Mario Draghi's Mixed Messages
Europe’s central banker doesn’t need to always placate investors, but he can better clue them in.
By Richard Barwell
The European Central Bank’s policy decision last week took financial markets by surprise. The cut in the already negative deposit rate and extension of its asset-purchase program to 2017 would normally have been understood as a stimulus. However, investors had expected deeper rate cuts and bigger monthly asset purchases. As investors abandoned those expectations, market interest rates rose and the euro appreciated. The ECB effectively tightened financial conditions despite announcing an easing package.
Investors blamed the ECB for this misunderstanding. That’s unfair. People like me are employed to listen to what central banks say and forecast what they will do. We take the credit when we get it right, so we must take the blame when we get it wrong. In retrospect, we clearly misinterpreted the signals the ECB had sent about its assessment of the economy and its appetite for taking decisive action to restore price stability.
Comments by ECB President Mario Draghi and Chief Economist Peter Praet and the official account of the October policy meeting led many investors to conclude that the ECB was concerned about the inflation outlook. Mr. Praet recently described the risk of a possible deanchoring of inflation expectations in an economy in which there is still considerable slack as a “dangerous cocktail.”
Policy makers appeared to believe that the much-anticipated recovery in inflation would be further postponed and they no longer seemed willing to dismiss the possibility of full-blown deflation. When Mr. Draghi said that the ECB wouldn’t “ignore the fact that inflation has already been low for some time” and wanted to feel “suitably confident” that inflation will “stabilize around levels close to 2%” and that “we will do what we must to raise inflation as quickly as possible” in a recent speech, many ECB watchers concluded the central bank was shifting into risk-management mode. The policy board would err on the side of doing too much and overshooting its inflation target rather than doing too little and allowing deflation to take hold.
We in the markets were wrong. The ECB is still in business-as-usual mode. We were looking for a policy response you could legitimately describe as decisive. Instead, what we got was described by Mr. Draghi as “adequate.” With the benefit of hindsight it appears we put too much faith in Mr. Draghi’s powers of persuasion, in his ability to convince a sufficient number of his colleagues that the only safe plan for the ECB was the brave plan.
That said, while investors learn lessons about how to interpret the ECB, the ECB has lessons to learn about communicating with markets. The last thing the ECB needs right now is for the market to misunderstand its motives. If investors start questioning whether the ECB can do enough—fast enough—should the situation deteriorate, then financial conditions could tighten, complicating the pursuit of price stability. If investors erred in reading too much into central bankers’ statements, the central bank erred in leaving too much ambiguity.
The ECB needs to do a better job matching words and deeds. The ECB isn’t obliged to validate market expectations. It must do what it thinks is right. If policy decisions shock and surprise investors, so be it. However, the ECB should avoid encouraging investors to expect one thing if it intends to deliver another.
If you don’t plan on raising inflation as quickly as possible, then don’t suggest that you are required to do precisely that. If you don’t plan on increasing the pace of bond purchases except under dire circumstances, then don’t suggest that you are contemplating upping the pace.
One way to do this would be to publish a detailed road map of how the ECB expects the future to unfold. The ECB’s governing council, which sets rates and approves other measures, should publish a plan each quarter describing how it expects the economy to evolve and how it plans to adjust the stance of monetary policy in response.
The current plan would describe the expected size, composition and duration of its asset-purchase program, known as quantitative easing, and when interest rates are expected to rise.
The road map should also describe why, when and how the plan could change. For example, the council could describe some circumstances under which it would consider increasing the pace of asset purchases or cutting rates further.
Policy makers at the ECB also need to be more mindful of speaking with one voice. There is clearly a debate on the governing council about the appropriate conduct of policy. Mr. Draghi appears to be trying to influence that debate by making the case in public for his preferred policy options. The market understands this and puts its faith in Mr. Draghi’s message on the assumption that he gets what he wants.
That rule of thumb failed this month. Next time, perhaps Mr. Draghi and his lieutenants on the Executive Board would be better served by first winning the internal battle among members of the council before publicly signalling a likely change in monetary strategy. It would be best if we could hear the full range of views on the council. However, it might not be wise for council members to openly debate whether the ECB’s remit really requires them to do whatever it takes to raise inflation as quickly as possible, or to expose the limits of Mr. Draghi’s power of persuasion, so long as inflation expectations remain fragile.
Central bankers have struggled for much of the past decade to find better ways to communicate with markets, as with various experiments in so-called forward guidance and the like. Last week showed how much room the ECB has for improvement. No one should expect, or even necessarily desire, that investors and central bankers will always be perfectly attuned to each other. But nor is it healthy for the ECB to allow such a wide divergence to develop between what markets think it will do and what it’s prepared to announce.
