Anything that happens after 18 years of waiting stands a good chance of being celebrated, but this may not happen with the second review of the ECB monetary policy strategy whose outcome was communicated by the central bank on 8 July (ECB 2021a) (the first review is dated 8 May 2003). The new review disappoints expectations on several fronts.
Why was a review necessary in the first place?1 It needed, first and foremost, to address two issues directly related to the ECB’s primary goal of price stability – namely, the numerical definition of price stability and the price index to be used for this purpose.
On the numerical target, the goal formulated in 2003 (“an inflation rate below but close to 2%”) left the central point undetermined and was asymmetric, hinting that the ECB cared more about too high than about too low inflation. In the age of looming deflation, this needed to be corrected (Angeloni 2020).
The composition of the price index was also a problem, due to the exclusion of one key component which is clearly part of everybody’s cost of living, the cost of owner occupted housing (OOH).
The review only solves the targeting problem, and even that only partially. The new central target – 2% with a symmetric but unspecified range around it – offers no clue to what deviation the ECB is willing to tolerate. This is likely to complicate the ECB Council’s discussions going forward, perhaps as early as in the coming weeks.
On the appropriate price index which serves as the basis for the 2% target, the ECB press release states that “… the Governing Council recognises that the inclusion of the costs related to owner-occupied housing in the HICP would better represent the inflation rate that is relevant for households.” This recognition is welcome and overdue. But there are two problems. First, the inclusion of OOH costs is announced as a multi-year project of unspecified duration. What will happen in the meantime? Will the ECB Council already adjust its focus in an informal way? Moreover, with housing prices and rents increasing, the inclusion of OOH may, based on available information (Gros and Shamsfakhr 2021), move the inflation index up by at least 0.4%. The “below but close” formulation was generally regarded as meaning an effective target at or above 1.8%. A 2% target with OOH included would thus be more restrictive than the present HICP target without OOH at 1.8%.
Figure 1 The consumer price index since the last review: Actual versus the implicit 1.8 % target
Source: Ameco online.
Note: the vertial line indicates the start of unconventional monetary policy measures (negative rates, targeted long term refinancing operations (TLTRO) and asset purchases (PSPP).
The more fundamental problem of how to interpret inflation dynamics is not addressed. No technical studies have been published or announced, for example of the kind that were conducted for the earlier review (ECB 2003). Detailed empirical studies are needed to answer that question and to guide the central bank’s approach going forward.
This fundamental question begged an answer, or at least some analysis. Why has inflation, however targeted or measured, remained stubbornly low in spite of a nearly decade-long extraordinary monetary expansion? Inflation has been averaging 1.5% since 2003 and has been especially below the target since 2014, when asset price increases and other “unconventional measures” were itensified. Over the same period unemployment has fallen steadily by four percentage points. What has happened to inflation dynamics and to the monetary policy transmission mechanism?
There is one other issue that nobody anticipated in 2003, namely, the risk to the euro itself. Ever since the euro crisis, the ECB has struggled to “preserve the euro” (the expression used by Mario Draghi in his much-cited speech of 26 July 2012) – in other words, to fend off the centrifugal forces between core and peripheral countries that occasionally put the cohesion of the monetary union at risk. Neither the creation of a banking union, still unfinished after ten years, nor the closer cooperation with the fiscal authorities inherent in the approach taken to solve the crisis in 2012 has so far been able to put that risk at bay. The tensions which flared up at the height of the financial market turbulences in early 2020 show that these tensions between core and perifery can happen at any time again (Angeloni 2021). Unfortunately, the review does not recognise this problem and is silent on whether and how the central bank will engineer better and more systematic fiscal-monetary cooperation in the future.
In this new strategy the ECB seems to venture into new territory: climate change. But this is more formality than substance.
It is worth quoting the key passage from the press release (ECB 2021b):
“While governments and parliaments have the primary responsibility to act on climate change, within its mandate, the ECB recognises the need to further incorporate climate considerations into its policy framework. Climate change and the transition towards a more sustainable economy affect the outlook for price stability through their impact on macroeconomic indicators such as inflation, output, employment, interest rates, investment and productivity; financial stability; and the transmission of monetary policy. Moreover, climate change and the carbon transition affect the value and the risk profile of the assets held on the Eurosystem’s balance sheet, potentially leading to an undesirable accumulation of climate-related financial risks. With this action plan, the ECB will increase its contribution to addressing climate change, in line with its obligations under the EU Treaties.”
This text is as clear as it is puzzling. The impact of climate change on price stability and its implications for banking supervisions were – at least in principle – already covered by the previous approach. No strategy review was needed; perhaps only a refinement of the analytical tools. The issue that needed and still needs clarification is the extent to and the way in which the ECB pursues “secondary objectives” (objectives unrelated to the ECB’s inflation goal which may enter monetary policy decisions without prejudice for the attainment of that goal), as the EU Treaty requires. This question – which incidentally does not only involve climate change – does not seem to have received an explicit answer yet (Gros 2020).
A monetary policy strategy (or “framework”, as central bankers across the Atlantic like to call it) is like guard rails in a road: it allows drivers some flexibility in steering, but not to the point of risking a fall off the cliff. The new strategy of the ECB does not seem to fulfill this essential task.
Ambrocio, G, A Ferrero, E Jokivuolle and K Ristolainen (2021), “What academics think of central banks’ current inflation targets and other objectives”, VoxEU.org, 6 March.
Angeloni, I (2020), “The ECB strategy review: Walking a narrow path”, VoxEU.org, 3 December.
Angeloni, I (2021), “European Central Bank must increase co-operation to solve long term challenges", OMFIF, 29 June.
ECB (2003), Background studies for the ECB’s evaluation of its monetary policy strategy.
ECB (2021a), “ECB’s Governing Council approves its new monetary policy strategy”, Press Release, 8 July.
ECB (2021b), “ECB presents action plan to include climate change considerations in its monetary policy strategy”, Press Release, 8 July.
Goodhart, C, T Schulze and D Tsomocos (2020), “Time inconsistency in recent monetary policy”, VoxEU.org, 4 August.
Gros, D (2020), "The dangerous allure of green central banking", Project Syndicate, 18 December.
Gros, D and F Shamsfakhr (2021), “The rising cost of housing”, CEPS update, 9 July.
Hartmann, P and G Schepens (2021), “Central banks in a shifting world: Takeaways from the ECB’s Sintra Forum”, VoxEU.org, 12 May.
Ilzetzki, E (2020), “Rethinking the ECB's inflation objective”, VoxEU.org, 16 November.
Martin, P, E Monnet, X Ragot, T Renault and B Savatier (2021), “Helicopter money as a last resort contingent policy”, VoxEU.org, 5 July.
Rehn, O (2021), “Will inflation make a comeback as populations age?”, VoxEU.org, 13 January.
1 Recent Vox columns relevant to the ECB strategy include Hartmann and Schepens (2021), Martin et al. (2021), Ilzetzki (2020), Ambrocio et al. (2021), Rehn(2021) and Goodhart et al. (2020).