Central banks should favour interest rates they can change quickly when economic conditions shift, European Central Bank policymaker Isabel Schnabel said on Nov. 5, drawing lessons from the pandemic.
Pandemic-era promises about future policy tied the ECB too closely to expectations of persistently low inflation, she said. The central bank published her speech, “Navigating stormy waters: reflections on monetary policy”, on Nov. 5.
Schnabel drew on seven years of policymaking, spanning below-target inflation, the pandemic and the subsequent surge in prices. She described the conclusions as personal reflections on how those experiences changed her thinking.
Interest rates can change at each policy meeting, while large asset purchases continue supporting the economy after buying stops, she said. Instruments that are difficult to reverse therefore constrain future decisions.
She nevertheless said asset purchases remain useful when financial markets suddenly struggle to trade and when rates cannot fall further to counter declining prices. Separating market stabilisation from broader policy decisions could limit purchases and make them easier to reverse.
The ECB was slow to recognise the change from repeatedly overestimating inflation before the pandemic to underestimating it afterward, Schnabel said. Its economic frameworks also gave insufficient weight to companies changing prices more frequently and protecting profits against rising costs.
Unlike the inflation of the 1970s, which she attributed almost entirely to labour costs for each unit produced, rising profits per unit accounted for part of the post-pandemic surge.
Schnabel said central banks should respond to a shock's expected effect on inflation, rather than simply distinguish between disruptions to supply and changes in demand. Overlapping shocks can keep inflation elevated longer.
Services inflation still exceeded 3% before the Middle East conflict began, reflecting adjustments to the earlier price surge, including staggered wage negotiations, she said. Consumer inflation expectations over medium and longer periods have since moved away from the ECB's 2% target following the latest energy shock.
A large, lasting supply disruption can require a timely policy response if its effects spread through prices, wages and expectations, she said. Each shock requires an assessment of its size, persistence and the economy's condition.
Schnabel also said rising public debt and the expansion of financial institutions outside banking could threaten central banks' freedom to pursue price stability. Those non-bank institutions now hold financial assets comparable in size to banks' holdings.
Euro area public debt relative to economic output has risen nearly 20 percentage points since the early 2000s, with wide differences between countries, she said. She cited IMF projections putting U.S. government debt at 145% of output in 2031, against 124% last year.
The IMF projects China's ratio to reach 122% over the same period, from 99%, she said. Strong bank capital and profitability helped the ECB raise rates during the post-pandemic inflation surge without putting banks under financial strain.
