ECB Insight: Villeroy Squares the Forward Guidance Circle
16 February 2022
By David Barwick – FRANKFURT (Econostream) – European Central Bank Governing Council member François Villeroy de Galhau on Tuesday sought to avoid throwing out the baby with the bathwater, preserving some semblance of forward guidance for ECB policy while acknowledging room for improvement.
In a speech at the London School of Economics, Villeroy, who heads Banque de France, made no bones about the fact that ‘the ECB might need to adjust its current guidance to manage the path towards a normalisation of monetary policy.’
Although not intended as such, Villeroy offered an explanation of why the ECB with its current forward guidance, decided not seven months ago, might have erred. In particular, he 1) raised doubts as to ‘whether long-dated commitments are believable’; 2) observed that calendar-based guidance is ‘hostage to fortune because large shocks can occur in the interim’, whilst state-contingent guidance can lack clarity; and 3) argued that central banks ‘cannot totally bind our hands with rules, and should keep some element of discretion facing unexpected data or events.’
The implicit admission that the ECB should not have, as fellow Council member Pierre Wunsch warned his colleagues very clearly in July, felt ‘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’, is the basis for a discussion in which much remains to be said.
It is not without irony that Villeroy is now heard preaching with respect to forward guidance that ‘the greater the uncertainty, the shorter the forward guidance should be. Its reasonable horizon at present should be a matter of quarters rather than years.’
This is not at all what he – or, in fairness, most others - said when the ECB announced its revised forward guidance in July. The very next day, he praised the new guidance as a ‘strong answer’ to the question of how the Governing Council would achieve its objective, and made much of the lengthy horizon, measured not in quarters but in years.
But hindsight is 20-20, after all. ‘In the face of uncertainty, not being precommitted is an absolute imperative’, he said yesterday. ‘The two most important words for central bankers recently are “agility” and “humility” – frankly, these are more than just words, they are the daily reality for us.’
The desire to square the circle continues nonetheless to burn brightly, judging by Villeroy’s other comments: ‘The trick is obviously to articulate this increased optionality whilst at the same time giving sufficient predictability to economic agents to reduce the adverse effects of uncertainty.’
In other words, the ECB wants both its guidance (‘predictability’, Villeroy called it) and the discretion (‘optionality’) to deviate from guidance. In an environment of gradual change, that might be less of an issue. Under today’s circumstances and above all in view of recent experience, it might strike one as a contradiction best indulged while sleepwalking.
Still, in sharing his ‘personal reflections on how to increase this optionality’, Villeroy implicitly recognised the lessons of past mistakes. He thus rejected making net asset purchases open-ended from October, as ‘it ties our hands for too long’, which he clarified meant ‘some months in the prevailing uncertainty’.
But the ECB was heading towards its price stability target anyway, he noted, making ongoing net purchases unnecessary beyond ‘some transition’ that ‘could follow a bimonthly or monthly pace instead of a quarterly one’. Buying under the asset purchase programme (APP) ‘could therefore end in Q3, at some point to be discussed’, he said.
Another possible way of increasing optionality, he suggested, would be eliminating the word ‘shortly’ from the sentence that currently reads: ‘The Governing Council continues to expect monthly net asset purchases under the APP to run for as long as necessary to reinforce the accommodative impact of its policy rates, and to end shortly before it starts raising the key ECB interest rates.’
Although Villeroy argued that removing ‘shortly’ would ‘break the quasi automatic temporal link between the two instruments whilst retaining the sequencing’, so that ‘the lift-off could possibly take more time, if warranted’, we doubt this matters too much (which, of course, also makes it an easy option).
Queried at the February 3 press conference about what ‘shortly’ actually meant, ECB President Christine Lagarde made clear that the word imposed no such ‘quasi automatic’ constraint as envisioned by Villeroy. ‘Shortly before is probably a little shorter than just before, and that again is going to be in the estimation of the Governing Council, data dependent, and based on the assessment that is conducted’, she said.
Leaving that aside, however, it is to be noted that Villeroy in this context mentioned that a decision ‘about the calendar of rate hikes’ was one ‘that anyway we don’t need to make before our June meeting. Any speculation about this calendar of future lift-off is at this stage premature.’
He also distinguished between normalisation as being no more than ‘the exit from exceptional instruments and an extremely accommodative monetary policy’, as compared to tightening, which ‘would be another story, going beyond a neutral stance, which is not within our present policy horizon.’
This is of course just semantics, as he acknowledged, but there is naturally value in everyone being on the same page. That the ECB would merely ‘normalise’ but not necessarily ‘tighten’ policy was also indicated on February 6 by Council member Klaas Knot.
‘…I expect the first two [rate] steps to be taken fairly quickly, because they are the steps that will get us out of negative interest rates, so they will follow each other reasonably quickly’, Knot said. ‘Then it is still the case that if we do not get a wage-price spiral, and if inflation expectations indeed remain well anchored around our 2% target, then there is not so much reason for us to raise interest rates quickly and sharply.’
Villeroy echoed that in saying that ‘a scenario where we could pause or adjust rates significantly more slowly after having exited from negative territory … is not a preset course, but this would be a possibility as our hands here are completely free.’
As for the specific forward guidance conditions to get to such a point in the first place, Villeroy declared the first (‘inflation reaching 2% well ahead of the end of its projection horizon’) and the third (‘realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at 2% over the medium term’) to be fulfilled. The second condition (‘inflation reaching 2% … durably for the rest of the projection horizon’) was not, but ‘[t]his could possibly change in the next quarters’, he said.
In any event, the ECB should stay true to its announced sequencing, he insisted, so that lift-off must not take place amid ongoing net asset purchases. ‘We should not pre-empt this calendar: it is about the credibility of the sequencing, and also about some caution on the most fragile of our criteria - the medium-term forecast-based one.’
This of course obliged Villeroy to remind that forward guidance ‘is an “expectation”, and the Governing Council has to “see” and “judge”: even if and when the three criteria will be fulfilled, we could take into consideration exogenous or exceptional contingencies, including geopolitical ones.’
As to the outlook on the price front, Villeroy was firmly in safe mode, noting merely that the Council had agreed that high inflation would be more persistent than anticipated and that Lagarde – who is no economist, but whom Villeroy is always happy to reference – had said that the forces behind elevated HICP would ‘play themselves out gradually as the economy re-equilibrates’.
He declined explicitly to ‘comment further on the expected outlook for inflation – this will be for our next projections on the 10th of March.’