so the story goes, requires greater emphasis on inflation in setting policy—and not reacting prematurely to a growth scare. We previously discussed the Bundesbank’s experience here.
Reconciling these views is a real test for the ECB.
Pitfalls of vague guidance
This brings us back to Wunsch’s observations to the Financial Times earlier this year.
Concealing information about Governing Council thinking risks surprising the market. Vagueness means guessing individual preferences as well as the collective reaction function of the ECB at a crucial time.
We can appreciate the quality of Schnabel’s speech this week while still lamenting how, on the matter of policy guidance, it seems unnecessarily prolix.
To be sure, it’s difficult not to sympathise with Lagarde’s plight. Managing the Governing Council must be more difficult than herding cats. A “cacophony of voices” creates its own problems in terms of market volatility. Tuning down these voices instead risks more surprises “on the day.” How should these be best managed?
Of her approach, in a recent interview with Nikkei, Lagarde remarked:
I think overall, in very tough and uncertain times, in almost all cases, we have managed to rally enough consensus around the table. I would like to think that it is because of me, but I think it has more to do with the fact that we are all driven by the same objective, which is our mandate… There are different perspectives and intellectual backgrounds as well as macroeconomic circumstances… It is that very rich diversity that comes together around the table to form a common view on the optimal policy to arrive at price stability. And so far it’s worked. And it’s also my way of working; I’m not a dictatorial central bank governor.
September represents perhaps Lagarde’s biggest test yet in terms of building a consensus. This observation is typically trite. Every meeting must feel like this for those involved. But the next meeting is interesting, shall we say.
Finally, we should add, it is yet to be confirmed whether consensus building trumps the benign dictator when it comes to ECB policy.
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