At the end of October, the ECB maintained the status quo on key interest rates. Christine Lagarde then clarified that a reduction, or even the possibility of it, was “totally premature”.
For any action, credibility is essential. It makes it easier to achieve the desired objective because everyone thinks that the person who acts is trustworthy. In the appropriateness of the desired goal. In the determination to achieve it. Likewise in the judicious choice of the means. This is the case both in business management and in politics and obviously in monetary policy as well. However, there are paradoxes in this subject which in no way contradict the principle stated here, but which make it more complex.
The first lies in the fact that central banks, by showing their credibility in the 90s and the first half of the 2000s, both in obtaining regular economic growth and low inflation (aided by globalisation and the digital revolution), consequently considered that a long period of regular growth and controlled inflation should simultaneously induce financial stability id est : a reasonable increase in asset prices (stocks and real estate), and a stable level of indebtedness of economic players.
However, the financial crisis of 2007-2009 clearly showed that long term interest rates too low for too long- relative to the growth rate – easily led to financial bubbles. Therefore the credibility of central banks must henceforth go beyond this first paradox. It must be exercised simultaneously aiming at these three objectives: balanced growth, controlled inflation and financial stability. Even if it is far from easy to make these three objectives compatible in the short term, in the medium to long term, however, it is much more effective in terms of growth to not neglect any of them.
There is a second paradox that central banks face currently. The more credible they are in their desire to not allow an inflationary regime to take hold, the more easily and quickly inflation expectations, both of households and businesses, converge towards the aim pursued, therefore the more effective the monetary policy is. The ability of central banks to bring inflation back to the desired level is in fact due to the impact on the level of demand of the increase in their key rates – thus impacting long-term rates – but also, through their credibility, in maintaining the anchoring of expectations on the desired inflation target. Otherwise, the drift in expectations leads to an indexation of prices on prices, of wages on prices and of prices on wages.
So where does the paradox come from? This credibility, so necessary and so useful, can however lead the financial markets, anticipating the success of the central banks’ fight against inflation, to push long-term interest rates to lower levels too soon, thwarting the effect of the rate weapon’s fight against inflation. Likewise, as soon as they think that the central banks have completed the upward cycle of their key rates they immediately lower long-term rates. However, historically monetary policies slackened prematurely have often led to significant and very damaging subsequent rebounds in inflation. Hence what we are currently seeing in the announcements from the central banks: affirming that they are not about to lower their rates, or even that they can still increase them if necessary. Central banks are thus showing their determination to not weaken their position prematurely for the objective reasons mentioned above, equally through the necessity of a tactical game with the markets. They must in fact not let them believe that the battle is won in advance, despite their credibility . In fact, in the short term, and as long as underlying inflation remains too high, only a severe economic-financial crisis could lead central banks to modify their announcements and their policy.
These paradoxes show, among other things, that monetary policy is as much a science as it is an art.