FRANKFURT (Reuters) – The European Central Bank can press ahead with interest rate cuts this year but needs to rethink how it forecasts inflation and sets policy based on these projections, Belgian policymaker Pierre Wunsch said on Wednesday.
The ECB all but promised a rate cut on June 6 but sent few signals about subsequent moves given high services inflation and worries that a delay in monetary policy easing by the U.S. Federal Reserve could also force it to take its time.
Wunsch, Belgium’s central bank governor, however, made the case for further moves, arguing that staying tight for too long was now a bigger risk than easing too early.
“Although the outlook remains foggy, I see a path for initiating rate cuts this year,” Wunsch said in a lecture in Frankfurt.
“With no sign of de-anchoring (of expectations) in the longer term, the costs of remaining tight for too long seem to outweigh those of a premature loosening,” Wunsch, one of the first policymakers to warn about the recent inflation surge, said.
Commenting on the broader policy direction, Wunsch took issue with how the ECB forecasts inflation, given the poor accuracy of its projection models, especially during periods of economic volatility.
“Models may not always be the reliable compass on which we should rely,” Wunsch said. “We were led to believe that inflation was transitory, only to find out it was not.”
“This underscores the need for a critical re-evaluation of our modelling frameworks and of the role of model-based projections in policymaking,” he said.
STRUGGLE WITH EXTREME EVENTS
Models miss large economic shifts, struggle with extreme events and emphasize inflation further out over short-term developments, Wunsch said.
While the ECB targets inflation over the “medium term”, short-term trends are still crucial because workers and companies set wage demands and price expectations based on them, so overlooking them could send the ECB in the wrong direction, like in 2022 when it raised rates relatively late, Wunsch added.
Thus, the ECB should place greater emphasis on short-term inflation expectations and wage dynamics, especially in the current climate of unusual volatility, he said.
The ECB should also become less fixated on a single-point inflation target and could exercise more flexibility, especially when small deviations from the target would require extraordinary effort to correct.
The ECB could introduce alternative scenarios when making projections to signal the uncertainty and it could also declare its flexibility in interpreting target when inflation expectations remain “reasonably well-anchored”, Wunsch said.
“Where does this leave us? Probably with a humbler form of monetary policy. One that tolerates some more deviation from our target when economic conditions are benign and when risks of larger deviations are contained. This is more art than science,” he added.
