ECB’s Lagarde: Can Give Framework Guidance Under Shocks, But Not Forward Guidance

12 March 2025

By David Barwick – FRANKFURT (Econostream) - European Central Bank President Christine Lagarde on Wednesday said that while forward guidance was inconsistent with an environment of repeated shocks, the ECB could provide framework guidance involving greater clarity about its reaction function.

Speaking at the annual conference The ECB and Its Watchers, Lagarde said that expectations had been ‘swept aside in the last few years, and in the last few weeks in particular’, and called current uncertainty ‘exceptionally high’.

This uncertainty required unwavering dedication to price stability, which in turn implied agility in reacting to shocks and clarity about the ECB’s reaction function, she said.

In the new policy environment, shocks could have a more direct impact on inflation in the euro area, which was ‘highly exposed to some of the new types of shock’, she said.

In this connection, Lagarde cited trade fragmentation, energy and other commodity prices, and exchange rates.

If the shocks became larger, the inflation impact could be more enduring, she said. ECB research indicated a propensity to overreact to big shocks and underreact to smaller ones, she said.

‘If such state-dependent pricing becomes standard when the economy is hit by large shocks, but the frequency of wage-setting remains below that of price adjustment, we could see inflation becoming more persistent’, she said. ‘Large shocks would lead to a faster pass-through to inflation, and then wages would have to catch up with prices in a staggered way.’

The ECB’s current symmetric price stability target had worked well under high inflation, but it was impossible under present circumstances to maintain inflation permanently at 2%, she said.

The ECB must therefore set policy to ensure that inflation ‘is always converging back towards 2% over the medium term’, independent of shocks, she said.

One implication of this was that the ECB’s reaction function in the new normal would need to focus on close observation of inflation expectations, she said.

With expectations having been firmly anchored, the ECB would also have to assess ‘how the current environment affects the optimal policy reaction to different type of shocks’, she said.

A steepening of the Phillips curve under conditions of higher inflation should make it easier for monetary policy to subdue inflation with a low sacrifice ratio, she said.

‘This would weaken one of the main rationales for “looking through” large supply shocks’, she said.

‘All told, simple policy prescriptions will not be appropriate in the environment we now face’, she said. ‘Within a well-articulated strategy and an unwavering commitment to price stability, we will need to retain agility to respond to complex circumstances as they arise.’

The recent period had taught that forward guidance was less appropriate under increasing uncertainty about the kind of shocks hitting the economy, she said.

In general, therefore, there could be no precommitment to a particular rate path under such uncertainty, as this would make it difficult for policy to readjust rapidly to changes, she said.

However, the ECB can ‘clarify how we are likely to be affected by different states of the world’, in which context she observed increased reliance on scenario analysis and sensitivity analysis as well as the traditional discussion of how risks are balanced.

The ECB could also make clear what data it will base its decisions on, ‘which helps the public to distinguish signals from noise’, she said.

Clarity regarding the ECB’s reaction function, she said, amounted to ‘framework guidance – i.e. a type of guidance that comes from the discipline implicit in a monetary policy framework – without pre-committing to any particular rate path, as the latter would excessively constrain agility.’