How did ECB change its monetary policy?

European Central Bank (ECB) President Christine Lagarde in Frankfurt, Germany, March 12, 2020. REUTERS/Kai Pfaffenbach/File Photo

On the surface, the changes seem very minor; equivalent to increasing the inflation target by a few tenths of a percent. But, below the surface, the changes may be more profound.

The ECB’s new inflation target is 2%. Before, it was close to, but below 2%. When pressed, ECB officials used to say that it meant a desired level of around 1.75%. So, in effect, the change in the target just lifts this aim be a few percentage points, which does not seem like very much given all the work the ECB has put in.

For   instance, it is far short of the changes that the Fed announced last August when it moved to an average inflation target and stressed inclusivity as a key component of the full employment aim. In addition, it also stressed that it has moved to an outcomes-based policy as it is no longer willing to tighten policy just because it forecasts that inflation and/or   employment will bust the targets. So, the Fed’s changes seem far more profound but does that mean that the ECB’s are inconsequential?

For   one thing, the Standard Bank said, our sense has been that the ECB would ready itself in the past to tighten policy whenever inflation moved towards the 2% level. In other words, it had little tolerance for   overshoots. The 2% level was seen as more of a limit     than a target. This might seem a semantic issue, but the key here is that attitudes in the market most definitely, and possibly among the public as well., were swayed by these suspicions. For   instance, if the market sensed that the ECB would be quick to lift rates under the old system whenever inflation approached the target, it could set off a chain reaction, such as rising yields. And this increase in yields could help constrain the very economic activity that might push inflation beyond target. This might seem beneficial as ECB policy could actually start to work even before policy changed.

However, in the era of lowflation and deflation, it has been a curse in our view because it has engendered a deflationary mindset that threatens to keep inflation below target for   a sustained period of time and keep policy rates pegged to the lower bound. The key issue now is whether the market really thinks that the ECB has changed its spots, so to speak, and will act irresponsibly by allowing inflation to overshoot target by some distance and some time. Only time will tell on this one but we have our doubts, said the Standard Bank.

The key questions for   the market surround QE and whether the ECB might extend bond buys for   longer, and/or   taper by less, than under the old policy regime. Another issue is whether the new strategy might push back the date of any rate hikes.

In the Standard Bank’s view, unless the strategy review causes any change in the inflation outlook, perhaps by raising inflation expectations, then policy is likely to be easier than it would have been under the old regime. And, the change in the ECB’s strategy won’t cause inflation to be higher than it otherwise would have been. However, this change in the inflation target cannot be seen in isolation. The ECB made some other changes, such as focussing on climate change to a significantly greater extent and recommending that a measure of owner-occupied housing prices be a part of the CPI. In theory at least, both of these could add to inflation. Firms, for   instance, might have to employ more costly green policies to continue accessing ECB cash in the same way. House prices are surging and their inclusion in the CPI could lift the data. And even if the inclusion of house price inflation takes a long time, the ECB has said that it will, even now, come into the bank’s thinking much more.

In sum, there’s a chance that any extra dovishness created by the rise in the inflation target is compromised by other strategy changes, and that might be one reason why, for   now at least, the market will see the moves as being more like “no change” than “all change”.