ECB Insight: Insiders Ready to Stop Labelling Monetary Policy ‘Restrictive’

13 February 2025

By David Barwick – FRANKFURT (Econostream) – With a March rate cut poised to bring the European Central Bank to within just one more cut of the range it defines as neutral, the ECB may three weeks from today also find the time right to revisit its language.

In this respect, there are at least two candidates for change, in our view, though these could involve more substantial modification of ECB communication than the word ‘two’ might suggest.

The candidate that has gotten the most attention is the variously worded assertion that, as expressed in the 30 January monetary policy statement and reinforced by ECB President Lagarde at the press conference, ‘monetary policy remains restrictive’.

Ever since 12 September, the statement has also included a reference to the ‘gradually fading effects of restrictive monetary policy’. The last hike was in September 2023, with monetary policy generally considered to operate with a lag of about a year and a half.

That would make March the month by which, with exceptions geographical and otherwise, the pass-through of previous policy tightening has in theory largely petered out: an appropriate moment to adapt to shifting circumstances.

The release of ECB research last Friday may have laid the groundwork. The paper confirmed nominal neutral as probably in a range of 1.75% to 2.25% but left no stone unturned in an effort to discredit the whole notion of neutral as any sensible guide to monetary policymaking.

The next step would be for the ECB to desist from indicating that current policy is restrictive, whether or not it is. Every such indication is fodder for the idea that some precise level at which interest rates delicately hover between accommodation and restriction is observable ex ante.

To the ECB’s annoyance, this conceptual level is in turn seen as a proxy for the terminal rate of the easing cycle, at least if the ECB doesn’t decide that it needs to end in accommodative territory.

Insiders Econostream spoke to agreed that underscoring the restrictiveness of policy may have made sense when the ECB’s monetary policy was so restrictive that the question of where it would no longer be was academic. This is no longer the case.

According to one agency, Executive Board member Isabel Schnabel two weeks ago already wanted to change the relevant language, but the attempt fell flat. One insider who spoke to Econostream disputed this, but either way, a discussion in March seems inescapable.

‘If the forecast materialises, we will be very close to the target by March or at most by mid-year’, this person said. ‘So then, obviously, there will be a point to changing the language. But that was not discussed.’

For this insider, a change in communication, and the discussion around it, was less a function of the distance from the neutral rate, which the ECB couldn’t pin down anyway, and more a matter of how far from its target the ECB was.

Indeed, when the ECB in December scotched its previous reference to rates being ‘sufficiently restrictive for as long as necessary’, Lagarde’s explanation was that ‘we are in a completely different environment. We are getting much closer to target.’

‘In December, inflation had already converged a lot, and the gap between projected inflation and our target was already small’, the insider commented. ‘In March, if things happen as expected, then the gap would be even smaller.’

Though the precise change of language, if any, would depend on information then available, the result could see ‘restrictive’ modified by a qualifier like ‘less’ or ‘mildly’, but likelier was that all reference to being currently restrictive would fall by the wayside, he said.

Another insider questioned whether characterising policy as restrictive was even ‘a necessary concept in in our communication.’ The problem, he said, was that ‘it gives the impression about where we see not only the neutral rate, but also the terminal rate in this rate cycle.’

The fixation on a neutral level was ‘not helping our communication, because people seem to misinterpret the meaning of that or the consequences we draw from it’, he said.

Though reasonable at an earlier stage of the cycle, at this point ‘one should probably just drop that wording’, he said. ‘It's creating confusion rather than giving guidance. So, why have it there?’

A second potential candidate to our mind for possible language modification is the reassurance that there is no doubt as to the direction of interest rates.

At the last press conference, Lagarde said that ‘under the baseline that we have and with the data that we have received, we can comfortably indicate that we are directionally on this downward slope, the pace and sequence of which will be determined by data and will be decided on a meeting-by-meeting basis.’

Pronouncements about the direction being clear are probably less likely than the reference to restrictiveness to undergo change. If one understands ‘direction’ to mean merely ‘bias’, as one insider suggested, then taken together with Lagarde’s various qualifiers, the statement could still have some life in it.

And yet, it didn’t help that Executive Board member Piero Cipollone last Thursday declined even to affirm the likelihood of a March cut, saying, ‘I don’t want to seem elusive, but the uncertainty is so high that anything can happen.’

One could have a view as to what would happen in March, one insider conceded. Further out, not so much.

‘I cannot see anything beyond March’, he said. ‘Nothing. Nothing at all. So many things can change in both directions. For me, the point is in both directions.’

‘Uncertainty is huge’, another insider said, echoing a comment by ECB Vice President Luis de Guindos last week, ‘but having said that, we are more confident than we’ve been in a while that we are on the path of disinflation.’

The previous insider also expressed growing confidence in the disinflation process, observing that some inflation measures had been surprising to the downside of late. This was despite the fact that higher oil and gas prices were ‘already exerting some upward pressure’, he said.

‘The key message here is that the December forecast is pretty much materialising, with some small tendencies to deviate in one direction or the other’, he said.

However, confidence in disinflation in part reflected disappointment about the economy, he said. ‘The most recent hard data clearly pointed to the downside’ in this respect, he commented.

Similarly, another insider said that the economy was going through a difficult patch and that he didn’t expect significant improvement anytime soon.

However, insiders agreed that services inflation and wages were confirming the return to price stability.

‘For at least the last six months, we have been getting it right with services inflation, which is even lower than we were expecting’, one insider said. ‘This is one thing that gives us comfort.’

There was reason to expect this to continue, he said. Importantly, base effects with respect to services prices should materialise as soon as this month, making February and March spot inflation of particularly high interest, he said.

These favourable base effects would be flanked by an expected deceleration of wages and the associated reduction in demand for services, he said.

Moreover, with respect to possible tariffs, in the words of one insider, ‘the implications for inflation are not massive in the central scenario’, as the effects of weaker growth and a weaker currency should more or less cancel each other out in Europe.

Though there was plenty of uncertainty about how different scenarios would play out in the real world, models indicated ‘no big impact’ on euro area inflation unless the tariffs were assumed to be very high, he said. This was the case whether tariffs were one-sided or Europe retaliated.

For such reasons, insiders saw the risk that the ECB would drive inflation to below its target as having risen just in the last few weeks, after having previously been more or less balanced.

In this context, one insider asked rhetorically what would cause declining inflation to stop falling at 2%. There was nothing in the slightest automatic about such an outcome, he said.

Whilst always underscoring the great uncertainty now prevailing, insiders thus voiced no objections to current market expectations of further back-to-back rate cuts.

‘If things don't change, if there is no escalation of the trade conflict and no major disruption on energy markets, if the economy doesn’t fall off a cliff and if inflation maintains its current trend, then market pricing is not unreasonable’, one insider said. ‘Because that's the pricing embedded in our December projections.’

Another insider agreed, remarking that ‘if the path is getting confirmed month after month, then I think the baseline is clear.’