The ECB – driving with its nose glued to the rear-view mirror?

Data dependent: Christine Lagarde used this expression for the first time on 3 February 2022, and we have heard it emphasised time and again since then. This was again the case at the press conference on 7 March 2023 when it was used five times to describe the approach of the European Central Bank (ECB) to managing its monetary policy. In other words, the ECB is not using forward-looking models to anticipate the economic trajectory of the eurozone. Its approach is based on data – by definition something that has been noted in the past – and is therefore backward- rather than forward-looking. This amounts to the driver of a car steering their vehicle by focusing on the rear-view mirror rather than peering through the windscreen – in principle, a dangerous practice.

Let’s go back to the start of 2022. At this point in time, eurozone inflation was over 5%, after close to 25 years of lethargy. Its least volatile version of “core inflation” was over 2.5% – indicating a level of pressure unprecedented since the creation of the single currency. The causes were identified as: supply chain tensions due to COVID-19, commodity price hikes on the back of the war in Ukraine, and greedflation^[1] on the part of companies in an environment of restricted supply when faced with recovering demand post-COVID-19. At this very time, most economists – including those at the ECB – expected a temporary and limited surge in inflation. With hindsight, they were wrong and inflation in the eurozone had leapt above 11% by the end of 2022.

In the eye of the storm, the ECB chose to abandon its traditional approach – rather than trusting in its forward-looking models and offering visibility via its forward guidance, it opted for a data-based approach.

Yet today the situation has changed substantially. With a cumulative hike of 4.5% in key rates, monetary tightening has kick-started a shift to disinflation. At 2.6%, inflation is no longer very far from the ECB target. But there was no question of mentioning the possibility of lowering rates at the last meeting of the Governing Council. However, the ECB’s own forecasts anticipate inflation of 2.3% in 2024 and then perfectly aligned with its target of 2.0% in 2025 – a clear decline versus estimates last December.

Having waited too long to react to the surge in inflation, the ECB is now willing to accept the risk of acting too late to disinflation. This is a risky gamble, given that its last decisions took longer to take effect than anticipated. Does the ECB need to trade in its rear-view mirror for a pair of binoculars to avoid a monetary policy error?

Final version of 8 March 2024 Clément Inbona, Fund Manager, La Financière de l’Echiquier (LFDE)

[1] An increase in selling prices that is not justified by an increase in production costs, in an inflationary environment which allows margin increases to be disguised.