The ECB keeps repeating that it is on a path of monetary policy “normalisation”. But what is behind this phrase and why does the ECB like it so much? I argue that it currently functions to deceive and legitimise the potentially severe effects of policy rate hikes.
What does “normalising” monetary policy mean?
Since December, the ECB has used the story of “normalisation” to explain how it is responding to price increases. Normalising implies that there is some definition of normal. So: What does this “normal” refer to?
“Normal” could refer to the choice of instruments. The ECB currently uses a wide range of monetary policy tools: a set of policy rates (1), forward guidance, asset purchases and longer-term refinancing operations. Until 2009, it only used one of these instrument sets: the policy rates. If one revives the old dogma of pre-2009 central banking, policy rate changes could be considered the “normal” monetary policy instrument.
“Normal” could also refer to a certain level for the ECB’s policy rates. Some argue that the policy rates should be close to the hypothetical “neutral rate of interest” at which, supposedly, global savings are in equilibrium with global investment. Some central bankers pay attention to this construct, because it might give an indication of the interest rate at which economic growth is neither stimulated nor slowed. Another supposedly “normal” level for the policy rates would be 0% or higher.
There is no “normal” monetary policy
It is outdated to view policy rate changes as the “normal” instrument. After the Global Financial Crisis, central banks purchased huge amounts of assets to help get inflation up to target, realising that policy rate reductions were not enough to achieve their mandate. In the last few years, policy rates played only a minor role in the ECB’s decisions and were anything but “normal”.
Nevertheless, at the last ECB press conference, Lagarde suggested that “normalisation” involves a transition from asset purchases to policy rate changes. If she really meant to characterise policy rates as the normal tool and asset purchases as the abnormal tool, this would be a position at odds with the ECB’s new strategy. This explicitly validated asset purchases as a monetary policy instrument and only said that the policy rate remains the primary tool, which is much different from saying it is “normal”.
Aiming at a “normal” rate is anything but advisable for the ECB. One of the candidates for the definition of “normal”, the “neutral” rate, where savings and investments are supposed to balance each other, is a concept that is worse than useless. It is incoherent and cannot be empirically observed such that basing one’s monetary policy on it is irresponsible. The other option, lifting policy rates such that they are all at 0% or higher, which is supposedly “normal”, would also constitute bad policy. Central banks should choose a level of policy rates that allows them to achieve price stability, not that could be considered “normal”. The ECB supposedly knows this and its executive board hasn’t yet tied its “normalisation” process to any definition of “normal” policy rates.
It really seems unclear what kind of “normal” the ECB wants to have reached by the end of its “normalisation” process. There are reasons to believe that this ambiguity is intentional.
The term “normalisation” is ideological
The word “normalisation” has one advantage over the word tightening: people interpret it positively because it implies that one moves away from what is abnormal and unsustainable, i.e., from what is bad. In contrast, tightening – the act of slowing down the economy – is negatively interpreted, or simply not understood. Hence, using the term “normalising” makes it easier to gather public support for one’s actions.
By using the term “normalising”, the ECB suggests that its actions and plans are in no need of justification. It serves to get around difficult questions, such as: why does the ECB want to increase the cost of borrowing, now? How is this supposed to address price increases that are mainly attributable to the pandemic and the war in Ukraine? Thereby, the talk of “normalisation” suppresses a democratic debate on what to do given the current price increases – a debate that is already set up in ridiculously narrow terms.(2)
This matters, because the actions that the frame “normalisation” serves to legitimate are not only anything but normal, they could badly hurt many Europeans.
Behind “normalisation” lurks the danger of brutal income cuts
The ECB is preparing a decision on raising the policy rates, maybe already in July, maybe more than twice this year. Rates hikes unfold their effect through slashing employees’ income and spending. Aggressive rate hikes can be brutal, throwing millions of people out of work and suppressing the wages of many millions more. They also increase the cost of financing investments which is particularly important for renewable energy. After a cycle of policy rate increases, Lagarde suggested that, depending on incoming data, selling assets from the ECB’s portfolio would be the next step to complete “normalisation”. Even the word “tightening” is not adequate to capture the drastic effects that all of this would have.
The reasons for justifying these effects are thin. Relying on policy rate hikes won’t tackle the price increase in energy that is dominant right now. If they bring down prices, then only through dragging down the entire economy. Aggressive rate hikes are also counterproductive for the situation we’re currently in: a military war that dampens economic growth and a climate crisis that demands urgent resource mobilisation. Policymakers should keep in mind that a successful transition away from fossil fuels is beneficial for price stability and requires more-than-usual monetary support. Rate hikes might achieve the opposite.
In sum: The path the ECB has taken could end very badly for many Europeans. Describing and legitimating all of this with the feel-good word “normalisation” is not only intransparent, it is deceitful and dangerous.
(1) The ECB has three policy rates: The rate on the marginal lending facility (currently 0.25%), the rate on the main refinancing operations (currently 0%) and the rate on the deposit facility (currently -0.5%).
(2) The researchers Paul JW Mason, Devika Dutt, Rohan Grey, and Nathan Tankus have written on the undue narrowing of the debate on how to respond to price increases. They argue that fiscal measures and financial regulation would be more effective to manage demand, especially today.