Economy & Markets

2022-10-03 Donato Masciandaro

Monetary Normalization: The Lesson of Whatever It Takes

The European Central Bank (ECB) has begun a process of monetary normalization. It will be successful only if actions and words are properly combined. Christine Lagarde will need to follow the example of Mario Draghi. Ten years ago Draghi’s “whatever it takes” was not the invention of the monetary policy announcement, but it was unquestionably the most successful implementation: the music and libretto had already been there, but the execution on July 26, 2012 was memorable. Then, as often happens, that performance, that went down in history, generated good repeat performances over the years, but also poor imitations; in part due to Lagarde.

On July 26, 2012, Mario Draghi pronounced the words that would enter the Treccani Dictionary as an expression that “opened another, unprecedented horizon in European politics.” To shed light on the significance of “whatever it takes,” we can tell the story of the evolution of the monetary announcement as an opera in three acts.

Act I: We are at the end of the 1970s, when the dominant problem for the policies of advanced countries is to defeat the Great Inflation. Economic analysis offered a recipe to obtain an effective monetary policy, that was based on two ingredients, mixed together: central banks needed to be independent of governments, whose action influenced financial market expectations. Politicians gladly applied that recipe, because they always landed on their feet: if inflation was defeated, they deserved credit for making central banks independent; if it wasn’t, central bankers would be a perfect scapegoat. For their part, central bankers had a dual need: convince markets of their independence and give an account of their actions to legislatures.

It was in response to this dual need that the monetary announcement began, in its first version of inflation targeting. The central bank publicly committed to protecting the value of the currency issued, in a credible and transparent manner. Thus, three key words emerged in the central bankers’ new score: commitment, transparency, and credibility. The inflation announcement was to follow the approach of Ulysses: Homer’s hero clearly committed not to give in to the Sirens’ song, and he was believed, since he was tied to the mainmast of his ship.

Those precepts translated into institutional reforms that separated central banks from executive power. For their part, central banks adopted the inflation announcement: from the time of its birth, the ECB explicitly identified the variation in consumer prices as its compass. In general, the independence of central banks, oriented by inflation announcements, contributed to defeating the Great Inflation, which was followed by the Great Moderation, stable growth of the economy and employment.

Act II: suddenly, the Great Financial Crisis of 2008 came. Central banks systematically unconventional monetary announcements (“forward guidance”). These are communications that, in addition to inflation targeting, regard tools of monetary policy: interest rates, but also interventions to purchase public and private securities on the financial markets. It should be recalled that examples of forward guidance monetary announcements can be found in the experience of central banks before 2008 as well. For example, thinking of the Federal Reserve, in 2003 and 2004 Alan Greenspan announced that he would keep rates “low for a considerable period.” But the Great Financial Crisis is a watershed from at least two points of view.

On the one hand, while inflationary problems were absent – at least until autumn 2021 – there were risks of recession in those years, in different times and ways, and also of financial and banking crises, as well as troubles with the sustainability of sovereign debt. Thus, the need grew for central banks to explain monetary strategy in a convincing manner. On the other hand, and as a consequence, the awareness grew that monetary announcements must not be aimed exclusively at financial markets, but also at families and businesses.

Three key words to the score remain, however; those which were perfectly declined by Mario Draghi on July 26, 2012. “Whatever it takes” was a binding and clear announcement: “Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough.” The credibility of the announcement was demonstrated empirically ex post, for example calculating the effect on Italian and Spanish state bonds two years afterward of approximately two hundred base points, with positive cascading effects on economic growth and inflation. But what was the credibility effect based on? Economic analysis stresses at least two points. The first is the virtuous combination between the two ingredients recalled above: independence of the central bank and effect on expectations. The second is the importance of both the de jure independence of a central bank – the ECB is a central bank whose independence is guaranteed by the European treaties – and by factors that determine its de facto independence. One of those factors is political: the other economic policies, and fiscal policies in particular, that are controlled by governments, must be consistent with monetary policy. At the time of “whatever it takes,” there was unanimous recognition of the role played in this sense by the European Council the previous June, on impulse from the Monti and Rajoy governments. Another factor is psychological: central bankers, or at least the majority of them, must anticipate a positive reputational effect from the decisions they make. And there is no question that in July 2012, the risk elegantly defined as redefinition of the currency – i.e. the end of the euro – was likely very relevant for those who were making decisions in Frankfurt at the time.

