ECB’s Lagarde: To Continue to Set Rate Path Based on Tripartite Reaction Function

14 June 2024

By David Barwick – DUBROVNIK, Croatia (Econostream) – The European Central Bank will continue to set monetary policy based on its current three-pronged reaction function, ECB President Christine Lagarde said Friday.

In a dinner speech during the Dubrovnik Economic Conference, Lagarde observed that since March 2023, the ECB’s reaction function had been built on the inflation projections, underlying inflation dynamics and policy transmission strength. This had been flanked by greater reliance on scenario analysis as a way of assessing the distribution of risks, she said.

‘This framework served us well in calibrating when to stop raising rates, how long to hold them constant and, most recently, when to start cutting them’, she said. ‘And for the time being, we will continue to use it to set the rate path in an uncertain environment.’

Recent experience had shown policy could not be predicated solely on forecasts, she said, noting that sometimes the latest spot readings of inflation had most accurately signalled inflation ahead. However, with the passage of major shocks, projections grew more reliable again, she said.

‘In 2023, for example, we saw a reduction of about 70% in the average absolute error in our staff projections relative to 2022, one quarter ahead’, she said. ‘Relying too much on current data in this setting would have been equally misguided and led to policy falling behind the curve.’

Policymakers however cannot invariably realise which regime would best serve them, particularly when policy is near an inflection point, she said. Nor can they constantly change the data guideposts, she said.

‘For inflation expectations to remain anchored in an environment of structural changes and less quantifiable shocks, people need to be able to broadly predict our reaction function and know what developments we will tolerate and what we will not’, she said.

Future policy frameworks will thus need to include forward-looking as well as current-looking elements, she said.

‘We need forecasts of the medium term, but we also need to be alert to the fact that available models have been “educated” using data from previous structural regimes that may no longer be valid’, Lagarde explained. ‘So, analysing current data and identifying persistent components allows us to account for structural changes and forecast the future in a more robust way.’