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The long-awaited new strategy from the European Central Bank (ECB) includes a higher inflation target and a climate action plan. The main consequence seems to be maintaining low interest rates for longer, although the ECB denies this.
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After a year and a half of reflection, the ECB executives have unanimously agreed on a new strategy. An adjustment was necessary because the world has changed since the last update in 2003. Interest rates have fallen structurally and inflation has been below target for years. These are the main thrusts of the new strategy.
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What changes in the inflation target?
The ECB raises its inflation target to ‘2% inflation in the medium term’. Until now, the ECB has aimed for inflation of ‘less than but close to 2 percent over the medium term’. The new inflation target is symmetrical. This means that negative and positive deviations from the target are equally undesirable.
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In addition, in certain circumstances, such as now, inflation may temporarily rise above 2 percent. Because inflation remains stubbornly below the desired level despite the floor interest rate, the ECB has to resort to strong unconventional measures, such as bond purchases, to boost inflation. ‘That could mean that inflation will be moderately above the target for a transitional period.’ It is unclear how long that overshooting may last.
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The new inflation target is clearer and shows that 2 percent is not a ceiling.
Christine Lagarde
President of the ECB
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ECB president Christine Lagarde said at a press conference that the new target is clearer and shows that 2 percent is not a ceiling. “The previous definition was often misunderstood.” She emphasized that, unlike the US central bank (Fed), the ECB does not aim for ‘average inflation of 2 percent’. In the US, a period of under-inflation must then be offset by a period of over-inflation to reach the average.
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Will the ECB take rising house prices into account from now on?
The consumer price index is the best measure of inflation, according to the ECB. But she acknowledges that including the cost of owner-occupied housing in the index would provide a better measure of longevity. Now the consumer price index only takes rents into account.
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The ECB cannot yet say exactly what costs it will take into account. This includes the costs of maintaining the home. An important question is whether the interest on mortgage loans is also included. Lagarde did clarify that the ECB will not take into account investment expenditure, in other words house prices.
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It will be years before Eurostat publishes an adjusted consumer price index. Therefore, the ECB will already take into account estimates of the cost of owner-occupied housing. The long-term impact on inflation is minimal, says Lagarde.
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What are the concrete consequences?
Many analysts say the new strategy opens the door to an extended period of stimulus. ‘My intuition is that this will lead to an even more flexible policy for an even longer period’, notes Carsten Brzeski, head of macroeconomics at ING.
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My intuition is that the new strategy will lead to an even more flexible policy for an even longer period of time.
Carsten Brzeski
Head of macroeconomics ING
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Lagarde did not want to confirm that, on the contrary. “The new inflation target does not mean that monetary policy tightening will shift further into the future. Ex-chairman Jean-Claude Trichet interpreted the old target as an inflation of 1.95 percent. That is very close to the new target.’
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Lagarde thus suggests that hardly any additional stimulus will be needed to achieve the slightly higher goal. According to a poll from a few weeks ago, analysts expect the first rate hike in 2024.
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Konstantin Velt of asset manager Pimco calls the adjustment of the strategy ‘an evolution, not a revolution’. He points out that the ECB does not say how it will achieve its inflation target.
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How do the markets react?
The financial markets reacted relatively calmly. Long-term interest rates bounced slightly and equity markets stabilized after the publication of the new strategy.
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What about sustainability and climate?
The ECB is launching a major climate action plan for the next four years. One of the measures is a greening of the bond portfolio. When purchasing corporate bonds, the central bank will take into account climate change criteria. Corporate bond issuers must at least comply with European legislation that applies the Paris climate agreement.
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The ECB will take into account climate change criteria when purchasing corporate bonds.
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Other measures are also planned. The ECB will evaluate the climate risks of bonds pledged by banks.
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What else does the ECB promise?
Clear communication. “We will communicate in a more accessible and visual way and to a wider audience,” Lagarde promises. ‘The announcement after each board of directors will be more to the point and contain less jargon.’
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