Summary
- ECB policymakers increasingly refer to a ‘neutral rate’ in discussing the hiking cycle
- Eurozone neutral rate was seen between 1%-2%, but economists and policymakers still divided
- Neutral rates vary widely between different member states
Eurozone interest rates soaring to at least 0% by September is expected as inflation surges, but how high rates should go afterward is disuniting policymakers and economists in a bloc of 19 extremely different economies.
The European Central Bank (ECB) convened on Thursday and was expected to verify its first rate rise will occur in July. Like other central banks, its goal is now changing to achieving a neutral rate: high enough to curb inflation, but not so high it weakens growth.
The challenge is determining where exactly the rate lies.
It is a heated discussion globally. For example, most economists differ with the Federal Reserve’s forecast of a 2.4% long-run U.S. rate. The ECB’s role is even more problematic, given its remit ranges from Italy, with debt at 150% of GDP, to Germany, whose debt ratio is lower than fifty percent of that.
Predictably, forecasts among the investment banking community and ECB policymakers differ widely.
Some ECB officials, including Bank of France Governor Francois Villeroy de Galhau, expect the neutral rate at between 1% and 2%. Slovakia’s hawkish Peter Kazimir maintains it’s closer to 2%, while Spain’s Pablo Hernandez de Cos places it around or just above 1%.
Nevertheless, policymakers faced with surging inflation are progressively regarding the neutral rate as a yardstick to estimate how high rates should hike this cycle.
Allianz’s global head of macroeconomic and capital markets research Andreas Jobst commented:
“It’s somewhat of a new way of communicating the monetary policy stance that fits the situation. In a supply shock world, the inflation forecast is no longer helpful, so you need to find a different way of anchoring your forward guidance, and the neutral rate, you cannot touch it, and you cannot see it. It gives you the flexibility.”
ECB president Christine Lagarde maintains borrowing costs should be normalized “towards the neutral rate” if inflation is seen settling around 2% in the medium term. But she refrained from estimating where neutral might be or how fast the bank should move.
In markets, rates are seen climbing over 1.8% in 2024, traders have raised that bet sharply after an exceedingly higher than estimated May euro zone inflation print.
ONE SIZE FITS NOBODY
The debate gives a glimpse of difficulties the ECB encounters as it seeks to relax years of stimulus while controlling fragmentation risks – the divide between the bloc’s poorer and wealthier states, revealed in diverging borrowing costs.
Kazimir and Villeroy have requested a move to neutral territory in 2023. The former sees a 1.5% rate as inadequate to curb prices – but Italian board member Fabio Panetta, viewed as a dove, has cautioned that “normal does not mean neutral” in policy terms.
While inflation is the ECB’s key mandate, finding neutral rates will not lower energy costs or ease supply chains, but may well deteriorate the weak economic outlook, said Credit Agricole ECB watcher Louis Harreau.
“Not only do countries have different neutral rates, but on top of that, the transmission of the monetary policy is not the same for all countries, due primarily to sovereign spreads,” Harreau said, citing the premium charged for poorer states to borrow over top-rated Germany.
Allianz forecasts Germany’s neutral rate at 1.5%, compared with 0.7% in Italy, and 1.3% for the eurozone generally.
The divergence indicates weaker productivity, below-potential economic output, and higher debt in southern European states. Member countries’ inflation and unemployment rates also differ greatly – euro zone inflation reached 8.1% last month, but was 5.6% in Malta and 20.1% in Estonia.
“Is it one size fits all?” Danske Bank chief analyst Piet Christiansen said of a eurozone neutral rate.
“Not really, it’s probably like one size fits not anyone.”
IS THERE DANGER?
The ECB’s Panetta warns against depending on an undiscernible neutral rate to guide policy, demanding a consistent removal of stimulus in times of high economic turmoil.
Take Italy: UniCredit, supposing the country’s neutral rate is below 1.5%, notices that three-year borrowing costs have exceeded this level, now at 2%, meaning its economy may experience restrictive conditions as support from cheap ECB loans declines.
Erik Nielsen, the chief economic advisor at the bank, says the ECB risks not having control of its narrative by dropping previous references to visible “financing conditions” all for neutral rates.
Regulating monetary policy while monitoring the neutral rate is “like driving a car through the desert aiming for an oasis on the horizon, that you know is nothing more than a Fata Morgana,” he told clients in a recent note.
