FRANKFURT (Reuters) – As the European Central Bank raises interest rates to control inflation, the main debate is whether it can stop at the so-called “neutral” level or whether it will still need to cool the economy even though it is heading towards it. Recession.
While the word “neutral” has become a kind of buzzword for policy makers and ECB watchers, it is a vague concept and its exact level is elusive, threatening to overwhelm an already complex debate.
What is a “neutral” rate?
A neutral rate is the rate that neither stimulates nor slows down growth, bringing aggregate economic output in line with its potential with inflation stabilizing.
There is one flaw: it is “unobservable”, which is that the central bank speaks for no one really knows its exact level. There are infinite estimates but it is mainly a theoretical average and is only known after the fact, perhaps years later.
What is certain is that the Neutral Zone has been on a downtrend for decades, mostly due to the potentially weak growth rate in the Eurozone, an aging population, and lower productivity improvements.
What is ECB Neutral?
Few policy makers will put a number on it, but a couple of them have recently ventured into public guesses and even raised their estimates, bringing neutrals well above the current filing rate of 0.75%.
French Central Bank President Francois Villeroy de Gallo is now putting the rate at or close to 2% against his previous estimate of 1% to 2%. Meanwhile, Greek Central Bank President Yiannis Stournaras raised his estimate to “about 1.5%, or even 2%” from 0.5% to 1.5%.
Market economists also tend to put it in the 1.5% to 2% range, which makes it one of the lowest neutral rates among major economies.
Societe Generale (OTC:) sees the ECB as neutral at 1.5%, albeit with “low conviction”, while setting that rate at 2.15% in the US, 2.5% in the UK and 1.75% in Switzerland. At 1%, Japan’s rate is the lowest.
Another complication is that the economic turmoil of the past three years, from the pandemic to supply shortages and Russia’s war in Ukraine, has dragged the neutral rate in opposing directions, making it less predictable.
German Bank (ETR 🙂 argues that the energy shock may reduce the mass growth potential and thus create pressure on the neutral rate.
“On the other hand, higher energy investment needs and a weaker current account indicate a change in the investment-saving balance that could push (the neutral rate) higher,” it said in a note.
From a conflicting viewpoint, Commerzbank’s Michael Schubert argues that the ECB significantly underestimates the neutral, raising the risk of a policy error.
“Therefore, there is a risk that the ECB will normalize monetary policy too slowly or end the process too soon, so that inflation will remain above the 2% target over the long term,” he said.
Chart: ECB estimate of the neutral rate: https://fingfx.thomsonreuters.com/gfx/mkt/mypmnzwkkvr/Pasted%20image%201663306785660.png
Is neutral even enough?
Mostly not. Policy makers started talking about the need to cross the neutral level, and there was a rapid upward shift in market expectations.
Investors are now seeing the final price, or peak hiking cycle of more than 2.5% sometime next spring after a steady pace of hikes. That rate rose by nearly half a percent after the European Central Bank raised its interest rate by 75 basis points last week, indicating that markets see a more robust path for the rate going forward.
The problem is that inflation is too high and too persistent, adding to the need for decisive action. Not only is headline inflation at a record high, core price growth is also more than double the ECB’s target and even the long-term outlook is moving above 2%.
European Central Bank President Christine Lagarde refused to say last week whether the central bank would stop at neutral, simply saying the current rate was “too far from the rate that would help us bring inflation back to 2%” – its policy target.
BNP Paribas (OTC:) anticipates that the central bank will have to go further.
“Our bias will remain that if there is a risk in this centralized situation, this will not be enough to rein in inflation in the medium term, and that as the economic situation improves, the ECB may have to do more,” said BNP Paribas. in a note.