The ECB faces a big credibility test on its new inflation target
PremiumIts ‘symmetric 2%’ aim allows policy flexibility but is rather vague
The European Central Bank’s (ECB’s) first strategy review in 18 years is about to get its first credibility test. President Christine Lagarde has fired the starting gun for the implementation of the ECB’s new policy framework. It will soon issue its updated guidance on policy rates, in preparation for a fresh programme of quantitative easing (QE) to replace the current pandemic sovereign bond purchases, which runs out in March 2022. The centrepiece is the ECB’s revised inflation target. It replaced its 2% upper inflation limit, based on its 2003 “below but close to 2%" formulation, with a “symmetric 2% over the medium term" target. This requires “especially forceful or persistent monetary policy action to avoid negative deviations from the inflation target becoming entrenched," it said. And it allows for “a transitory period" of inflation above target.
Markets yawned when the metrics were announced last week. They aren’t wrong to be sceptical. In a likely attempt to achieve unanimity between the hawks and doves on its governing council, the ECB language has been left vague. We don’t know what “forceful or persistent monetary policy action" means or how long the “medium-term" horizon for hitting the target will be—or the “transitory" period of an inflation overshoot. We also don’t know anything about how the ECB plans to achieve its target.
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But establishing a credible target for anchoring inflation expectations in the euro region is ground zero for rebuilding the central bank’s credibility. The cost of failure has been high. Core euro-zone inflation (excluding volatile items) has averaged just 1% over the past decade—less than half the ECB’s target and at the threshold of deflation risk territory. Worse, downward pressures on both headline and core inflation expectations have built up after the euro sovereign debt crisis.
During the ECB presidencies of Wim Duisenberg and Jean-Claude Trichet, from 1998 to 2011, the euro-zone medium-to-long-term inflation expectations were “firmly anchored", a pronouncement that proudly appeared six times in the last ECB strategic review of 2003. That measure was dropped from the governing council’s statements during the sovereign debt crisis in 2015 and hasn’t made a return since. Persistent expectations that the ECB wouldn’t meet its inflation targets reflect the central bank’s consistent failure to move early and forcefully enough to counter deflationary risks in the debt crisis era.
The remedy can’t simply be another firm target, not in a union of countries experiencing chronic demand shortages, excess savings and low inflation, that is set to emerge from the pandemic with near-record budget deficits and sharply higher debt levels. The ECB needs a credible policy framework to reach its inflation target and to stay in sync with the EU’s broader policies aimed at full employment, environmental protection and financial stability.
By shrugging off the Bundesbank’s legacy of hawkishness, the policy review takes up the ethos of Lagarde’s predecessor Mario Draghi (of “whatever it takes" fame) and creates much needed room for flexibility. By correcting the asymmetry in the inflation target, the ECB has been forced to tackle the asymmetry of its own tools, namely the inability to stimulate inflation when rates are already at the lower bound. To that end, while interest rates remain the chief policy tool, the extraordinary stimulus levers introduced since the financial crisis—bond purchases, long-term bank loans and forward guidance—are now considered ‘integral’ features of the ECB’s toolkit.
Covid threw the ECB back into depths as dire as the debt crisis. The shock to growth and sharply rising public debt—at a time when inflation is so low that rate cuts couldn’t stimulate—forced it to adopt a dual objective: Easing financial conditions to counter the demand shock in real economies and to fight signs of fragmentation in sovereign markets via direct bond purchases. The policy review and preparations for a new format for QE stimulus after 2022 in effect recognize the significance of European sovereign bond yields and spreads for the ECB’s price stability mandate.
The purpose is to reset ECB policy for the post-covid era. What’s left for ECB hawks and doves is to decide how forcefully they are prepared to act in the trade-off between more stimulus now versus a longer period of unconventional policy to meet its inflation target. By preparing to keep its monetary stimulus after the €1.85 trillion pandemic bond-buying ends, the ECB can buy some credibility by diverging from other central banks that are discussing tightening. This is significant as markets begin to assess the credibility of the ECB’s inflation target, and as the European Council begins to evaluate the conditions for fiscal and growth sustainability in the coming years. Now, all the ECB has to do is deliver.
Lena Komileva is managing partner and chief economist at G+ Economics, an international market research and economic intelligence consultancy based in London.
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