Exclusive: ECB Touts ‘Gradualism’ to Keep Markets Calm, But Data Will Set the Pace, Econostream Understands

4 April 2022

By David Barwick – FRANKFURT (Econostream) – The ‘gradualism’ that the European Central Bank has been tirelessly emphasising of late would characterise its approach to monetary policy will find itself cast overboard if incoming data so dictate, Econostream understands.

Gradualism, along with optionality and flexibility, are the three core principles the ECB deemed to constitute a ‘policy framework tailored to the current environment of heightened uncertainty and the new challenges it presents’, as ECB President Christine Lagarde said on March 17.

Admittedly, there is some inconsistency in ECB messaging, as one or the other of these principles is at times omitted, whilst at other times the list is enlarged (see Lagarde on February 25). Moreover, the criticality of data-dependence is noted with such regularity that it seems hard to imagine it is any less important.

In any case, the explanation of what exactly gradualism means has so far been somewhat wanting. Lagarde suggested that it was the proper response to ‘uncertainty about the resilience of the economy’, but such uncertainty is not nearly as new as the emphasis on gradualism.

More likely is that the sudden desire to stress gradualism has much in common with the change earlier this month in the way the ECB’s forward guidance on interest rates is worded. Indeed, Lagarde has explained the new wording directly in the context of gradualism: ‘to temper expectations of any abrupt or automatic moves.’

Leaving aside the question of the extent to which interest rate hikes were expected to be ‘abrupt or automatic’, the various conditions set by forward guidance for an increase in official borrowing costs have not changed recently, and continue to be highlighted by policymakers, above all those who seem most interested in going slow.

According to an ECB insider Econostream spoke to, gradualism is partly about reassuring observers about the ECB’s own expectations as to the likely pace and that there is no competition for the US Federal Reserve’s pole position.

‘I think it’s fair to say that they are maybe half a year or a year ahead of us in the cycle’, he said. ‘We may say similar things, but there are differences that we need to take into account, and the first one of course is that current inflation just hasn’t shown up in euro area wages that much yet.’

‘It’s a lagging indicator anyway, but you need to see that happening in order to be sure that we are going to see high inflation be more persistent’, he added.

The ECB is of course perfectly able to communicate – and has done so - that wage growth - a textbook precondition for sustained inflation - is part of what it needs to see, which leaves us thinking that the next reason suggested by this person is more relevant:

‘The other part is that we still have countries that are extremely fragile with respect to conditions in the financial market, and that’s why every step you take, you have to ensure that we won’t harm the overall balance and the markets won’t overreact’, he said.

‘Because if you have an overreaction, then you may end up all of a sudden having to turn policy around again’, he elaborated. That’s why I think this gradualism in a sense is needed just to make sure that markets are calm enough and we don’t see this kind of overreaction coming.’

The problem with that goes back to the key principle not typically on the ECB’s formal list of principles, namely data-dependence. Obviously, gradualism and data-dependence have the potential to conflict, as this person readily acknowledged.

‘At the same time of course, if you start to see more inflation pressure, especially persistent pressure in the coming years, then you need to react faster’, he said. ‘And maybe with bigger steps.’

It was ‘absolutely’ the case that one could interpret this to mean that the data-dependence is ultimately more important, he agreed. ‘This gradualism depends on the data in the end’, he said.