ECB Insight: Opposition to New Forward Guidance Leaves More Questions Than Answers
19 August 2021
By David Barwick – FRANKFURT (Econostream) – Almost a month after the European Central Bank revised its forward guidance on interest rates to reflect its new strategy framework, the nature of the opposition of a small minority of monetary policymakers remains somewhat unclear, with the majority clearly united behind the idea that guidance must defer to reality over time.
At the meeting on July 22, the Governing Council said it expected key rates ‘to remain at their present or lower levels until it sees inflation reaching 2% well ahead of the end of its projection horizon and durably for the rest of the projection horizon, and it judges that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at 2% over the medium term.’
Of the 25 members of the Council, National Bank of Belgium Governor Pierre Wunsch and Bundesbank President Jens Weidmann were the lone holdouts to oppose the new guidance.
‘I guess it boils down to the kind of commitment you can take over a possibly long period of time’, Wunsch ventured to explain in a CNBC interview very soon afterwards. ‘We are maybe talking about five, six years if we look at market expectations before we would hike, and I didn’t feel comfortable taking a commitment for such a long period, because … we might be faced with trade-offs that are a bit more difficult than we’ve been faced in the past.’
Weidmann as well sought to account for his opposition within hours of the meeting, albeit more briefly, telling German daily Frankfurter Allgemeine Zeitung simply that he had ‘felt that the potentially too-long continuation of the low interest rate environment went too far.’
Given the nature of the ECB’s own understanding of forward guidance, either governor’s explanation might be questioned.
‘To remain credible, the content of the ECB’s forward guidance on its policy intentions must always be consistent with the Governing Council’s assessment of the current economic situation and the outlook for the future, in particular for inflation’, according to the explication of forward guidance meant for public consumption on the ECB’s website.
The implication of the text, updated on July 8 in the wake of the unveiling of the new strategy framework, is clear: forward guidance is no ironclad commitment to a preordained future, come what may, but rather an orientative indication of intent always subordinate to the variables at the core of the ECB’s price stability mandate.
As such, it is not clear why Wunsch, who elaborated somewhat more on his dissension, fretted about ‘whether this proportionality test that we are going to have to make in the future — whether we can remain proportional in what we do and take commitments over a long period of time, like five or six years in the future.’
While his fears of the potential for fiscal or financial dominance may be perfectly valid, his apparent belief that forward guidance represents a binding commitment is less comprehensible, not just because the ECB’s own understanding clearly does not involve irrevocable commitment, but also because research shows that forward guidance would be ‘unnecessary if it’s purely a commitment tool’ (Bassetto, 2019).
Given the uncertainty about what will happen with inflation, the flexibility of an ‘escape clause’ would have made the forward guidance palatable to him, Wunsch suggested. ‘I would much have preferred to have an escape clause so that we would make it very clear that if we would be faced for instance with difficult trade-offs, that we would exit sooner.’
Whilst the other 23 members of the Governing Council did not join Wunsch and Weidmann, comments made publicly and privately by a number of them suggest at least some understanding for the dissenters’ standpoint. Still, all of those to have spoken also noted that forward guidance is not written in stone.
In an interview with CNBC, for example, Austrian National Bank Governor Robert Holzmann said he agreed with Wunsch that ‘one should have thought perhaps upon an escape clause … that would have allowed us to break the link earlier.’
Although the ECB’s price stability mandate has primacy over any forward guidance, he conceded, ‘I think it would have been more honest to the markets to tell [them], “Yes, we want to stay accommodative as it is for the time being, but we stand ready to change the rate if it’s necessary.”’
The new forward guidance ‘was a step too far … and we would have wished a different guidance, which doesn’t bind us too long in the future, in order to stay agile and ready in case inflation requires an earlier liftoff’, Holzmann said.
At the other end of the spectrum, Bank of Spain Governor Pablo Hernández de Cos squarely rejected the objections, stating in an interview days after the decision that ‘forward guidance is state contingent, so it demands a commitment to reacting in a certain way to a certain inflation outlook, not a commitment to setting policy rates at a certain level unconditionally.’