Act III: from 2012 to today, forward guidance monetary announcements have continued, but their trajectory has not always been coherent with the three key words. Alongside the Ulysses approach there has been the Delphi approach: monetary policy communications that are not binding, and not even transparent. As for the prophesies formulated in the temple of Apollo, the information offered can be interpreted in different ways, and thus is ambiguous. The Delphi approach has been applied systematically by the Fed. A typical example is the use of projections regarding future rates (“dot plot”); individual and anonymous forecasts, that are not binding for anyone. The Delphi-style monetary announcement becomes a catalyzer of uncertainty. The ECB’s attitude, however, appears more consistent with the Ulysses approach. In its monetary policy strategy review, announced in 2021, it underscored the importance of the communication of monetary policy, that must be “clear and coherent,” if the goal is to involve an increasingly broad public; if we add “binding,” we will have the three key words.

But even those who strive to apply a Ulysses approach must always be careful to respect the three key words, otherwise undesired effects are waiting. ECB President Lagarde discovered this at her own expense, for example the day after the press conference of March 12, 2020; which unfortunately repeated itself in September 2022.

A premise: in recent months, and for the months to come, Frankfurt will be in the spotlight, with a question: what will the score be for interest rates? Everyone wonders about hawks and doves, but the essential question is another: since the efficacy of monetary policy depends on its transparency, to borrow from Shakespeare, who will prevail? The larks, that love the light, or the nightingales who prefer opacity?

Why is the issue of transparency crucial today, more than ever? Let us start from the assumption that the common goal of all European central bankers is to safeguard monetary stability while minimizing risks of recession. That is, we will exclude the possibility that there are ECB board members who are concerned with the specific performance of their own country, or who have opportunistic or psychological reasons to pursue other aims. In this case, all central bankers should behave like larks.

The reason is that the efficacy of monetary policy depends on its ability to influence the expectations of families, businesses, and markets. That ability is in turn linked to the central bank’s announcements. The announcement policy is good if it provokes the Ulysses effect: operators believe the central bank and do what the central bankers wish. Today, for the ECB the Ulysses approach means the absence of destabilizing effects of current consumer price increases on structural expectations for inflation, i.e. no vicious circle between salaries and prices. The announcement policy is bad when the Delphi effect prevails: the central bank offers information that triggers undesirable reactions among market actors, because the monetary policy proposed is not convincing. Here is a concrete example: in July 2012, Draghi pronounced a short and generic sentence, and provoked a virtuous reaction. Everyone believes that the euro is irreversible. Powell pronounced a sentence of the same length and generic character last week, but with the opposite result: nobody seems to believe that the Fed will be able to contain inflation without creating risks of recession. The Draghi announcement shows the Ulysses effect, while Powell’s shows the Delphi effect.

The importance of having announcements with the Ulysses effect is an axiom that is always valid, but is particularly true in this economic situation, whose dominant trait is uncertainty. Expectations need a monetary policy that provides security and does not contribute to increasing instability. So there must be maximum transparency on the so-called reaction function of the ECB. What does this mean? That central banks must announce binding interest rate policies, based on their macroeconomic forecasts, although they will continue to be subject to revision, in light of new significant macroeconomic data. Concretely, we can imagine a lark ECB, that announces an at least semiannual path on rates and liquidity, and at the same time defines what macroeconomic data will be taken into consideration to modify that path, if appropriate. On the contrary, we could have a nightingale ECB, that does not commit to any one path, and takes refuge behind the formula of making decisions “depending on the data,” without even specifying what data, following the so-called “holistic” approach, that to borrow from Mario Monicelli this time, seems to be merely elegant “gibberish.” This is what happened in September.

Christine Lagarde seemed to be groping in the dark, while she communicated the decisions of the ECB; a decision on the present to raise rates, that was amply expected, presented with empty words on the future. More than giving a credible message, the goal seemed to be just finding a way to get by. There should be no surprise that the impact on the market was negative. We can only hope that this effect does not continue.

