At our recent Governing Council meeting on 3 February, we acknowledged that “inflation is likely to remain elevated for longer than previously expected.” As Christine Lagarde said, these forces are expected to play themselves out gradually as the economy re-equilibrates and returns to its potential growth rate and the impact of the energy price shocks dissipate. I will not comment further on the expected outlook for inflation – this will be for our next projections on the 10th of March. I will, however, be discussing (i) the theory and practice of forward guidance, in such uncertain times, (ii) and how the ECB might need to adjust its current guidance to manage the path towards a normalisation of monetary policy. I. FG in theory and practice Originally, as proposed by Eggertsson and Woodford in 2003, forward guidance is a clear and powerful instrument at the effective lower bound on nominal interest rates when conventional policy is impotent. Under this strategy, a central bank commits to provide extra stimulus in the future once the underlying adverse shock is over. It does so by announcing it will keep interest rates low for longer, departing from its standard reaction function. As long as financial markets understand this, medium-term nominal interest rates will be lower. In addition, rational forwardlooking agents recognise that this will generate above-target inflation in the future, which lowers expected real interest rates over the whole period, further stimulating demand and inflation from today. This works perfectly in the textbook.
Today, in my personal judgement, it might be considered that the first criteria (with a headline inflation significantly above 2% since summer last year and expected to remain there for months ahead), and the third one (with underlying inflation around or above 2% by most definitions) are fulfilled. At this stage, according to our December forecasts, the remaining one (about inflation remaining at or above 2% for the rest of the projection horizon) is not met. This could possibly change in the next quarters. However, we should be mindful of the uncertainty surrounding our 3year inflation projections in the extraordinary context we are going through, especially when price pressures are originating from sector-specific supply constraints with moderate signs of contagion so far to wages. And there is one additional element, calendar based, introduced by the sequencing: any rate hike should only happen after date X, the end of the net asset purchases. We should not pre-empt this calendar: it is about the credibility of the sequencing, and also about some caution on the most fragile of our criteria – the medium-term forecastbased one. This brings me to a key reminder: the forward guidance never calls for an automatic decision, and always preserves our possible assessment. In our own wording, it is an “expectation”, and the Governing Council has to “see” and “judge”: even if and when the three criteria will be fulfilled, we could take into consideration exogenous or exceptional contingencies, including geopolitical ones.