Decisions are ‘subject always to a rigorous proportionality assessment’ and the new guidance ‘can show us the way to an orderly process of policy change’ in the event that ‘the outlook improves more than anticipated’, he said.
The ECB’s medium-term orientation gives it the flexibility to consider financial stability issues as well as employment, he observed, so ‘I do not think it is really necessary to add any escape clause.’
Among peers of his who spoke to Econostream, one explicitly cited the ECB’s definition of forward guidance and noted that the ECB had already changed its forward guidance in the past.
‘Of course you don’t change it every quarter’, he said. ‘But if there is a substantial change in your assessment, you change your forward guidance.’ On the other hand, ‘if you have forward guidance and your inflation doesn’t move to 2%, you obviously need do something else, because it’s not working.’
Another person close to the decision-making process would have been willing to endorse Wunsch’ call for an escape clause, but echoed the idea that forward guidance was no indissoluble promise with a life divorced from the evolving economic and inflationary environment.
Perhaps speaking somewhat flippantly, Wunsch suggested to CNBC where the problem might lie.
‘Maybe I’m just taking forward guidance too seriously’, he said, ‘because some of my colleagues, when I would ask them so what do we do if this or that occurs, they would say, “Oh, then we change forward guidance”, so maybe I’m just taking forward guidance too seriously.’
Indeed, that is exactly what his colleagues seem to advocate, and properly so, given the nature of forward guidance.
In the case of super-hawk Weidmann, who was less forthcoming about the philosophical source of his opposition, it is easy to imagine that he was simply uncomfortable with a markedly more dovish monetary policy stance at this juncture, as countries – albeit haltingly - gain the upper hand over the pandemic and economies bounce back from lockdown-induced lethargy.
That is all the more the case given his recently expressed expectation ‘that inflation will accelerate sustainably in the next few years and that we will then also see higher interest rates.’
Why, under such circumstances, lead markets yet further in the direction of lower-for-longer, Weidmann might well wonder.
Wunsch’ resistance is a bit harder to account for. Econostream considers him on balance to be slightly dovish, but we suspect that under otherwise identical but reversed circumstances, he would have also objected at the expense of a hawkish policy decision to anything he considered to lock the ECB into a course of action for an unduly long period.
That said, we don’t really think he would wish for a moment to refrain from adjusting forward guidance, along with other aspects of monetary policy, if changing circumstances warranted it sooner than anticipated.
As we wrote about him in this space on May 5, ‘Wunsch may raise pointed questions, particularly when it comes to the strategic review’, whilst ‘his view of the balance of risks, evidently more nuanced than that of many in the dovish camp, may yet confer on him disproportional influence.’
And in truth, had Weidmann been the solitary holdout on July 22, it is likely that many observers would have reacted with a knowing ‘par for the course’. The idea of an escape clause might have never made it into public discourse. That Weidmann was supported by Wunsch - rather than one of the other arch-hawks - makes the matter at least somewhat more noteworthy.
We are inclined to conclude that while Wunsch would be as open as his colleagues to modifying guidance as needed, in striking a balance with respect to the desirability of forward guidance susceptible to a need for subsequent modification, he is more concerned about what he sees as the potential cost in terms of credibility.
Whilst some might argue – and could invoke the ECB’s definition of forward guidance in so doing – that the credibility of forward guidance relies precisely on its consistency with relevant developments that everyone knows can change across time, Wunsch may regard this argumentation as somewhat specious and the forward guidance based on it as spurious.
In the end, some Council members may see an element of truth in Wunsch’ own supposition that he is ‘taking forward guidance too seriously’.
The account of the Governing Council’s last monetary policy meeting, due to be published on August 26, could shed some light on this part of the discussion .
As for the next few such meetings, Wunsch will in any case mostly be relegated to the role of observer. According to the ECB’s rotation of voting rights, he will be obliged to abstain at the gatherings in October and December – not September - from any formal vote, though he can still voice his mind during deliberations.