A layman's guide to ECB watching: ten simple rules for analyzing the European Central Bank.

• Author: Callow, Julian
• Position: Statistical Data Included

"ECB watchers" have had a much less successful record at forecasting the immediate outcome of ECB meetings than "Fed watchers" do on the FOMC. Using data from regular Bloomberg surveys of analysts, taken just a few days in advance of policy meetings, we found that ECB watchers correctly forecast ECB rate changes just 36 percent of the time, compared with an accuracy rate of 86 percent for "Fed-watchers" and 64 percent for UK-based "MPC-watchers." Undoubtedly, part of this poor performance by "ECB watchers" has resulted from the much higher frequency of ECB policy meetings, which during most of its first three years were running at a rate of twenty-four or twenty-five a year, compared with twelve for the Bank of England's MPC and just eight for the Fed's FOMC. In this sense, the ECB's decision last November to consider monetary policy actions at only its first meeting of the month is very welcome and should make future policy actions considerably more predictable. Meanwhile, here are ten "rules of thumb" to help investors better understand the ECB.

1. THE ECB'S MANDATE DIFFERS FROM THAT OF THE FED.

   Much of the explanation for the ECB's different behavior to that of the Fed appears to result from a different mandate. The ECB's primary objective is "to maintain price stability"; only without prejudice to this may it then contemplate its secondary objective, "to support the general economic policies of the Community." In contrast, the Fed's objective is "to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates." The ECB's interprets price stability as harmonized CPI inflation over the medium term of "below 2 percent"; more recently officials have begun to imply that this represents a 1-2 percent range. Recall also that the ECB is a new institution, responsible for an economic region larger by population and geography, with a more inflation-prone history than the US, as well as being more diverse economically, politically, and culturally, than is the Fed. As such the ECB is still highly preoccupied with reputation building--in particular, to emphasize to economic agents in the euro area that it will not tolerate inflation above 2 percent in the medium term.

2. A DIFFERENT NOTION OF PRIMUS INTER PARES ("FIRST AMONG EQUALS")

   The phrase, primus inter pares ("first among equals") might also be used to describe the authority that the Chairman of the Federal Open Markets Committee (FOMC) exerts over his fellow members. In practice, what the Fed Chairman wants, the Fed Chairman appears to get. In contrast, this may not always be the case for the President of the ECB, who strives for consensus amongst the eighteen-person Governing Council (GC). This collegiate approach reflects several factors--the newness of the institution; cultural inclination; the personalities involved. The formation of the ECB has involved a tremendous concentration of power--from twelve national central banks to effectively one organization. Many senior central-banking officials, especially governors of national central banks, had been accustomed to a highly visible public profile, and inevitably still want their voices heard in public and in private.

   Another difference with the Fed is that the ECB's economics and research directorate works in principle for the GC as a whole, but its research tends to be aggregated by Chief Economist Issing, who is said to open the meeting with an economic exposition that concludes with a recommendation on interest rates. In contrast, Fed Chairman Greenspan has de facto become the Fed's "Chief Economist" and therefore has exerted a degree of influence over the research conducted by the Fed's staff and its presentation to the FOMC. That said, the ECB President does usually represent the ECB before the European Parliament and takes responsibility for monetary policy at the ECB press conferences, and therefore can still exert a high degree of suasion over the committee.

3. THE "STEADY HAND" TRADITION CONTINUES.

   The ECB's perception of the effectiveness of monetary policy appears to differ from that of the Fed. It would argue that above all monetary policy should be "stability-oriented"--a legacy of Bundesbank thinking. It regards Europe's growth prospects as best achieved through achieving a high rate of investment, which in turn requires low and stable long-term rates. It sees these as particularly important for Europe, given a higher dependency of corporate and household financing using long-term rates. The ECB focuses less than the Fed on stock market movements, partly because it does not believe that equities play much role in affecting the euro area economy. It does, however, pay close attention to (and takes considerable pride in) inflation expectations derived from index-linked bonds. As well, the volatility of the euro and its potential impact on the formation of inflation has meant that the currency's external value has assumed proportionately more importance in ECB considerations and actions than it has for the Fed (which has traditionally paid scant attention to the dollar's value).

   The ECB appears to have a stronger preference than the Fed to minimize volatility in its official policy rate (the "repo rate"). It therefore has a very "gradualist" approach that, it believes, helps to foster lower long-term rates (by lowering the risk premium). In general, it would prefer not to reverse interest rate decisions within a considerable time-span--indeed, some officials would doubtless have preferred, with the benefit of hindsight, not...