ECB’s Schnabel: Short-Term Rates ‘Remain the Instrument of Choice in Most Circumstances’

14 November 2024

By David Barwick – FRANKFURT (Econostream) – Central banks should prioritise measures that can be easily undone to react promptly to altered circumstances, implying the continued primacy of short-term rates, European Central Bank Executive Board member Isabel Schnabel said Thursday.

In remarks at the 25th Jacques Polak Annual Research Conference in Washington, Schnabel, according to a text made available by the ECB, said that ‘the fight against inflation has not yet been won, with domestic price pressures remaining high’. She otherwise spoke in general terms about the need for monetary policy to be agile.

Central banks were now operating under ‘more uncertain and more volatile’ conditions, she argued. For example, she said, whereas pre-pandemic inflation had been stably low for years also because economic shocks had been generally disinflationary, the opposite may now be the case.

Moreover, r* had apparently risen in recent years, but its level was now more unclear, meaning that ‘central banks need to be prepared for all scenarios’, she said.

A third change in the macroeconomic environment was the less flat, more state-dependent slope of the Phillips curve, suggesting the potential for major shocks to affect economies rapidly, she said.

As not all monetary policy instruments could be deployed and unwound equally quickly to respond to circumstances apt to change more quickly than in the past, it was appropriate for central banks to choose carefully what tools to use preferentially, she said.

Interest rates ‘clearly pass the agility test’, she said, pointing to the speed with which recently higher borrowing costs had dampened inflation. Though controversial, in the vicinity of the zero lower bound negative rates in particular ‘can be a powerful instrument’ easily undone, she said.

‘Short-term interest rates therefore remain the instrument of choice in most circumstances’, she said.

Asset purchases, on the other hand, ‘need to be used more cautiously and selectively’, she said. However, for financial stability purposes, they ‘need to remain part and parcel of central banks’ toolkits’, she said, especially in the euro area, being susceptible to fragmentation.

Asset purchases made for the sake of economic stimulus via lower long-term borrowing costs were another matter, she said, as the large volumes involved entailed ‘significant costs’ and resisted being quickly unwound.

‘[T]he bar for starting QE should be higher than in the past’, she said. ‘There needs to be a clear threat to medium-term price stability for central banks to activate large-scale asset purchases.’

If confronted again by the effective lower bound, the use of QE should be preceded by a careful cost-benefit analysis, she said. Other instruments, including targeted longer-term refinancing operations (TLTROs) used by the ECB, might be preferable, she suggested.

Finally, Schnabel said that ‘forward guidance must not excessively tie policymakers’ hands’, this tool being appropriate only ‘when the risk of central banks having to renege on previous commitments is limited.’

That was not the case in a more volatile and uncertain world in which ‘forward guidance almost mechanically implies that central banks either take the risk of falling behind the curve or take a course of action that is inconsistent with their previous guidance’, she argued.

Forward guidance was thus now of only ‘limited use’, and even if stably low inflation one day returned, central banks should convey their monetary policy expectations in a manner that is conditional on economic developments.

‘Importantly, the conditions should be formulated in a qualitative rather than a quantitative manner to account for the uncertainty around the inflation and economic outlook’, she added.