Mr. Barwell is a senior economist at BNP Paribas Investment Partners.
Investors blamed the ECB for this misunderstanding. That’s unfair. People like me are employed to listen to what central banks say and forecast what they will do. We take the credit when we get it right, so we must take the blame when we get it wrong. In retrospect, we clearly misinterpreted the signals the ECB had sent about its assessment of the economy and its appetite for taking decisive action to restore price stability.
Comments by ECB President Mario Draghi and Chief Economist Peter Praet and the official account of the October policy meeting led many investors to conclude that the ECB was concerned about the inflation outlook. Mr. Praet recently described the risk of a possible deanchoring of inflation expectations in an economy in which there is still considerable slack as a “dangerous cocktail.”
Policy makers appeared to believe that the much-anticipated recovery in inflation would be further postponed and they no longer seemed willing to dismiss the possibility of full-blown deflation. When Mr. Draghi said that the ECB wouldn’t “ignore the fact that inflation has already been low for some time” and wanted to feel “suitably confident” that inflation will “stabilize around levels close to 2%” and that “we will do what we must to raise inflation as quickly as possible” in a recent speech, many ECB watchers concluded the central bank was shifting into risk-management mode. The policy board would err on the side of doing too much and overshooting its inflation target rather than doing too little and allowing deflation to take hold.
We in the markets were wrong. The ECB is still in business-as-usual mode. We were looking for a policy response you could legitimately describe as decisive. Instead, what we got was described by Mr. Draghi as “adequate.” With the benefit of hindsight it appears we put too much faith in Mr. Draghi’s powers of persuasion, in his ability to convince a sufficient number of his colleagues that the only safe plan for the ECB was the brave plan.
That said, while investors learn lessons about how to interpret the ECB, the ECB has lessons to learn about communicating with markets. The last thing the ECB needs right now is for the market to misunderstand its motives. If investors start questioning whether the ECB can do enough—fast enough—should the situation deteriorate, then financial conditions could tighten, complicating the pursuit of price stability. If investors erred in reading too much into central bankers’ statements, the central bank erred in leaving too much ambiguity.
The ECB needs to do a better job matching words and deeds. The ECB isn’t obliged to validate market expectations. It must do what it thinks is right. If policy decisions shock and surprise investors, so be it. However, the ECB should avoid encouraging investors to expect one thing if it intends to deliver another.
If you don’t plan on raising inflation as quickly as possible, then don’t suggest that you are required to do precisely that. If you don’t plan on increasing the pace of bond purchases except under dire circumstances, then don’t suggest that you are contemplating upping the pace.
One way to do this would be to publish a detailed road map of how the ECB expects the future to unfold. The ECB’s governing council, which sets rates and approves other measures, should publish a plan each quarter describing how it expects the economy to evolve and how it plans to adjust the stance of monetary policy in response.
The current plan would describe the expected size, composition and duration of its asset-purchase program, known as quantitative easing, and when interest rates are expected to rise.
The road map should also describe why, when and how the plan could change. For example, the council could describe some circumstances under which it would consider increasing the pace of asset purchases or cutting rates further.
Policy makers at the ECB also need to be more mindful of speaking with one voice. There is clearly a debate on the governing council about the appropriate conduct of policy. Mr. Draghi appears to be trying to influence that debate by making the case in public for his preferred policy options. The market understands this and puts its faith in Mr. Draghi’s message on the assumption that he gets what he wants.
That rule of thumb failed this month. Next time, perhaps Mr. Draghi and his lieutenants on the Executive Board would be better served by first winning the internal battle among members of the council before publicly signalling a likely change in monetary strategy. It would be best if we could hear the full range of views on the council. However, it might not be wise for council members to openly debate whether the ECB’s remit really requires them to do whatever it takes to raise inflation as quickly as possible, or to expose the limits of Mr. Draghi’s power of persuasion, so long as inflation expectations remain fragile.
Central bankers have struggled for much of the past decade to find better ways to communicate with markets, as with various experiments in so-called forward guidance and the like. Last week showed how much room the ECB has for improvement. No one should expect, or even necessarily desire, that investors and central bankers will always be perfectly attuned to each other. But nor is it healthy for the ECB to allow such a wide divergence to develop between what markets think it will do and what it’s prepared to announce.
Mr. Barwell is a senior economist at BNP Paribas Investment Partners.
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