FRANKFURT (Reuters) – 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 though it is heading towards recession.
While “neutral” has become a sort of buzzword for policymakers and ECB watchers, it is a cryptic concept and its precise level is elusive, threatening to confuse an already complex debate.
WHAT IS A “NEUTRAL” RATE?
The neutral rate is one that neither stimulates nor slows growth, bringing the overall economy’s output into line with its potential while stabilising inflation.
There is one glitch: it’s “unobservable”, which is central bank speak for nobody really knows its exact level. There are countless estimates but it is essentially a theoretical rate and only known after the fact, potentially years later.
What is certain is that the neutral has been on a downward trend for decades, mostly because of the euro zone’s weak potential growth rate, the ageing of its population and low productivity improvements.
WHAT IS THE ECB’S NEUTRAL?
Few policymakers will put a number on it but two of them recently ventured public guesses and even raised their estimates, putting the neutral well above the current 0.75% deposit rate.
French central bank chief Francois Villeroy de Galhau now puts the rate at below or close to 2% versus his previous estimate for 1% to 2%. Greek central bank chief Yannis Stournaras meanwhile lifted his estimate to “around 1.5%, or even 2%” from between 0.5% to 1.5%.
Market economists also tend to put it in the 1.5% to 2% range, making it one of the lowest neutral rates among major economies.
Societe Generale sees the ECB’s neutral at 1.5%, albeit “with low conviction,” while putting this rate at 2.15% in the United States, 2.5% in the UK and 1.75% in Switzerland. At 1%, Japan’s rate is the lowest.
Another complication is that the economic upheaval of the past three years, from the pandemic to supply shortages and Russia’s war in Ukraine, pull the neutral rate in opposing directions, making it even less predictable.
Deutsche Bank argues that the energy shock may lower the bloc’s growth potential and thus creates a drag on the neutral rate.
“On the other, higher energy investment needs and a weaker current account suggest a change in the investment-saving balance that may push (the neutral rate) higher,” it said in a note.
Taking a contrarian view, Commerzbank’s Michael Schubert argues that the ECB significantly underestimates the neutral, raising the risk of a policy error.
“Consequently, there is a danger that the ECB will normalise monetary policy too slowly or end the process too early, so that inflation will persist above the 2% target in the longer term,” he argued.
Graphic:ECB’s estimate for the neutral interest rate: https://fingfx.thomsonreuters.com/gfx/mkt/mypmnzwkkvr/Pasted%20image%201663306785660.png
IS NEUTRAL EVEN ENOUGH?
Probably not. Policymakers have started talking about the need to go above the neutral and there has been a rapid upward shift in market expectations.
Investors now see the terminal rate, or the peak of the hiking cycle at over 2.5% sometime next spring after a steady pace of hikes. This rate moved up nearly a half a percent after the ECB’s 75 basis point rate hike last week, suggesting that markets see a more aggressive rate path ahead.
The issue is that inflation is too high and too persistent, raising the need for decisive action. Not only is headline inflation at a record high, underlying price growth is also more than twice the ECB’s target and even longer-term expectations are moving above 2%.
ECB President Christine Lagarde refused to say last week if the central bank will stop at neutral, simply saying the current rate was “far away from the rate that will help us return inflation to 2%” – its policy goal.
BNP Paribas expects the central bank will have to go further.
“Our bias would still be that if there is a risk to this central case, it is that this will not be sufficient to rein in medium-term inflation and that, as the economic situation improves, the ECB may be forced to do more,” BNP Paribas said in a note.
(Reporting by Balazs Koranyi; Editing by Susan Fenton)
