Between 2011 and 2015, I attended the monetary policy meetings of the European Central Bank (ECB) Governing Council, which comprises the Governors of the 20 central banks in the Eurosystem and the six members of the ECB’s Executive Board in Frankfurt. Each Governor brings a staff member, and I attended on behalf of the Irish central bank. As a “backseater” or “accompanying person” in ECB terminology, I sat behind my Governor, followed the discussions and took notes.
It was an invaluable experience and I learned a great deal. Setting monetary policy isn’t always what people expect. Here are four common misconceptions: First, the data are unclear. Some imagine central banking as being akin to air traffic control – experts who sit in dimly lit rooms monitoring screens filled with real-time economic data, carefully guiding the economy toward stability.
In practice, central banks face widespread uncertainty. Think of it like air traffic control but without a functioning radar. While there is plenty of economic data much of it is outdated by the time it is published. For example, inflation data may be from last month and GDP statistics from one or two quarters ago. And data are often preliminary and subject to revision, sometimes several times. How does one take a firm stand on something that might change?
Furthermore, economic indicators are often conflicting and can be interpreted in different ways. Headline inflation may rise, while core inflation – excluding volatile food and energy prices – declines. Goods prices might increase even as service prices fall. Wages could grow, yet a stronger exchange rate might reduce import costs.
As a result, central bankers do not focus on individual data points. Instead, they take a holistic view, much like stepping back from an impressionist painting. Up close, it appears as a collection of colourful blobs but when viewed from a distance, the full picture emerges. Policy discussions focus on the overall perspective – the mosaic formed by a large number of different data – rather than on a few numbers highlighted in the news.
Second, economic theory is often not as helpful as one would have thought. Commentators often argue that central banks should act according to some economic theory. A popular current idea is that monetary policy should be guided by the “neutral interest rate” or r*. However, central bankers know that theory does not always translate neatly into practice. While the neutral interest rate is a clear concept – it is the interest rate that the central bank would set if inflation was on target and the economy was growing at potential – in practice the economy is hardly ever in that fortuitous position. Pinpointing r* with precision is nearly impossible. Basing policy on an estimate subject to great uncertainty is plainly ill-advised.
Rather than relying on hard-to-use shortcuts like r* when making decisions, central banks must instead look at overall economic conditions. Third, there is often less urgency than implied by public commentary on monetary policy. Commentators worry that unless the central bank sets interest rates at the “right” level immediately, it will fall hopelessly behind the curve. Central banks are frequently criticised for acting too slowly.
However, central bankers understand that any single interest rate decision has a limited impact on the economy. What matters are cumulative rate changes over time, such as the 4 – 5% increase in rates over six to eight quarters after inflation surged following the pandemic and Russia’s invasion of Ukraine. A short-term deviation from the ideal policy path of 0.25% or even 0.50% for a month or two is insignificant in the bigger picture.
And if central banks find themselves behind the curve, they can accelerate rate changes. While they typically adjust rates in 0.25% increments, they can also move in steps of 0.50% or more. For example, when it became clear that rapid action was needed as inflation surged in 2021– 2022, the Federal Reserve raised rates by 0.75% several times in a row.
Fourth, good judgment and effective communication skills are arguably more important for a central bank governor than narrow technical expertise in economics – though the latter remains valuable – since they can rely on large and competent economics departments.
Given the empirical and theoretical challenges highlighted above, setting policy under such conditions is a complex exercise. The greatest danger lies in losing the public’s trust. If people come to believe the central bank will be unable to stabilise inflation, their expectations of future inflation may start to drift. This, in turn, makes it much harder for the central bank to maintain price stability.
Clear and credible communication is therefore crucial to ensure public trust. The central bank must demonstrate competence and exercise sound judgment in its decision-making to secure broad support among citizens.
In summary, setting monetary policy is quite a different exercise from what people often have in mind. The state of the economy is highly uncertain and economic theory often has few answers to the practical questions that central banks face. Individual policy decisions are less significant than getting the cumulatively-large policy changes over the business cycle correct. Ultimately, good judgment and effective communication are essential for maintaining public trust, which in turn is indispensable for ensuring economic stability.
This text was published in the spring 2025 edition EFG’s InTalks magazine.