The starting point is the analysis that the ECB itself offered of the economic situation. Inflation data was defined as too high, regarding both the current figures and forecasts. In the absence of interventions, the trend of prices is far from the European goal of 2 percent. The causes? Following the analysis from Frankfurt, the top cause is energy costs, followed by food prices, and then geopolitical uncertainty. What is the common element? These are shocks that affect aggregate supply. They must be countered, the ECB continues, because otherwise a contagion effect will be triggered, through the mechanism of expectations. In these cases – and here we draw conclusions regarding the ECB’s analysis – the only tool that can make monetary policy effective is to create the Ulysses effect: markets, families, and businesses must be convinced that the central bank not only knows what it’s doing but is committed to doing so. So binding announcements are needed that define the strategy of monetary normalization. 

Concretely: we expect the ECB to know what level of interest rates is consistent with the goal of bringing prices back onto a virtuous route. This means knowing what the interest rate is that provokes a change in the orientation of monetary policy from expansive – as it is now – to restrictive. This has always been called the neutral rate – the real long-term rate plus the optimal inflation rate – even though now, perhaps to further muddy the waters, it is becoming fashionable to use the word “terminal” rate. But whether it is neutral or terminal, the substance doesn’t change: the ECB must know what it is. Certainly, each month new information can modify the forecast, but that doesn’t change the structural estimates on the neutral rate, nor the inflation target. So an interest rate target must exist. Given the target, within the ECB hawks and doves can then discuss how gradual the path towards reaching the target interest rate should be. Moreover, new data can reopen the debate on the speed of normalization, that hawks think should be rapid, while doves prefer it be slower. But the target doesn’t change.

But no. Christine Lagarde has candidly told us that nobody knows where they want to go. Yes, she has informed us that rates will rise; why and how, though, nobody knows. The magic formula is to say that everything depends on the data – without specifying what data – and to add that decisions will be made each time. These are two platitudes. Just as it’s a platitude to say that the trade of the central banker is an art, given the limits of mathematic models.

How sad, it seems we have gone back 150 years, to when economic science was at its dawn, and central bankers were bureaucrats employed by governments. Today they are independent authorities, at the service of citizens, with the obligation of transparency. The central banker must embrace the light, like the larks in the Shakespearean metaphor, regardless of whether they are a hawk or a dove. Moreover, the ECB was a lark during the entire period in which the orientation of monetary policy was expansive. And now? It’s true that it’s easier to receive applause, from politicians and markets, by promising to print money. The contrary is not true: making binding commitments in a restrictive phase is more costly, especially if the decision-makers come from a series of wrong predictions. Is that the difference?


To learn more:

  • Acemoglu, D., Johnson, S., Querubin, P., Robinson, J.A., 2008, When Does Policy Reform Work? The Case of Central Bank Independence, NBER Working Paper Series, n.14033.
  • Altavilla, C., Giannone, D., Lenza, M., 2014, The Financial and Macroeconomic Effects of OMT Announcements, ECB Working Paper Series, n. 1707.
  • Bernanke, B.S., 2020, The New Tools of Monetary Policy, American Economic Review, 110(4), 943-983.
  • Contessi, S., Li L., 2013, Forward Guidance 101A: A Roadmap of the U.S. Experience, Economic Synopsis, Federal Reserve Bank of St. Louis, n.25.
  • Evans, C.L., 2012, Macroeconomic Effects of FOMC Forward Guidance, Brooking Institution, March 22.
  • European Central Bank, 2021, Clear, Consistent and Engaging: ECB Monetary Policy Communication in a Changing World, Occasional Paper Series, n. 274.
  • Favaretto, F., Masciandaro, D., 2016, Doves, Hawks and Pigeons: Behavioral Monetary Policy and Interest Rate Inertia, Journal of Financial Stability, 27, 50-58.

Donato Masciandaro is a Professor of Political Economy at the Bocconi University, where he holds the Intesa Sanpaolo Chair in Economics of Financial Regulation. Since 1989 he has written for the newspaper il Sole 24 Ore. Since 2005, he has contributed to Economia & Management drawing on and developing his comments and analysis published in that economic-financial daily.