Forget all those bars of gold that are heavily guarded because they are incredibly valuable. Credibility is the most valuable asset for a central bank. It is the monetary version of what goodwill is to a company. In this respect, the ECB could learn a lot from the Fed. An analysis.
The more credible a central bank is, the more effective its policy is. With high credibility, a central bank needs to do less actual work to achieve the desired result: bludgeoning inflation. More words, and less action, so to say.
If a credible central bank says inflation will not be too bad in the long run, there is little chance that companies will anticipate high inflation, raise prices in advance or that unions will make higher wage demands.
With low credibility, therefore, as a central bank you are already behind before you started. Then, to get high inflation back in the pen, for instance, you have to raise interest rates even more, to convince the outside world that you mean business. Indeed, action. Not words. This additional raising of interest rates risks causing economic damage.
Credibility is always very valuable for a central bank, especially at a time when global uncertainty is high, casting clouds on the course of inflation in the years to come. In other words, periods like those we live in at present.
Monetary knights do not deliver
The ECB’s credibility problem is evidenced by the fact that eurozone residents see inflation reaching around 3 per cent every year for the next few years. The ECB, meanwhile, swears that inflation will be structurally back to 2 per cent as early as next year. Europeans do not believe in their monetary knights, not least because in 2021 and part of 2022, they mostly shrugged off skyrocketing and rising inflation.
The ECB›s credibility, like that of its US sister institution the Fed, has declined in recent years. But where the Fed’s credibility has recovered somewhat, the same is not true of the ECB.
If you ask me, the fact that the bank poses as a climate policy institution almost every week and presents itself as a sort of monetary version of Greenpeace also has something to do with it.
Stay in your lane, is a slogan that is wasted on the ECB. However, it is not for the Fed. Recently, Sweden’s central bank, the Riksbank, held a monetary conference at which Fed chairman Jerome Powell, among others, spoke.
It was a short, to the point speech, without any frills. The Fed, he said, “should ‘stick to our knitting,’ and not wander off to pursue perceived social benefits that are not tightly linked to our statutory goals and authorities. … We are not, and will not be, a climate policymaker.”
Central bankers are not climate policy makers
Conducting climate policy is what elected politicians should do, said the Fed chief. If a central bank were to implement that policy, it would put its independence at risk. Independence and credibility are two sides of the same coin. The difference with how the ECB thinks about climate policy could not be greater.
Lagarde and the ECB should take a cue from Powell and the Fed. Not because climate change is not important, but because they are not the appropriate institutions to make policy on it and, if they do, the damage to independence and credibility could be huge and long-lasting.
The above is especially true if, as a central bank, you are lightyears away from fulfilling your task of ensuring price stability.
Indeed, there is a danger that this could see you further erode the ECB’s credibility. To rectify this, the ECB may be tempted to use a lot of tough language and act like a hawk, raising interest rates unnecessarily to show the outside world that the bank is credible. The price of that would be major short-term economic damage.
Speaking of confidence in and credibility of the ECB, it turns out that it is not only the outside world that questions it, but also its own staff. Two-thirds of ECB employees surveyed say confidence in the bank’s governance has fallen since 2019. Just under half say they have reasonable or high confidence in the leadership qualities of Christine Lagarde and her board.
In the Eurotower, we need less focus on climate change, and more on monetary goodwill.
Edin Mujagić is chief economist of OHV Asset Management and author of the book ‹Turning Point 1971›. Every last Friday of the month he writes ‘ECB Watch’ on the European Central Bank’s monetary policy for Investment Officer.