ECB’s Schnabel: Must Consider Full Risk Distribution; Fall in Real, Risk-Free Rates Could Thwart Us

31 August 2023

By David Barwick – FRANKFURT (Econostream) – High uncertainty about the medium-term outlook means the European Central Bank has to consider the full distribution of risks, ECB Executive Board member Isabel Schnabel said Thursday.

In a speech at a conference organised by the ECB, Schnabel did not directly address the choice facing the ECB at its upcoming monetary policy meeting, from which either a pause or a renewed hike is expected to emerge, but noted that the retreat of real risk-free rates across the gamut threatened to thwart the timely restoration of price stability.

She endorsed the ECB’s data-dependent approach as being appropriate given uncertainty about how quickly inflation would subside, arguing that this approach allowed policy to adjust to economic developments in the context of an unprecedentedly steep tightening cycle.

The ECB would at each meeting ‘assess whether the impact of the cumulative tightening on the future path of inflation is sufficiently strong to ensure a sustained and timely return of inflation to our 2% target, or whether the pace of disinflation is too slow for us to be confident that our current monetary policy stance can provide medium-term price stability’, she said.

Robust decisions imply taking into account ‘the entire distribution of risks’, not merely the central inflation scenario, she said. Despite the decrease in forecast error size, the medium-term outlook is still subject to great uncertainty, evidenced by the ECB’s survey of professional forecasters, she said.

The materialisation of upside risks such as high unit labour cost growth or new supply-side shocks could sustain inflation at a high level for longer or even lead to a resurgence, she said.

On the other hand, monetary policy’s impact could turn out to be stronger than expected, she said.

‘On net, respondents in our survey of professional forecasters judge that the balance of risk for inflation in 2025 remains tilted to the upside’, she said. ‘Moreover, respondents also see upside risks to inflation over the longer term. The distribution of inflation expectations for 2028 continues to show a fat right-hand tail, with a significant probability for inflation outcomes being above 2.5%. Option prices in financial markets also suggest upside risks to the longer-term inflation outlook.’

These and other risks would figure in the Governing Council’s deliberations, she said, and if policy is not seen as being in line with the timely restoration of price stability, then ‘a further increase in interest rates would be warranted.’

‘In an environment of tight labour markets and structural inflationary headwinds, this would also insure against the continued elevated risk of inflation remaining above our target for too long’, she added.

Were the ECB to decide that disinflation is taking place appropriately, then ‘we may afford to wait until our next meeting to gather more evidence on how the slowdown in aggregate demand will feed through to price and wage-setting over time’, she said.

Monetary policy’s data-dependency excludes predicting where interest rates would peak or the duration of restrictiveness, she said.

There can also be no precommitments, ‘meaning we cannot trade off a need for a further tightening of monetary policy today against a promise to hold rates at a certain level for longer’, as this could be time-inconsistent, she said.

‘Ultimately, the incoming data may well prescribe holding rates at restrictive levels over a significant period of time’, she said.

Moreover, how restrictive rates need to be would also depend on expectations, given the importance for consumption and investment of real rather than nominal rates, she said.

‘The past few weeks have highlighted the pertinence of this consideration’, she said, what with real risk-free rates now back at February’s level.

‘This decline could counteract our efforts to bring inflation back to target in a timely manner’, she warned.