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Eurozone rate-setters have urged economists to stop fixating on the so-called neutral rate, warning that the measure was “not a good guide” to what will happen to borrowing costs in a region increasingly exposed to weak growth and global uncertainty.
After five interest rate cuts, economists are becoming fixated on when the European Central Bank hits neutral — a goldilocks level at which borrowing costs neither stimulate, nor constrain, economic activity. They think reaching this level could lead policymakers to keep borrowing costs on hold — or delay further reductions.
But with the outlook for the Eurozone weakening fast, officials argue that hitting a level consistent with this crucial, but theoretical, benchmark matters less than economists think.
Olli Rehn, governor of the Bank of Finland, told the Financial Times that the ECB should stand ready to ease borrowing costs to a level lower than neutral to boost growth.
“We should not constrain our freedom of action because of a theoretical concept,” he said, adding that the ECB should keep “an open mind” on where interest rates end up.
On Wednesday ECB chief economist Philip Lane pointed out that while the neutral rate was an “important concept in understanding the likely long-run average interest rate”, it was “not a good guide to near-term policy decisions”.
ECB vice-president Luis de Guindos on Wednesday also warned against using the neutral rate as a “reference for monetary policy decisions”.
In an interview with Slovakian daily Hospodárske Noviny, De Guindos said the ECB needed to consider “all relevant incoming data and a vast range of indicators”, adding: “While the neutral rate makes for an interesting academic concept, it is not very useful from a policymaking standpoint.”
Piero Cipollone, another executive board member, told Reuters in an interview published Thursday that, while the neutral rate was “a very powerful analytical concept”, it was “not terribly useful for setting monetary policy”.
While the neutral rate is almost certainly lower than 2.75 per cent, the ECB’s current benchmark deposit rate, there is also disagreement about what the exact figure is. It cannot be directly measured but economists use mathematical models and real-world data to estimate its level.
ECB president Christine Lagarde caused a stir in Davos last month when she said the neutral rate was likely to be between 1.75-2.25 per cent — a range that was lower than assumed by many experts. Lagarde later revealed that the bank would disclose updated calculations on Friday.
While Lagarde said after last week’s rate cut that the ECB’s governing council would take its new neutral estimates into account, it would be guided by the real world too. “We will also be looking out of the window,” she said.
Many economists had thought that one or two additional quarter-point cuts — which are widely expected during the first half of 2025 — will place the ECB in the neutral zone.
One reason for their focus on the rate is because hawkish voices, including influential ECB executive board member Isabel Schnabel, have previously said the pace of cuts should slow once they reach neutral or risk stoking inflation, which for now remains above the central bank’s 2 per cent goal.
Rehn told the FT that Bank of Finland estimates point to a “lower end” of the neutral rate at “approximately 2 per cent or slightly below”.
Lena Komileva, chief economist at the consultancy G+ Economics, said the neutral rate “may not guide policymakers meeting by meeting”, but it was still a useful benchmark. “Prolonged deviation will either risk disanchoring inflation expectations and runaway inflation, or [if the rate is lowered towards zero], quantitative easing and deflation.”
BNP Paribas chief European economist Paul Hollingsworth said the ECB was keen to avoid a “perception” that they would halt cuts once they reached neutral and to stop investors’ expectations “being overly-anchored around a particular level”.
A transcript of the FT’s interview with Olli Rehn is available on our Monetary Policy Radar service here
