MNI INTERVIEW: ECB Guidance Change Indicates Broad Pessimism

By Luke Heighton

     PARIS (MNI) - The European Central Bank's decision to drop the

calendar-based leg of its forward guidance suggests that the majority of

Governing Council members share Mario Draghi's pessimism regarding the state of

the eurozone economy, a former senior Eurosystem official told MNI in an

interview.

     The ECB said last Thursday that it would keep interest rates at current or

lower levels until inflation "robustly" approaches its target and such

convergence has been "consistently reflected in underlying inflation dynamics."

The phrase replaced its earlier promise to keep rates steady or lower at least

through the first half of 2020.

     Gaetano Gaballo, an associate professor at the HEC Paris business school

who is on leave from his role as senior economist at the Banque de France, said

making forward guidance state-dependent was the right decision.

     It's certainly a more precise form of communication than a horizon that is

shorter than what the market already expects," he said. "The more communication

can be state contingent the better it is, because it's more predictable."

     Such guidance requires greater consensus about economic trends, he said:

"It needs strong agreement on the Council, since we're talking about states that

could never materialise."

     In his press conference after September's monetary policy decision, which

included the relaunching of quantitative easing, ECB President Draghi said

Governing Council members agreed about the need to act to provide further easing

measures, but acknowledged "a difference of views ... about the severity of the

outlook."

     The following day, opposition to the decision to return to net asset

purchases was made more stark, as the Dutch National Bank took the unusual step

of issuing a communique to criticise the measure.

     Gaballo, who in April published a paper co-authored with three ECB

economists on the relationship between forward guidance and market uncertainty,

said that with interest rates expected to be lower for longer and inflation

subdued, now was a good time to change the central bank's language. The

introduction of a tiered deposit rate also called for refined guidance.

     --TIERING

     "Communication becomes a way to manage these new tools that people don't

know how to predict in the future. It takes time to build up that understanding,

but the more you have [new tools] the more difficult it will become," he said.

     Gaballo, who is also a member of the Washington-based thinktank The Center

for Economic and Policy Research and had working experience in the ECB's

research division, said the central bank sent confusing signals and gave the

market little notice before its September decision to cut the interest rate on

its deposit facility by 10 basis points, which it had only signalled by an

alteration to its July guidance.

     "If they couldn't previously have excluded cutting rates, they should have

spoken about it before, and perhaps discussed the costs of going down. But my

perception is that this was not the case."

     Large central bank packages of measures, like that of Sept. 12, carried

risks, he said.

     "It can look desperate. It's a signal that things are going badly. So if

you don't give a framework to signal what else you could do, what you are doing

and that there is space left, there is a serious danger that you could worsen

the momentum of the economy."

     In July, the ECB also added a reference to the "symmetry" of its inflation

target, a move promoted by Draghi despite opposition from some central bankers

such as Germany's Sabine Lautenschlaeger. For this to be effective, the bank has

to be more explicit, Gaballo said.

     "It's saying 'I could tolerate inflation being 2.5% for a year' ... When

the Fed did state-contingent forward guidance in December 2013 they explicitly

said they could tolerate 0.5% above target for a while. It could help raising

inflation expectations now."

     More radical ECB measures, such as so-called helicopter money, were

unlikely, he said, either because they would fail to significantly boost

inflation or because they were too close to fiscal policy.

     As former IMF head Christine Lagarde prepares to take over from Draghi,

Gaballo said the ECB's decision making still faced structural challenges as a

result of the eurozone's multinational nature.

     "They think from a national perspective not a European perspective, that is

more dangerous than anything else."

--MNI London Bureau; +44 203 865 3829; email: jason.webb@marketnews.com

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