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Does the ECB Strategy Review Represent an Overhaul of Euro Area Monetary Policy?

Thomas O’Mahony

No. The results of the strategy review were more about clarifying and making explicit how European Central Bank (ECB) policy is currently run, rather than signalling a radical departure for monetary policy in the single currency bloc. Several of the changes, discussed below, were of a dovish nature, albeit moderately so. Indeed, expectations for any policy tightening from the ECB were already so minimal and remote that the impact on asset markets was negligible. Changes to reflect the cost of owner-occupied housing in the inflation rate, and to account for the impacts of climate change, may have more meaningful effects, though these are likely to be several years in the making.

The highest profile change to come out of the strategy review was to set the inflation policy target to 2% over the medium term, from ‘close to, but below, 2%’ previously. Sell-side economists and strategists have long assumed that this meant a de facto inflation target of somewhere between 1.8% and 1.9%. However, in the associated press conference, ECB president Christine Lagarde noted that her predecessors considered this wording to imply an inflation target of something more like 1.95%. In this light, setting the target to 2% represents a relatively minor adjustment.

This 2% target is now also explicitly considered to be symmetric, with overshoots and undershoots versus target deemed equally undesirable. However, the ECB’s latest forecasts show an expected change in the Harmonised Index of Consumer Prices (HICP) for 2023 of just 1.4%, suggesting further accommodation is required to reach that target. It is possible that the first set of inflation projections to be released post the strategy review will be revised higher to incorporate an anticipated impact from this ‘new’ strategy. Nonetheless, the existence of an effective lower bound (ELB) for interest rates continues to crimp the ECB’s ability to provide sufficient accommodation through conventional channels.

In the absence of room to cut interest rates further, the ECB has leant on more unconventional measures, such as forward guidance, asset purchases, and longer-term refinancing operations. The review states that these measures will remain a key part of the ECB’s toolkit, especially when in proximity to the ELB. Forward guidance will have an especially important role to play in providing monetary accommodation given interest rates remain the primary policy instrument. The ECB will be at pains to communicate that there will be no premature tightening, thereby seeking to keep a lid on any potential rise in market rates. The latest language states that rates will remain at current or lower levels until inflation reaches 2% in a durable manner and well ahead of the end of its projection horizon. Asset purchases will also continue to play a part in monetary policy given the importance of sovereign risk in Euro Area financial stability. Though the Pandemic Emergency Purchase Programme (PEPP) will draw to a close, a further programme of asset purchases will likely succeed it. However, limits to the effectiveness of these unconventional measures remain, especially at the ELB, and as such President Lagarde will continue to lobby for fiscal policy to play a more significant role in driving any recovery.

A further related element in the strategy review is a recognition that the forceful policies required to avoid negative deviations from the inflation target becoming entrenched ‘may also imply a transitory period in which inflation is moderately above target’. This should be self-evident given the muted inflation forecasts and the apparent commitment to symmetry. However, the linkage of these potential periods of inflation overshoot solely to managing policy when at the ELB would appear to be an effort to distinguish this policy from that of the US Federal Reserve’s Flexible Average Inflation Targeting. Indeed, President Lagarde plainly stated that this was not to be interpreted as average inflation targeting. Overshoots may be a consequence of policy that seeks to avoid what is seen as damaging disinflation, and only in specific circumstances, rather than being desirable per se as part of a broader policy or ‘make-up’ strategy. Nevertheless, the unspecified nature of the wording used (‘transitory’ and ‘moderately’) will provide the ECB, much like the  Fed, with ample wiggle room.

On a longer horizon, the planned inclusion of owner-occupied housing (OOH) in the inflation measurement will help to align the Euro Area more closely with other developed economies. The chosen method of representation would add approximately 0.2% to HICP at the current time, though the short history of the existing series means the complete impact over the course of a cycle is unclear. In any case, the measure will not be ready for inclusion into a ‘HICP+OOH’ index until 2026 at the earliest, though the Governing Council will pay some heed to what the OOH index is saying in the meantime. Finally, the ECB will explicitly take climate change and the carbon transition into account in its decisions. This involves the enactment of an action plan to integrate such considerations into macroeconomic and financial stability modelling. Nevertheless, the impact of climate change considerations on macro variables, especially inflation, remains a subject of some debate.

Thomas O’Mahony, Investment Director, Capital Markets Research