The ECB Governing Council has given hints that it will keep rates low for long (see its May and June statements). On 4 July 2013, the Council went further embracing ‘forward guidance’ (Praet 2013, Woodford 2013).1
“The Governing Council expects the ECB interest rates to remain at present or lower levels for an extended period of time.”
By providing information on expected future policy decisions, policymakers remove uncertainty about the policymakers’ own expectations. This type of forward guidance of market expectations is used more and more widely among central banks.
- The central banks of Norway and Sweden belong to those that have moved furthest in this direction by regularly publishing their forecasts of policy rates together with their forecasts of inflation and economic activity (see Norges Bank 2013 and Sveriges Riksbank 2013 for descriptions of their practices).
They even add measures that reflect the likelihood of different policy paths depending on the uncertainty around the economic outlook.
Forward guidance and the ECB’s aim
More information on the ECB’s forward guidance was given by Draghi at press conferences held on 4 July and 1 August 2013.2 On August 1, for example, he stated that future policy rates are being conditioned on the ECB’s macroeconomic outlook.3
The exact numerical expectation of the policy path and the length of time, for which the Governing Council anticipates policy rates to stay at current or lower levels, remain uncertain to market participants. Draghi stressed that there was no precise deadline to this “extended period of time”. But then he gave an important hint. He said:
“As a matter of fact, you can … extract a reaction function and, from there, estimate what would be a reasonable extended period of time”.
This is precisely the purpose of this column. (See Bletzinger and Wieland (2013) for detailed calculations etc.)
Estimating how long rates will stay low
We use a reaction function from the literature to project the interest rate path that is consistent with the macroeconomic outlook. Specifically, we use the interest rate rule from Orphanides and Wieland (2013), which matches past ECB interest rate decisions quite well.
This interest rate rule, i.e. reaction function, assumes that the ECB changes the interest rate in response to two deviations:
- Deviations between forecast inflation and the ECB’s target; and
- Deviations between forecast GDP growth and estimated GDP growth potential.
The two deviations are given equal weights. A one-percentage-point deviation of the inflation forecast from target would result in a 50-basis-point adjustment of the policy rate. A one-percentage-point deviation in growth would have the same impact on interest rates.
Despite its simplicity, this rule already incorporates two of the concerns mentioned by the ECB statement directly, i.e. the inflation and growth outlooks. It could be extended to include monetary dynamics, but it already matches past ECB decisions very well in its current form. See Figure 1, which compares the historical interest rate prescriptions from the Orphanides-Wieland rule to the ECB policy rate on its main refinancing operations (MRO Rate). The range of prescriptions spanned by the 1.5% and 2% assumptions on the inflation objective matches the ECB’s interest rate decisions very well.
Figure 1. Main refinancing operations rate versus Orphanides and Wieland (2013) Rule using Survey of Professional Forecasters Forecasts
Notes: The black line shows the ECB’s interest rate on its main refinancing operations in the second month of each quarter from 1999:Q1 to 2013:Q3. The grey shaded area is constructed with the OW Rule: MRO rate = (previous MRO rate) + 0.5(3-quarter ahead forecasted inflation deviation from target) + 0.5(2-quarter ahead forecasted GDP growth rate gap from potential). The lower line of the shaded area has an inflation target of 2% and the upper line a target of 1.5%. The forecast data is from the ECB Survey of Professional Forecasters (SPF).
Projecting ECB interest rates forward
The reaction function requires forecasts. Ideally, one would want to feed in ECB Governing Council members’ forecasts of inflation and output growth, but those are not publicly available. Instead we use those of the Survey of Professional Forecasters published by the ECB most recently on 9 August 2013.
Figure 2 displays the resulting projection of the interest rate path. Since the ECB inflation target is not explicit, we do the projection with that inflation target at 1.5% (long dashes) and 2% inflation target (short dashes).
- The lower projection (based on the 2% target) breaches the current interest rate setting in the first quarter of 2014.
- By the second quarter of 2014, both projections are above the current interest rate (MRO rate), which is now at 50 basis points.
As the relevant timing of the interest rate is the second month of the quarter, this projection implies that the ECB should anticipate raising its key interest rates at the latest by May 2014.
Figure 2. Projected rate path using the Orphanides and Wieland Rule with Survey of Professional Forecasters forecasts until 2014:Q3
Notes: The black line shows the ECB’s interest rate on its main refinancing operations in the second month of each quarter from 2012:Q1 to 2013:Q3. The gray dashed lines show the OW Rule: MRO rate = (previous MRO rate) + 0.5(3-quarter ahead forecasted inflation deviation from target) + 0.5(2-quarter ahead forecasted GDP growth rate gap from potential). The lower gray line has an inflation target of 2.0% and the upper line a target of 1.5%. The blue lines show the projected rate path implied by available inflation and output growth forecasts. The forecast data is from the ECB Survey of Professional Forecasters (SPF).
Projections with the macro forecasts of ECB staff
Figure 2 uses macro projection from the ECB’s Survey of Professional Forecasters. If instead we use Eurosystem staff projections, the resulting estimates of the ECB’s “extended period of time” moves even further into the future. However, the rule with staff projections does not match past ECB decisions, including those in 2012 and the first half of 2013 as well as the rule with Survey of Professional Forecasters forecasts.
What about normative concerns?
Should other interest rate benchmarks be given weight in the policy decision? Of course, there are other well-known benchmarks that could be used. For example, the well-known Taylor rule has provided a useful signal ahead of the financial crisis by indicating that policy rates in the US were too low for too long prior to 2007.
- Applied to the Eurozone at the current juncture the original Taylor rule would prescribe higher interest rates now and in the future.
Bletzinger, T and V Wieland (2013). “Estimating the European Central Bank’s ‘Extended Period of Time’”. Institute for Monetary and Financial Stability, Goethe University Frankfurt.
Norges Bank (2013): Monetary Policy Report with financial stability assessment, 2/13, June 2013.
Praet, P (2013), "Forward Guidance and the ECB", VoxEU.org, August 6.
Sveriges Riksbank (2013), Monetary Policy Report, February 2013.
Woodford, M (2013), “Inflation targeting: Fix it, don’t scrap it” in Baldwin, R and L Reichlin (eds), Is inflation targeting dead? Central Banking After the Crisis, VoxEU.org eBook , 14 April.
1 The full quote is: “Looking ahead, our monetary policy stance will remain accommodative as long as necessary. The Governing Council expects the ECB interest rates to remain at present or lower levels for an extended period of time. This expectation is based on the overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the real economy and subdued monetary dynamics.”
2 Further information on the implementation of the ECB’s forward guidance and its motivation has been provided in a paper by Peter Praet (2013), the Member of the Executive Board in charge of the Directorate General Economics.
3 Specifically, Draghi said: “our formulation of forward guidance is in line with our strategic framework, which is anchored in our assessment of the medium-term outlook for inflation, or price stability. And this outlook depends on economic activity and on money and credit developments. So this is our strategic framework, within which we can say that medium-term inflationary expectations remain firmly anchored.”