The members of the Governing Council of the European Central Bank (ECB) do not cease to have a political profile. Therefore, what is said behind closed doors differs from what is said behind closed doors. With the echoes still reverberating from several Eurobank officials warning of the danger that inflation in the services sector continues to pose, it turns out that the internal debate is already about how far to lower interest rates to stimulate zero economic growth with uncertain prospects. Within this ‘new’ debate, which the agency reports this Wednesday Reuterssome voices go further and They propose leaving rates below what is known as the neutral rategiven the pressing economic weakness and the need to revive activity.
The question that many will ask is what is the neutral interest rate, where is it and why does the ECB obsess? The concept of neutral interest rate (TIN), natural or equilibrium was coined for the first time by Swedish economist Knut Wicksell. In a more technical sense, this type is consistent with a labor, goods and capital market that is in equilibrium. This type does not depend on the decisions of central banks (although it is a fundamental guide for making their decisions) but on factors such as productivity, population growth, automation of production processes, globalization or agents’ preferences/propensity for consumption and savings, which in turn may depend on many other factors. The neutral rate is the price that money should have in the economy according to mathematicsthat is, according to the econometric models that calculate it.
In principle, a region with strong population growth, mostly young, with a greater preference for consumption and investment and robust productivity, will present a high neutral real interest rate so that the economy remains in balance and bubbles in asset prices, inflation or any other imbalance do not occur. This may be the case in economies like India, for example. On the other side are the advanced economies, where the real neutral interest rate could be close to 0%, according to the ECB’s own calculations.
Advanced economies and, above all, the Eurozone present factors opposite to those described above (which would define ‘Japanization’), which would reflect a low neutral interest rate. Before covid, it was believed that the neutral rate was between zero and 0.5%, during the pandemic it even fell to negative territory in the Eurozone and, perhaps, also in the US. After the pandemic, it is estimated that the neutral rate could have risen slightly, but the latest comments from experts and the ECB itself once again place this indicator very close to 0%.
What does this mean for the ECB? Opening the doors to bringing the official interest rate below or to the level of the neutral interest rate is to recognize that the ‘price’ of money is going to fall to 2% or even below. As elEconomista.es anticipated a few days ago, bringing rates to this level would imply lowering them below 2%. The technical explanation is as follows. If the neutral interest rate is at 0% to achieve savings and investment in a balance consistent with full employment and price stability and inflation remains close to 2%, the ECB will have to maintain the interest rate. deposit in that 2%. A deposit rate below 2% will be an expansionary monetary policy (drives greater growth and demand), while any rate above 2% will be contractionary. All as long as inflation remains at 2%. Right now, the deposit rate is at 3.25% after the latest cut by the central bank.
Lack of consensus within the ECB
The sources consulted by Reuters, who have spoken on condition of anonymity, clarify that there is still a long way to go to reach a consensus among officials on this point, but the debate itself marks a significant change in the formulation of the central bank’s policies. These people related to the organization also reveal that, for the moment, it is a still small – although growing – group within the Council that argues that the ECB has been left behind and that Deeper rate cuts will be needed than previously thought to prevent inflation from falling too much. This nascent group is also advocating that the Eurobank review its “meeting-by-meeting” guidance and abandon the reference to restrictive rate levels as a sign that it is taking downside risks seriously.
“I think neutral is not enough,” says a source with direct knowledge of the discussion. “There is still some time for that decision, but the economy has been stagnant for two years and there is no recovery in sight,” he adds to Reuters. Gediminas Simkus, head of the Lithuanian central bank and member of the governing council of the ECB, has been one of the first to speak publicly about this risk. “If disinflation processes take hold… it is possible that rates will be lower than the natural level. We have been like this for decades,” he stated this week. Sometimes “natural” is used to refer to this neutral type.
Before this information from Reuters emerged, some analysts had already predicted that the ECB will have to leave rates below what was expected at the end of this cycle, considering the option of this ‘goal line’ being below the neutral rate. . Mathieu Savary, chief economist for Europe at BCA Research, in statements to elEconomista.es, last Friday gave high probability that interest rates in the euro zone will fall to 1% during 2025. It is not an extreme scenario, it is the base scenario of this Canadian analysis house that draws on a reality that is making its way: the central bank will have to do everything possible to stimulate the patchy economy of the eurozone.
Savary calculates that the neutral real interest rate is close to 0%. So if inflation remains at current levels, the ECB should keep rates close to 2%, but if prices moderate further, the ECB will have room to lower rates below that level. “Our estimates of the neutral real interest rate for the eurozone are around 0%, which coincides with the ECB’s own estimates. In nominal terms, this gives us a neutral interest rate of approximately 2%. With the economy weak, inflation easing and tensions in France creating a risk to financial stability, we expect the ECB to cut rates below that neutral rate. We therefore expect the ECB’s deposit rate to be somewhere between 1% and 1.5% by the end of 2025.“, concludes the expert.
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