Can the ECB really stop at the “neutral” rate?

As the European Central Bank raises interest rates to control inflation, a key debate is whether it can stop at a so-called “neutral” level or whether it would still need to cool the economy even if it is headed for recession.

While “neutral” has become something of a buzzword for policymakers and ECB watchers alike, it is a cryptic concept and its precise level is elusive, threatening to confuse an already complex.

WHAT IS A “NEUTRAL” RATE?
The neutral rate is one that neither stimulates nor slows growth, bringing the output of the overall economy back to its potential while stabilizing inflation.

There is a catch: it is “unobservable”, it is the language of the central bank because no one really knows its exact level. There are countless estimates, but this is essentially a theoretical rate and known only after the fact, potentially years later.

What is certain is that the neutral has been on a downward trend for decades, mainly due to the euro zone’s low potential growth rate, its aging population and weak productivity gains.

WHAT IS ECB NEUTRAL?
Few policymakers will put a number on it, but two have recently dared to publicly guess and even raised their estimates, putting the neutral rate well above the current deposit rate of 0.75%.

The head of the French central bank, François Villeroy de Galhau, now puts the rate below or near 2% compared to his previous estimate of 1% to 2%. The head of the Greek central bank, Yannis Stournaras, meanwhile raised his estimate to “around 1.5%, even 2%”, from 0.5% to 1.5%.

Market economists also tend to put it between 1.5% and 2%, making it one of the lowest neutral rates among major economies.

Societe Generale sees the ECB neutral at 1.5%, albeit “with little conviction”, while evaluating this rate at 2.15% in the United States, 2.5% in the United Kingdom and 1.75% in Swiss. At 1%, Japan’s rate is the lowest.

Another complication is that the economic upheavals of the past three years, from the pandemic to supply shortages and Russia’s war in Ukraine, are pulling the neutral rate in opposite directions, making it even less predictable.

Deutsche Bank argues that the energy shock could reduce the bloc’s growth potential and thus create a drag on the neutral rate.

“On the other hand, higher energy investment needs and a weaker current account suggest a shift in the investment-savings balance that could push (the neutral rate) up,” he said in a note.

Taking a contrary view, Michael Schubert of Commerzbank argues that the ECB significantly underestimates neutrality, which increases the risk of a policy error.

“Therefore, there is a danger that the ECB will normalize monetary policy too slowly or end the process too soon, so that inflation persists above the longer-term 2% target,” he said. he explained.

IS NEUTRAL EVEN ENOUGH?
Probably not. Policymakers started talking about the need to go beyond neutral and there was a rapid upward shift in market expectations.

Investors now see the terminal rate, or the peak of the cycle rising above 2.5% next spring after a steady pace of increases. That rate rose nearly half a percent after the ECB’s 75 basis point rate hike last week, suggesting markets are eyeing a more aggressive rate path.

The problem is that inflation is too high and too persistent, hence the need for decisive action. Not only is headline inflation at an all-time high, but underlying price growth is also more than double the ECB’s target and even longer-term expectations are above 2%.

ECB President Christine Lagarde declined to say last week whether the central bank would stop at neutral, simply saying the current rate was “far from the rate that will help us bring inflation down to 2%” – its political objective.

BNP Paribas expects the central bank to go further.

“Our bias would always be that if there is a risk on this central case, it is that it will not be sufficient to contain inflation in the medium term and that, as the economic situation improves, the BCE may be forced to do more,” BNP Paribas said in a note.
Source: Reuters (report by Balazs Koranyi; editing by Susan Fenton)

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