ECB’s Panetta: Shouldn’t Take a One-Sided View of Risks as We Calibrate the Policy Stance

3 November 2022

By David Barwick – FRANKFURT (Econostream) – European Central Bank Executive Board member Fabio Panetta on Thursday gave a carefully worded defence of a slower pace of monetary policy normalisation.

In a speech at the ECB Money Market Conference, Panetta conceded that ‘the medium-term inflation outlook presents clear upside risks in a general context of extraordinary uncertainty about the future evolution of the European economy.’

Though ‘[a] further policy adjustment is warranted in order to keep inflation expectations anchored and stave off second-round effects,’ he agreed, ‘the calibration of our stance should not rely on a one-sided view of risks’, especially under high uncertainty.

Price stability should be restored ‘as soon as possible, but not sooner’, he said, as being too fast could ‘create unintended effects, achieving little reduction of inflation in the short term, but causing excessive market volatility and a protracted economic slowdown beyond what is necessary to stabilise inflation in the medium term.’

The neutral rate is for various reasons of little help, he said. The endpoint of normalisation is unknown, a more useful concept being the ‘target-consistent terminal rate’, he said, defined as ‘the level of the policy rate that − if reached at the end of a short normalisation phase and then held constant − stabilises inflation at target by the end of the policy-relevant horizon in the absence of new shocks.’

The target-consistent terminal rate ‘emphasises that we can gear our policy to a clear state-contingent reference in order to bring inflation back to target within a clearly defined period.’ Estimates of this rate form part of the Governing Council’s monetary policy meetings, he said, though medium-term inflationary risks imply their continual reevaluation.

In this context, Panetta said that expectations had remained anchored and the risk of a wage-price spiral limited, with the outlook in line with the ECB’s goal. ‘But we need to remain extremely vigilant in view of prolonged high inflation, which increases the likelihood of a pass-through to wage growth, especially as labour markets are now tighter than before the pandemic’, he said.

On the other hand, ‘other forces may increasingly push in the opposite direction and contain the risk of second-round effects’, he continued, as lower real wages and purchasing power depress demand.

Monetary policy, he said, is thus confronted by the trade-off of anchoring expectations, which would imply aiming for a relatively high target-consistent terminal rate, and the need to ‘keep basing our decisions on the latest evidence and factor in downside risks to the economic outlook.’

Whilst public discussion has focused on concerns of failing to contain inflation, ‘this should not make us underappreciate the risk of doing too much’, he said. Panetta argued that the moves taken to date were still in the pipeline with respect to their real economic impact.

‘The debate should thus not be distorted by an excessive focus on short-run inflationary developments, which cannot be controlled by monetary policy’, he said. ‘The full impact of our measures will likely reach the economy when activity and inflation are already on a declining path. This implies that our tightening will need to end when inflation is still above our target.’

The effect of simultaneous monetary policy tightening in multiple jurisdictions also mattered for local policy, he said. ‘ECB analysis finds that a tightening by the Federal Reserve System generates spillovers to euro area real activity and inflation that are comparable to its effects on the US economy’, he said.

Moreover, an inappropriate pace of normalisation could have financial stability ramifications, he said.

Panetta urged that both policy moves and the associated communication ‘avoid amplifying market volatility’, and that frontloading, which he did not reject out of hand, ‘remain commensurate to the benefits and risks it creates.’ Surprising markets has limited value in the euro area in terms of expectations, he said.

‘And if these bigger-than-expected increases are interpreted as signalling a higher terminal rate, rather than simply frontloading the normalisation, we could have a stronger impact on financing conditions – and ultimately on economic activity – than intended’, he said.

The ECB should clearly define the sequence of normalisation, he said. Compared to official borrowing costs, the ECB has only a ‘limited understanding’ of the possible impact of quantitative tightening, he said.

The maturing of TLTROs and early repayments following last week’s Governing Council decision would in any case reduce the size of the ECB’s balance sheet, he said.

‘We should take the necessary time to assess the impact of our rate hikes and of phasing out the TLTROs’, he said. ‘As we normalise our monetary policy, we should expect bank lending conditions to tighten. What we need to avoid, though, is a sudden stop in the supply of credit to the broad economy.’

Reinvestment of maturing securities should be maintained until TLTRO repayments have been absorbed, he said. ‘And when considering how we would then reduce the size of our bond portfolios, a controlled reduction – whereby only redemptions above a cap are not rolled over – is preferable to active sales, which may unsettle markets in an already volatile financial environment’, he added.

Finally, Panetta advocated that liquidity be kept ample to keep money markets working smoothly, so that the ECB can ‘continue tightly steering money markets through changes in our deposit facility rate.’