So, what can monetary policy do from here? The ECB has two main instruments.  First, it can continue to increase short term interest rates. The overnight lending rate is 3.75%, having risen from 0.25% in mid-2022. In the near term the ECB should continue to nudge this rate higher, but probably slow down the pace of tightening so as to assess the impact of earlier increases.

Second, the ECB can vary the pace at which it shrinks its own balance sheet – so-called “quantitative tightening” or QT. The ECB has contracted its balance sheet about 10% over the past 9 months (though it still exceeds pre-pandemic levels), mostly by not replacing securities and repurchase agreements when they matured. In the United States, the Federal Reserve is going through a similar process of raising interest rates and contracting its balance sheet.

As any tightening cycle progresses, the central bank has to be alert to signs that it should either accelerate tightening or decelerate and ultimately stop, as monetary policy works with a lag. This was the argument many analysts made in 2021 when inflation was picking up and central banks were anchored to zero interest rate policies. During 2021 central banks, including the ECB, should have begun a gradual increase of interest rates recognizing the lag inherent in policy outcomes.  They failed to do that, and the result was the highest inflation in more than four decades.

In the same way, they should now be considering what signposts would make them slow down or stop. If tightening continues until reported inflation is back to 2%, the lagged effects of earlier tightening will assure both a further decline of inflation below target and a deep recession.  

One signal to watch for is the health of the banking sector. Banking stress in both the United States and Switzerland has been noteworthy throughout early 2023.  Perhaps these are coincidental idiosyncratic events that are unconnected to monetary policy and broader liquidity conditions. But perhaps not. In a period of uncertainty – and with other signs pointing to a slowdown or recession – should central banks be taking that risk?

The prudent course would be to slow down the pace of tightening and be prepared to adjust (faster or slower) as circumstances warrant. Similarly, the pace of quantitative tightening could also slow down for the same reason. Tighter policy could impact banks in several ways. First, all other things being equal, the economy will slow down, and the resulting pressure on certain sectors like commercial property could lead to rising bad loans. Second, banks will naturally hold back and be less willing to make new loans. Finally, the withdrawal of liquidity through quantitative tightening will tend to increase volatility and thus risk premiums, further pressurizing financial intermediaries to hold back new credit.

Ultimately, the ECB and other central banks were slow to tighten in 2021 in response to rising inflation, and then raised rates very rapidly in Q1 2023.  Their recent haste creates a new set of risks that could restrain the economy in the future. Given the deep uncertainty and divergent risks of too much or too little tightening, the prudent course is to move cautiously and adjust gradually.

First published in “Views – The EuroFi magazine”, April 2023