Christine Lagarde, President of the ECB. (credit: BCE)
Before the FED, whose decision on interest rates is expected on Wednesday December 18, the ECB reduced its main rate by 25 basis points to 3%. For Christian de Boissieu, the European Central Bank is showing excessive caution in the face of the degraded economic context.
The ECB has just lowered its key rates again, the third time since last June. Thus, the rate of deposit facilities, the main reference of the central bank – which represents the rate used on the excess reserves of banks in the zone – increased during the period from 4% to 3%.
Few analysts criticize the ECB for doing too much. The slowdown in inflation and growth justifies this relaxation of rates, after their sudden increase in the face of accelerating inflation during the 2021-2023 period. In recent months, the ECB has respected the letter and spirit of the mandate entrusted to it by the Treaties: to contribute to general economic policy once the primary objectives of monetary policy have been achieved and ensured, namely monetary stability and financial stability.
The debate is different. With a step of 0.25 (25 basis points) last week, is the ECB doing enough? It can justify the gradualism of its policy, and therefore its prudence, by several arguments which reflect the implementation of a sort of precautionary principle on the part of the central bank. First, the fight against inflation has not yet been won. Given the high geopolitical tensions, we remain at the mercy of a new energy shock. Furthermore, certain sectors and certain occupations under pressure have experienced significant increases in nominal and real wages, and inflation in services is resisting the slowdown.
Secondly, even if the ECB does not set a target for the euro exchange rate, it monitors the evolution of the latter. The dollar has gained ground in recent weeks, with the election of Donald Trump. Without forgetting that the Fed’s key rate (the federal funds rate) is higher than the deposit facility rate in the euro zone, and will remain so even if the Fed decides this week to lower it again. The ECB is undoubtedly inclined not to cause too significant a decline in the euro against the dollar, which would complicate the fight against inflation.
The ECB’s caution can also be explained by the persistence of excessive public deficits, in France of course but not only. Even if the bad economic situation calls for a sufficiently expansive “policy mix” (currency, budget), there are thresholds that must not be exceeded.
During last Thursday’s press conference, the President of the ECB, Christine Lagarde, mentioned the discussion at the Governing Council of a jump of 50 basis points (the deposit facility rate then returning to 2.75 %). A debate which, ultimately, resulted in a unanimous decision in favor of 25 basis points.
Excessive caution
Despite the previous arguments, the ECB’s caution appears excessive while the euro zone economy is faltering. Given the time limits for monetary policy action, generally more than a year for a relaxation of rates to produce all its effects, it is now, and not in six months, that the ECB, now reassured of the fact that its objective of 2% inflation per year has every chance of being achieved, must make its contribution to the revival of activity (consumption and investment) and employment. So a 50 basis point jump last week would have been better.
ECB officials have suggested that there will be further reductions in key rates in 2025, without specifying the timetable or the extent. Wise precaution: the central bank must be pragmatic, it must be able to react to the most recent information on inflation, activity and employment, the health of the banks… How quickly to return next year to the rate of “neutral” interest? This rate is not observable. It represents the balance and tipping point between an expansive monetary policy and a restrictive policy. Calculated from theoretical considerations and models, it gives rise to necessarily approximate estimates. The ECB places it in a wide range, between 1.7% and 2.5%. The Fed is talking about a rate of around 3% for the United States.
For the euro zone, a neutral rate around 2% has a double meaning: 1/ It indicates that there are still approximately 100 basis points for the ECB to reach it in 2025, in two or three movements. But, if the economic situation in the euro zone falters while inflation remains under control, nothing prevents the ECB from setting the rate of deposit facilities below the neutral rate for some time. 2/ With inflation close to 2% per year, a neutral rate of 2% corresponds to a short-term real rate (excluding inflation) close to 0%. An observation which makes it possible to avoid frequent confusions these days: this neutral rate is very different from the “natural” interest rate (for example, among the Swedish economist Knut Wicksell at the beginning of the 20th century) which ensures the adjustment between savings and investment. Let us be wary of too rapid comparisons and assimilations!
Christian de Boissieu
vice-president of the Circle of Economists
Professor Emeritus at the University of Paris I Panthéon-Sorbonne
