ECB Announces New Inflation Target
Please note this blog post was published over 12 months ago and so may not include the most up-to-date information, for example where regulation around investing has changed.
Over the past few months we have discussed the inflation outlook and how different regions have differing ways of managing inflation expectations. Today, we will look at the recent announcement from the European Central Bank (ECB) setting a new inflation target.
When Christine Lagarde became the president of the European Central Bank (ECB), she promised to leave “no stone unturned” and announced a long overdue review of the ECB’s monetary policy strategy. This is the first review since 2003.
Why Was the Review Needed?
Inflation has undershot its target for at least a decade!
Chart: Euro Inflation v Target
Source: Bloomberg 09/07/2021
The ECB has struggled with excessively low inflation culminating in interest rates being cut to negative territory and money being printed, but with limited success. Negative rates have cast doubt on the effectiveness of central banks and their ability to generate higher inflation and faster economic growth.
Chart: Eurozone Interest Rates Since 2007
Source: Bloomberg 09/07/2021
With persistent negative rates in mind, Christine Lagarde has held an eighteen-month deep dive into the inner workings of a central bank challenging core principles of monetary policy in the hopes of resetting strategy and bolstering credibility.
What Did the Review Conclude?
In the key conclusion of the review, the central bank of the 19 countries that share the euro set its inflation target at 2% in the medium term, ditching a previous formulation of “below but close to 2%”, which had created the impression it worried more about price growth above the target than below it.
What Does This Mean?
According to Lagarde at a press conference to announce the change, she said “We believe the 2% target is clearer, simpler to communicate and a good balance,” She also added, “We know that 2% is not going to be constantly on target, there might be some moderate, temporary deviation in either direction of that 2%. And that is OK.”
The ECB now has a flexible 2% inflation target aligning it more closely with central banks in other advanced economies. This seemingly small shift is subtle but vitally important because the target is symmetric leaving the Bank open to a “transitory period in which inflation is moderately above target”.
Perhaps aware that she has simply copied the US, when asked if the new policy is the equivalent of the US Federal Reserve’s Flexible Average Inflation Targeting (FAIT), Lagarde said “No”, squarely. The ECB, by their own reckoning, are not looking to follow the US central bank’s policy of allowing overshooting to maintain a target average rate. A fine drawn, but important difference.
Our Concluding Thoughts
This shift illustrates how monetary policy is evolving in an ever-changing world and the challenges central banks face in an environment of low interest rates.
Communication of policy is important when interest rates are rock bottom and inflation is nudging higher. This announcement helps market understanding that inflation, temporarily above 2%, will be accommodated, and brings the ECB into line with other central banks.
The new target does not make higher inflation inevitable. Interest rate effectiveness is severely limited at the current lower bound levels, leaving fiscal policy as the bigger determinant of growth and inflation over the next business cycle.