The European Central Bank (ECB) is about to throw a crucial piece of information into the debate over where euro-zone interest rates are headed.
Fresh estimates for the neutral rate — a theoretical level that neither limits nor spurs demand in the economy — will be published Friday. President Christine Lagarde has said she and her colleagues “will operate on the basis” of the paper to help determine “what our monetary-policy stance should be.”
The release is arriving as talks intensify over where borrowing costs will settle after five cuts in the deposit rate, to 2.75%. With inflation on course for 2% this year, officials agree that more reductions are coming — particularly with the region’s economy flatlined. But where precisely the sweet spot lies is proving controversial.
While Lagarde herself has put the range for neutral at 1.75% to 2.25%, this week’s research may offer further clarity on the ECB’s landing zone.
“The debate in the Governing Council about the neutral interest rate is gaining traction,” said Cyrus de la Rubia, chief economist at Hamburg Commercial Bank. “While the concept itself is only of limited use in determining monetary policy, it can be used well to manage expectations, and in this respect we will look closely at what is coming next.”
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Officials started musing about neutral about a year ago, as inflation sank and rate cuts moved onto the horizon. Since then, hawkish Executive Board member Isabel Schnabel has offered some of the most comprehensive views, arguing that recent crises and structural shifts may have pushed neutral higher — to between 2% and 3%.
Others reckon it’s lower. Citing a study by his country’s central bank, Finland’s Olli Rehn has talked about 2.2%-2.8%, while France’s Francois Villeroy de Galhau and Greece’s Yannis Stournaras have both suggested a level of about 2%. Portugal’s Mario Centeno even sees it a touch below that.
Lagarde’s narrow range has raised questions about whether she may have inadvertently offered a preview of the ECB’s upcoming report. It would indicate a mid-point of 2% — where many investors and economists see the deposit rate ending up.
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A corridor like she suggested could also allow the ECB to delay a discussion over when to stop describing current policy as restrictive — language that signals more rate cuts will arrive.
Recent days, however, have seen some officials, including Chief Economist Philip Lane, grow skeptical on the idea that neutral should be the guiding star in their quest to staunch inflation without crashing the economy.
Lithuania’s Gediminas Simkus and Ireland’s Gabriel Makhlouf have argued that, as a theoretical concept that’s difficult to nail down, neutral shouldn’t play an outsized role in day-to-day decisions.
They instead favour focusing on the inflation outlook, underlying price pressures and the impact of past action on financing conditions and demand. Vice President Luis de Guindos pointed to the ECB’s bank lending survey as a better sign of restrictiveness.
“While the neutral rate makes for an interesting academic concept, it’s not very useful from a policymaking standpoint,” he said in an interview published Wednesday.
His Executive Board member colleague Piero Cipollone agrees, saying that “neutral is a very powerful analytical concept but not terribly useful for setting monetary policy”.
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Other central banks have varied in their approach to neutral.
The Bank of England has almost completely steered away from the subject, which has only come up twice publicly of late. In December, policymaker Swati Dhingra said she expects rates to land in a neutral range between 2.5% and 3.5%. The following month, her colleague Alan Taylor put the rate at near 2.75%.
By contrast, the US Federal Reserve’s quarterly economic projections contain long-term estimates for the federal funds rate — currently seen at 3%.
At 4.25% and 4.5%, US borrowing costs are still some way off neutral. That’s not the case for the ECB, with Schnabel likely to be among the first to suggest the level may have been reached as the year progresses.
“After the steep rate cuts over the last few months, we are getting closer and closer to the point where we have to take a closer look at whether and to what extent we can still reduce rates,” she said in January.
Charts: Bloomberg
