The key chart
Trends in the nominal and real composite cost of borrowing for EA HHs (Source: ECB; CMMP)
The key message
Which is more important for the successful transmission of ECB monetary policy – the real or nominal cost of borrowing in the euro area?
In an interview this weekend, ECB President Lagarde stated that, “we raise rates to make the financing of economic activity more expensive in a manner that dampens demand.”
According to standard macro frameworks favoured by the ECB and other central bankers, households (HHs) adjust spending and consumption in response to actual and expected changes in the real cost of borrowing as opposed to its nominal cost*.
The cost of HH borrowing in the euro area (EA) remains negative in real terms (-1.30%), however, despite the very rapid pass-through of higher policy rates to nominal costs of borrowing (see key chart above). How does this fit with recent calls from some Governing Council members for an end to rate rises and the apparent shift in emphasis in the ECB’s narrative from the level of policy rates to the potential duration of the higher rate period?
Clearly, and stating the obvious, the latest policy stance is very dependent on the course of future inflation. The real cost of borrowing for HHs and corporates will continue to increase if inflation falls even as policy rates remain the same. This will strengthen the second leg of the transmission mechanism of ECB policy – on the real economy.
The challenge for the ECB* (and others) turns then to the underlying assumptions in their policy framework.
In practice, the relative importance of nominal and real rates in dampening demand may be more nuanced than traditional frameworks suggest. Some economists argue, for example that it depends on the level of HH indebtedness/financial constraints (at the micro level) and on the nature of the macro shock (at the macro level).
More specifically, they argue that nominal costs are more important in the scenario when supply-side shocks coincide with high levels of HH indebtedness.
If correct, this implies that the risk of policy errors and potential over-tightening in the euro area remain elevated – a view supported by recent trends in financing flows to the EA private sector. Add the heterogeneous nature of HH debt levels, financing structures and macro trends across the euro area and the significant challenge for the ECB and its “one-size-fits-all” policy becomes clearer still…
Please note that the summary comments and chart above are abstracts from more detailed analysis that is available separately.