The European Central Bank has honed its forward guidance on interest rates by giving investors a new economic gauge to watch.
In the past week, ECB President Mario Draghi, Vice President Vitor Constancio and Executive Board member Sabine Lautenschlaeger have all cited the so-called output gap as a reason why the 18-nation euro area will need low rates even after growth and inflation pick up. ECB Chief Economist Peter Praet reinforced the message at a conference in Frankfurt today and fellow board member Benoit Coeure spoke on challenges for monetary policy.
Draghi is trying to assure investors that he’ll avoid the mistake of his predecessor, Jean-Claude Trichet, who raised borrowing costs in 2011 and inadvertently heightened a sovereign debt crisis that almost fractured the single currency. At the same time, he’s been reluctant to limit his scope by tying the ECB’s low-rate pledge to a narrower number such as unemployment, a strategy that has complicated communication at the Bank of England.
“Draghi made a deliberate attempt to push the discussion about rate hikes into the future despite evidence that the recovery is gathering momentum,” said Richard Barwell, senior economist at Royal Bank of Scotland Group Plc in London. “It’s his defense strategy against those linking growth with tighter policy. His message: Given the abundance of slack, there’s no need to act.”
‘Stock of Slack’
While there is no standard measure of the output gap, the International Monetary Fund predicts that gross domestic product in the euro area will remain below potential for a sixth year in 2014. It estimates the shortfall will only gradually narrow to 0.4 percent of potential GDP in 2018 from 2.5 percent this year.
“Our monetary policy stance will stay in place even after we see improvements in the economy, in the flow of data in the economy, because we have a stock of slack that is weighing on the economy,” Draghi said after the ECB’s March 6 policy meeting. “This was really the point of major consensus, if not unanimity, in the discussion we had.”
The comments marked the first time Draghi has referred to slack in the opening statement at his monthly press conference. The ECB kept its benchmark interest rate at a record low of 0.25 percent at the meeting. It forecast growth will accelerate to 1.8 percent in 2016 from 1.2 percent this year, and said inflation will climb to 1.5 percent from 1 percent.
While that’s only half the rate the ECB uses to define price stability, Coeure said there’s no deflation in the euro area.
“We see it as a possible risk,” he said. “We have to be ready to react to this risk if it materializes. We have a number of instruments.”
Like the BOE and the U.S. Federal Reserve, the ECB is looking for ways to ensure the fragile economic revival averts a relapse as expectations for tighter monetary policy push up market rates.
The BOE updated its guidance on Feb. 12 after unemployment fell faster than expected toward 7 percent, a level set for reconsidering its low-rate pledge, and stoked speculation borrowing costs would rise. The London-based central bank said it will keep rates low even after the threshold is breached because of “the existence of spare capacity in the economy.” Governor Mark Carney said yesterday that there may be more slack than the BOE’s main calculations show.
Fed Chair Janet Yellen, who holds her first rate-setting meeting next week, has signaled that she’s moving away from tying the U.S. central bank’s guidance to the level of unemployment. She said on Feb. 27 that the Fed will reduce the pace of stimulus at a “measured” pace and would reconsider if there is a “significant change” in the economic outlook.
Draghi’s reference to the output gap is a notable alteration to the forward guidance he introduced in July, when he committed to keep official rates at the current level or lower for an extended period. While he strengthened the pledge in January by saying he “firmly” reiterated the stance, he didn’t tie the promise to specific economic indicators.
“We reinforced the forward guidance at the last Governing Council by adding the allusion to economic slack,” Praet said today. “Because of the significant amount of unutilized capacity, our monetary policy stance will remain as it is -– with interest rates staying at the present or lower levels -– even as we see improvements in the economy.”
Lautenschlaeger said in an interview with the Wall Street Journal on March 10 that the output gap is a reason why rates will stay low “over a longer period of time and well into the recovery.” Constancio told Market News International yesterday that “the forward guidance was made more precise in relation to the existence of this slack.”
The ECB comments come after the euro-area economy showed signs of a pickup. GDP increased more than economists expected at the end of 2013, a gauge of services and manufacturing output is at the highest level in 2 1/2 years, and economic sentiment is improving.
The premium that investors demand to hold Spanish 10-year bonds over German debt has fallen to about 1.7 percentage points from a euro-era high of more than 6 percentage points in July 2012, indicating that the crisis has eased. The spread between Italian and German 10-year debt has dropped to 1.8 percentage points from more than 5 percentage points over the same period.
Even so, unemployment at 12 percent remains close to a record and output in the currency bloc in 2013 was still about 1 percent lower than in 2007, before the collapse of Lehman Brothers Holdings Inc. triggered the global banking crisis that eroded public finances in Europe.
Potential growth rates have crumbled as well, exacerbating the uncertainty surrounding forecasts for the output gap. The rates are “expected to only gradually return towards their pre-crisis levels over the period to 2023,” the European Commission said in a report published in January.
The commission sees maximum possible output growth in the euro area of 1.1 percent a year in the 10 years through 2023. While that’s more than the 0.7 percent in the crisis years of 2008 to 2013, it’s still only about half the 2 percent in the decade before then.
Economists surveyed last month predicted ECB policy makers will leave borrowing costs unchanged at a record low through at least the third quarter of next year. Separate surveys showed a majority of economists forecast the BOE will begin raising rates in the first half of 2015, and the Fed will start lifting them in the third quarter of that year.
“Once the economic data starts coming in showing that the economy is picking up, it is going to be very difficult to contain rate expectations,” said Anatoli Annenkov, senior economist at Societe Generale SA in London. “With 2015 now being considered the target for both the U.S. and the U.K. to start moving rates back up again, the ECB wants to let it be known that it will be the last to move.”