ECB’s de Cos: Impact of Monetary Policy Still a Downside Growth Risk; Disinflation ‘Fairly Advanced’

1 May 2024

By David Barwick – LONDON (Econostream) – The ongoing transmission of European Central Bank monetary policy could result in weaker-than-expected economic growth, according to Governing Council member Pablo Hernández de Cos on Wednesday.

In a wide-ranging speech at the London School of Economics, de Cos, who heads Banco de España, offered no specific prognosis for ECB interest rates, but confirmed that euro area disinflation was continuing.

Disinflation in Europe was ‘fairly advanced but has yet to be completed’, he said. ECB forecasts implied that price pressures would continue easing, albeit unevenly across time, restoring price stability in the middle of next year, he said.

'All in all, we are increasingly confident that we are on the right track to achieve our 2% inflation target relatively soon', he said.

Evidence suggested that ‘a stronger-than-expected monetary policy impact remains a downside risk to the euro area growth outlook, which, in turn, is an important factor behind our assessment that the risks to the inflation outlook are now balanced’, he said.

Prospects for growth this year were ‘relatively weak’, he said. At the same time, the trade-off of reducing inflation from the perspective of the real economy has been limited, he noted. That was also the case, and yet more strangely so, in the US, he said.

With respect to the euro area, well-anchored inflation expectations were significantly responsible for this phenomenon, he said, in contrast to the experience of the shocks of the 1970s.

‘All in all, in my view, the recent inflationary episodes vividly illustrate the crucial importance for central banks of acting and communicating in a way that keeps inflation expectations well anchored to their objectives in the face of inflationary shocks’, he said.

De Cos highlighted the optionality, gradualism and flexibility of the ECB’s approach to monetary policy as appropriate to the circumstance of elevated uncertainty. Monetary policy should not be rendered incapable of acting by an uncertain environment, and should rely on a risk-management approach, he said.

That argued for consideration of scenarios aside from the baseline forecast, and for modelling developments under alternative assumptions, he said.

In view of the uncertainty to which estimates of r* were subject, research supported an ‘inertial’ policy rate, meaning that ‘the previous rate should serve as the primary reference point, largely replacing the natural rate, with adjustments made based on inflation and estimated output gaps’, he asserted.

This approach supported setting monetary policy by means of ‘gradual adjustments in the policy rate, driven solely by estimated gaps, thereby promoting a data-dependent approach’, he said.

Moreover, when they make known their policy decisions, central banks ‘gain valuable insight into whether they have surprised financial markets and, if so, the extent to which these surprises impact expectations of inflation and economic activity’, he said.

Studying these market signals in response to policy announcements ‘often proves to be the most effective tool for assessing the stance of monetary policy’, he said.

De Cos called on fiscal authorities to refrain from contributing to price pressures and thus potentially inducing tighter monetary policy. Governments should thus wind down measures instituted to mitigate the energy crisis, he said.

‘This would alleviate demand-driven inflationary pressures and avoid a more forceful monetary policy response’, he said.

In other comments, de Cos said that as QT progresses and excess liquidity dries up, the central bank must identify what kinds of investors are buying the additional bonds now on the market.

‘Likewise, it will be essential to ensure that reserves remain ample at the endpoint of the QT process, as otherwise the impact of QT may be larger and the risk of liquidity events may increase’, he said.