The ECB's course and the importance of transparent words

Governor Panetta has indicated a course: be more larks and more doves. What will the hawks and nightingales in Frankfurt do: dress up as pigeons? The starting point is to imagine that the ECB is a ship, that its board - personified by Lagarde - is the captain, and that monetary policy is the best course to choose. Of this ship, the crucial feature is that the course will be the optimal one if a necessary condition is met: the crew must be fully convinced that the captain's is indeed the right choice. The crew of the metaphor, in reality, is the households, businesses and markets of the Eurozone. The thermometer that measures their conviction is their expectations.

But if expectations are crucial, then what the commander says and does becomes crucial. Words are the future direction of the course, that is, what the captain says about the future path of rates. Actions are the cruising speed, which can be zero, accelerating, or braking, whether the ECB's decision is to be neutral, restrictive, or expansionary.

The recent lecture by the Governor of the Bank of Italy, Fabio Panetta, helps us understand why the upcoming meeting of that council in Frankfurt may be important, both in terms of the direction and speed of the monetary course.

Regarding direction, in general the board of a central bank has to make an intermediate choice between two opposing strategies. The first strategy is that of maximum transparency, or the flexible rule, characterised by the so-called Ulysses effect. The central bank announces and commits itself to a given future path of rates, always emphasising that in the presence of relevant macroeconomic news, the announced path will be consistently corrected. This is what the central banks of New Zealand, Norway and Sweden have been doing since 1995, 2005 and 2007 respectively. They did it before the Great Financial Crisis, they continued to do it afterwards. The binding, yet flexible, announcement becomes a compass for the crew; if the crew believes it, it does what the captain hopes. The ship goes in the desired direction.

The second strategy is that of zero transparency, or complete discretion, characterised by the Delphi effect. The central bank says nothing about the future. In the absence of information, the crew must speculate, interpret, worse still guess. As with the oracle, guesses can be homogeneous or heterogeneous, right or wrong. The more heterogeneous and/or wrong the guesswork, the more uncertainty increases: the central bank becomes a float, which can amplify macroeconomic instability. The ECB, since 2022, has taken a policy close to this extreme, based on the two pillars of 'meeting-by-meeting' and 'available data' decisions.