The European Central Bank’s biggest strategic rethink since the creation of the euro sets the terms of engagement for a half decade of post-pandemic monetary debates—even if it stops short of signaling much about future policy.
The outcome that President Christine Lagarde unveiled on Thursday raises the inflation target and specifically acknowledges that it might need a temporary overshoot. That’s a win for doves on the Governing Council.
But it was also careful to portray that leeway as a special situation—albeit one that the euro zone has been in for years—when interest rates are so low that “especially forceful” monetary stimulus is needed to revive price pressures. That’s a win for the hawks, such as at Germany’s Bundesbank, who don’t want extraordinary measures to be used in normal times.
Granting both sides of the ECB’s policy spectrum devices to argue their case on the economic outlook underscores how the institution’s rethink is ultimately a technocratic version of the classic European compromise that has long characterized the region’s politics.
It means the strategy review became an exercise in ambiguity and discretion rather than the more rigid framework it might have produced. In return, Lagarde secured unanimous agreement, and a foundation of consensus for the next phase of policy that may clean the slate after years of bad-tempered decision-making under her predecessor, Mario Draghi.
“With Lagarde’s ECB, it’s always a compromise, there’s something for everyone,” said Marco Valli, head of macro research at UniCredit Bank. “We have always seen that the ECB in the end does the right thing. It just takes them longer to get there than other central banks.”
That argument is highlighted by the fact that the review ended almost a year after the Federal Reserve concluded its own reappraisal. That exercise resulted in a commitment to target average inflation of 2 percent—a step too far for its euro-zone peers.
The ECB opted for “symmetry” around its goal instead, meaning “negative and positive revisions of inflation from the target are equally undesirable.”
“This is such a subtle difference, and you have to know Lagarde a little bit to know maybe they needed to have this giveaway to the Bundesbank and the hawks,” said Agnes Belaisch, chief European strategist at Barings.
Consensus builder
The task Lagarde faced was daunting, with the ECB never really having comprehensively taken stock of its approach to managing an economy, which had clearly evolved considerably since the fledgling currency region was created in 1999.
With the institution forced to take the lead in repeated crisis battles, philosophical disagreements had festered on the Governing Council, culminating in a decision where Draghi pushed through stimulus against the wishes of governors representing much of the euro zone’s core.
Only Lagarde’s new presidency in 2019 allowed a hiatus to take hold, buying time for a review she inaugurated that grants a combination of concessions to policy-makers and citizens alike.
The new 2-percent inflation target is higher than the “close to, but below 2 percent” that it used to be, giving doves an allowance for more price growth than before. There’s also the acknowledgment that a “transitory period” above the goal can be tolerated.
“In theory this makes a continuation of the current ultra-accommodative monetary policy even more likely and pushes the prospect of any policy rate rises further into the future,” Simon Wells, an economist at HSBC Holdings Plc, said in a report. Still, “all in all, we don’t see today’s announcement as significantly changing the near-term policy outlook.”
“After years of undershooting the target and predicting an acceleration of inflation that never materialized, the Governing Council will wait until it sees evidence of higher inflation before starting to withdraw stimulus rather than purely relying on the staff economist’s medium-term forecasts,” said Bloomberg’s economists David Powell and Maeva Cousin.
Importantly for the likes of Bundesbank officials though, the possibility of an inflation overshoot is framed within the context of “when the economy is operating close to the lower bound on nominal interest rates.” Or in other words, when interest rates are so low that further cuts would be ineffective—as now.
The ECB’s acknowledgment of the need to include owner-occupied housing costs in assessing consumer prices also helps the hawks, at least as long as ultra-low interest rates are pushing up home prices. JPMorgan economists reckon such costs would currently add as much as 0.3 percentage points to core inflation.
“What I think is really important is the extent to which they are open to embrace the flexibility that they deployed in the crisis and make this a more permanent feature of their tools,” said UniCredit’s Valli.
For citizens, meanwhile, the ECB’s review places the institution at the vanguard of climate-change policy making for financial markets. That’s a regional response to concerns that mirrors the emphasis of the European Union’s new recovery fund and seeks to quell angst that has been displayed in demonstrations on the streets of its Frankfurt home—and on its roof.
Policy-makers approved the compromise unanimously, but if anyone is left dissatisfied, there’s even reason for comfort there: the ECB won’t wait so long for its next strategy review, with officials announcing that the next one should begin in 2025.