ECB Officials Zero In on Final Compromises of Policy Overhaul

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The European Central Bank is entering the final stretch of its biggest strategy review in almost two decades, with officials looking to hammer out key differences over future monetary policy.

The central bank’s top policy makers are gathering this week for discussions that were initially launched by President Christine Lagarde in early 2020 but were quickly delayed by the coronavirus pandemic.

A key issue at stake is agreeing to a new formulation of the ECB’s inflation target, a topic that dominated reviews by other major central banks such as the U.S. Federal Reserve after years of lackluster price growth. The ECB’s role in fighting climate change, as well as how to address an ever-evolving labor market will also be high on the agenda.

The discussions start with a dinner in Frankfurt on Tuesday and may culminate in an announcement as early as this week if final hurdles are cleared, according to people familiar with the matter. An ECB spokesperson said the institution has planned “several meetings that might be held in person, health and safety regulations permitting.”

One challenge is the number of people and economic ideologies that need to be aligned. The ECB’s Governing Council, which includes Lagarde’s Executive Board and representatives from each euro-area central bank, numbers 25, up from 18 the last time policy was reviewed in 2003.

“This is really quite a key moment. They can’t get this strategy review done without full agreement by the Governing Council,” said David Marsh, chairman of the Official Monetary and Financial Institutions Forum in London. “This does give some people blocking power. Vetoes have to be used very carefully.”

Since the last time officials undertook a review, the world around the ECB has also changed dramatically.

The currency bloc faced an existential debt crisis on the heels of the global financial turmoil that started in 2008. Then, in an environment of record low interest rates, an unprecedented number of policy innovations from the ECB failed to lift inflation toward its goal of “below, but close to, 2%.” Finally, Covid-19 erupted, triggering the deepest recession in living memory.

Here are the key issues to watch:

Inflation Goal

Price stability is the ECB’s primary objective, so the review of the inflation target goes to the heart of its mission. The current goal was defined at a time when fighting excessive price growth was the biggest concern, but in recent years, the wording was seen by some as having contributed to too low inflation.

There’s consensus that it should change, but still some disagreement on an alternative. Some favor a precise goal of 2% with flexibility, while others -- especially from southern Europe -- want an explicit pledge to tolerate higher rates after periods in which it has run below target. Bundesbank President Jens Weidmann and ECB Executive Board member Isabel Schnabel are among those who are skeptical of such an approach. Bloomberg Economics expects the ECB to adopt a simpler and more symmetric target of 2%, making clear that undershooting the goal will lead to an equally strong reaction as overshooting.

What Bloomberg Economics Says...

“The ECB is relatively isolated in seeking inflation of less than 2%. Only one other central bank of an advanced economy does the same -- the Swiss National Bank.”

--David Powell. To read his report, click here

Resolving this question will influence other aspects of the review, such as the debate over how inflation is measured and whether to give greater consideration to house prices. It will also impinge on the shape and timing of the ECB’s exit from the emergency measures deployed during the pandemic, most importantly the 1.85 trillion-euro ($2.2 trillion) bond-buying program that’s currently set to run until the end of March 2022.

Green Ambitions

One of Lagarde’s key focus areas since the start of her presidency has been the ECB’s role in combating climate change. While the initiative was initially greeted with some skepticism, she has managed to bring round even some of the more reluctant members of the Governing Council.

A possible outcome could see the ECB alter its approach of mirroring the composition of the market when buying bonds -- known as “market neutrality” -- to one that pays greater attention to climate risks. While officials are unlikely to start favoring certain industries outright, Weidmann argued recently that climate change poses a risk to central bank balance sheets, and officials might need to take measures to safeguard them.

That could include “limiting the maturities or the amount of corporate bonds of certain sectors and issuers in the Eurosystem’s monetary policy portfolio,” he said in June.

Employment and Inequality

The ECB’s vigor in addressing climate change has, at least on the surface, been mirrored less in its reflections on the labor market -- even though economic models assume a direct link between the amount of slack in an economy and prices. Paying more attention to inequality formed a core part of the Fed’s conclusions during its own review, and Chair Jerome Powell frequently cites higher unemployment among disadvantaged groups as a reason to keep monetary support in place for longer.

The ECB, however, lacks the Fed’s dual mandate for price stability and full employment, and also faces a shortage of data that could give them a fuller picture of inequalities. Lagarde has acknowledged it would be hard for her to emulate Powell, even though some Governing Council members, including Finland’s Olli Rehn, have called for a greater focus on the labor market. Others are worried that focusing more on issues such as climate change and inequality could distract from their pursuit of price stability.

Monetary Toolbox

Even before the pandemic, the ECB, like other central banks, had already vastly expanded its toolkit and now relies on asset-purchase programs, cheap funding for banks, negative deposit rates and forward guidance to deliver on its target. Lagarde has said policy makers need to reflect on what happens if interest rates remain low, and what should be considered normal in such circumstances.

Officials are also looking into the links with fiscal policy, a topic that’s become more acute after coronavirus-triggered government spending. Some central bankers have warned against becoming too entangled with public finances, and cautioned that the ECB should always be able to raise interest rates if necessary, even if it means a greater burden for more indebted governments.

Answers to these and other questions, such as the impact from digitization and globalization, or how to optimize the ECB’s communication strategy, will ultimately be closely linked to one another. If officials are unable to agree on major issues this week, they may well save their conclusions for September, when they are expected to make their views public.

©2021 Bloomberg L.P.