By David Barwick – FRANKFURT (Econostream) – European Central Bank Governing Council member Olli Rehn said the ECB should retain forward guidance as a monetary policy instrument, arguing that the euro area's relatively low neutral interest rate leaves it more exposed than the United States to the effective lower bound, while warning against guidance that constrains policymakers' freedom of action.

In an opinion piece published Tuesday in the Financial Times, the Bank of Finland governor said the debate over the Federal Reserve's strategy and toolkit was relevant for the ECB, but that differences between the two economies meant the case for forward guidance remained stronger in the euro area.

"The ECB should preserve forward guidance as an instrument while not tying its hands unnecessarily," Rehn wrote.

He said current estimates put the euro area's equilibrium, or natural, real interest rate close to zero. Combined with the ECB's 2% inflation target, that implied a nominal neutral rate of around 2%, compared with estimates of roughly 3%-4% in the United States, he said.

The difference meant the Federal Reserve normally had more room to cut interest rates before reaching the effective lower bound, whereas the ECB had less conventional policy space, Rehn said.

"Forward guidance therefore retains particular value in Europe as a potential substitute for conventional rate cuts when monetary policy is constrained," he said.

Rehn, who participated in both the ECB's 2020-21 strategy review and its 2025 strategy assessment, said the experience of the years since the 2021 review had validated the core of the ECB's framework while also demonstrating the risks associated with overly prescriptive guidance.

The symmetric 2% inflation target and medium-term orientation had allowed the ECB to look through temporary shocks while responding forcefully when inflation became more persistent, he said. Forward guidance had meanwhile helped ease financing conditions during the preceding low-inflation period by influencing bond yields when policy rates were near their lower bound, he said.

Rehn said the possibility of the euro area returning to such circumstances should not be dismissed.

"We may still, one day, fall into the liquidity trap — there is no law of economics saying the lower-bound problem has disappeared for good," he wrote.

At the same time, he said the ECB's experience in 2022 showed the danger of allowing communication to turn into a rigid commitment. Earlier guidance had linked the start of interest-rate increases to the conclusion of net asset purchases, but the rapid acceleration of inflation ultimately forced the Governing Council to raise rates more aggressively than it had signaled shortly beforehand, he said.

"The lesson is that, in an uncertain economy, preserving freedom of action is not a communication failure but responsible policymaking," Rehn said.

He said that lesson had been incorporated more explicitly into the ECB's 2025 strategy assessment, which placed greater emphasis on risk management and scenario analysis.

"All instruments remain in the toolkit, but their choice and design should preserve agility," he said, describing this as a refinement rather than a rejection of the 2021 strategy.

Rehn also pointed to the ECB's 4.5-percentage-point increase in the deposit rate during 2022-23 as evidence that flexibility should not be confused with reluctance to act.

He said communication instruments would continue to evolve and that forward guidance would be appropriate in some circumstances but not others.

"But the objective is not negotiable: a firm commitment to stabilising inflation at 2% and the determination to deliver on it," Rehn said.