The European Central Bank unveiled a new policy framework that will likely keep its easy-money policies in place for longer and will aim to take account of housing prices as the eurozone emerges from the Covid-19 recession, but it stopped short of the major policy shift announced by the Federal Reserve last year.
The changes, the ECB’s first in nearly two decades, aim to give policy makers a broader tool kit to navigate deep shifts in the global economy, including the failure of ultralow interest rates to push inflation higher.
The central bank said in a statement it would aim to keep eurozone inflation at 2% over the medium term, instead of the current target of just below 2%, and would allow room to overshoot its target when needed. It also said it would move to incorporate owner-occupied housing costs into its calculation of the inflation rate, and would support efforts to combat climate change via its bond-purchase programs and collateral framework.
The reaction in financial markets was muted. Investors expressed skepticism as to whether the changes would affect the ECB’s policy course, which reflects a compromise between conservative policy makers in northern countries like Germany who tend to worry about high inflation, and those in Southern Europe who are more concerned about weak economic growth.
“At the crux of the challenge the ECB is facing, namely getting inflation up to 2%, the review probably falls short as it doesn’t answer the question of how monetary policy can be configured to generate” higher inflation, said Konstantin Veit, portfolio manager at Pimco. “The ECB’s answer seems to be more of the same.”
The Federal Reserve unveiled a more-ambitious policy shift last year, saying it would pursue an average inflation rate of 2% over time. That means the Fed plans to allow inflation to rise above 2% to offset periods when inflation falls below that level. Unlike the Fed, the ECB won’t actively aim to run inflation above target to make up for previous shortfalls.
“Are we doing average inflation targeting like the Fed? The answer is no, very squarely,” ECB President Christine Lagarde said at a news conference.
The ECB’s more cautious approach comes despite a growing divergence between the U.S. and eurozone economies.
The U.S. economy is expected to grow by about 7% this year and may already have surpassed its pre-pandemic size, supported by double-barreled stimulus from the Treasury and Federal Reserve. U.S. inflation surged to 5% in May on an annual basis, the highest annual inflation rate in nearly 13 years.
In contrast, the eurozone economy is expected to grow by about 4.5% this year, and won’t make up the ground lost to the pandemic until next year.
Eurozone inflation rose to 1.9% in June, but that largely reflects the sharp recovery in oil prices. Annual inflation in the eurozone has averaged about 1.2% since the summer of 2008, down from about 2.1% in the previous nine years, according to Natixis bank.
The ECB said last month it would keep its key interest rate at minus 0.5% and continue to buy eurozone debt under an emergency EUR1.85 trillion bond-buying program, equivalent to $2.2 trillion, through at least March 2022. Ms. Lagarde has said any discussion about scaling back the bank’s stimulus is premature, even as Fed officials suggest they might need to pull back their support for the economy sooner than they had anticipated.
“The result of the ECB strategy review does not change our outlook for monetary policy in the eurozone,” said Holger Schmieding, chief economist at Berenberg Bank.
Perhaps ominously for the ECB, Japan’s central bank in 2016 also committed to overshooting its inflation target of 2%, but consumer price inflation in Japan has since languished below 2%.
Still, a higher inflation target rate signals a longer period of easy money, which should provide additional stimulus to the eurozone economy. The ECB’s decision, after around 18 months of reflection, makes clear that undershooting its target is as bad as overshooting, meaning the bank might react sooner to long periods of low inflation.
Stefan Gerlach, a former deputy governor of Ireland’s central bank, said the new strategy could redirect delicate discussions within the ECB, by giving fresh ammunition to those who worry more about economic growth than inflation.
“The previous target, just below 2%, made it difficult for ECB policy makers to add stimulus when inflation was running at 1.5% because of the risk of exceeding 2%,” Mr. Gerlach said. “Now they will find it easier to do so…so I think it’s a big difference.”
The new strategy would also make it simpler for the ECB to turn immediately to more unconventional instruments such as asset purchases to combat an economic downturn, rather than having to turn first to traditional tools such as interest rates, he said.
“This makes an end to the very loose monetary policy even more distant,” said Joerg Kraemer, chief economist at Commerzbank in Frankfurt. “This is in the interest of the highly indebted states, but it further fuels asset prices and thus increases the risk of dangerous bubbles on the financial and real-estate markets in a few years’ time.”
Ms. Lagarde launched the strategy review at the start of 2020, motivated by the sobering probability that central banks around the world would face greater difficulty spurring growth than previously, due to low interest rates. It is the first revamp of the ECB’s policy-setting framework since it approved a formal inflation goal of “below, but close to 2%” in 2003, five years after the bank was established.
The ECB won’t wait so long before undertaking the next review of its policy strategy, which will be carried out in 2025.
By Tom Fairless