Central Bank Watch Macro Analysis

Macro Focus: Taking stock of the ECB’s new monetary policy strategy

Following the conclusion of its Monetary Policy Review, the ECB has updated its monetary policy strategy. The main evolution is the replacement of the ambiguous “below, but close to two percent” inflation target by an unambiguous two per cent inflation target over the medium term. The Governing Council’s commitment to this target is symmetric, meaning that negative and positive deviations from this target are considered as equally undesirable. In line with the Federal Reserve’s new average inflation targeting framework, the ECB acknowledges the necessity to tolerate above target inflation in order to anchor long term inflation expectations at two percent. The second change is the introduction of climate risk as an input in the Central Bank’s monetary policy operational framework. In this article, we analyse the rationale, the technicalities and the potential implications of these changes.

Worn-out ambiguity

Jean-François Paul de Gondy, better known as the Cardinal de Retz, a famous ecclesiastic figure, writer and political power broker in Louis XIV’s France, once said that the “you only get out of ambiguity at your expense“. The ECB’s Governing Council has nevertheless judged that the benefits of ambiguity are worn-out. This is all the more true as actual core inflation figures in the Euro Area have over the last decade barely come close to the vicinity of two percent (cf. chart below).

An unambiguous inflation target of two per cent underlines the ECB’s commitment to providing a safety margin to guard against the risk of deflation and protect the effectiveness of monetary policy in responding to disinflationary shocks. As mentioned in the new ECB monetary policy strategy statement, “To maintain the symmetry of its inflation target, the Governing Council recognises the importance of taking into account the implications of the effective lower bound. In particular, when the economy is close to the lower bound, this requires especially forceful or persistent monetary policy measures to avoid negative deviations from the inflation target becoming entrenched. This may also imply a transitory period in which inflation is moderately above target.

In the accompanying note, the ECB explains the structurally low inflation observed over the last decade by a “shift towards disinflationary shocks during and after the global financial crisis. It mentions the combined impact of the 2009 and 2012 twin recessions with structural trends (such as globalisation, digitalisation and demographic factors), in a context in which the effective lower bound means that disinflationary shocks cannot easily be offset by interest rate policy. The ECB also acknowledges that the persistence of low inflation has contributed to lower inflation expectations. This is an implicit recognition of its failure to lift the later despite continuous efforts. Amid fiscal restraint in the pre-COVID decade, the Euro Area has been engulfed in a Japanese-like deflationary trap with persistently low inflation and a widening of the economic and social gaps between a healthy export-oriented Northern Europe – epitomised by the so-called “Hanseatic League” – and a lagging “European Mezzogiorno” extending from Portugal to Bulgaria.

A biased dual assessment framework

The assessment framework remains based on two pillars. As mentioned in the policy statement, “the assessment builds on two interdependent analyses: the economic analysis and the monetary and financial analysis. Within this framework, the economic analysis focuses on real and nominal economic developments, whereas the monetary and financial analysis examines monetary and financial indicators, with a focus on the operation of the monetary transmission mechanism and the possible risks to medium-term price stability from financial imbalances and monetary factors. “

In practice, the monetary and financial factors have taken precedence over the analysis of real economic developments as the Central Bank felt it had more influence and control over the former than over the latter. There is plenty of evidence of that in the communication of ECB senior figures. The Great Financial Crisis and the Euro Area Sovereign debt crisis have only reinforced this bias. The fact that most of the financing in the Euro Area is delivered through the Banking channel has weighed heavily on this evolution with bank lending surveys being carefully analysed. The information extracted from the latter alongside fears of fragmentation have been instrumental in the decision to launch a large scale assets purchase programme in 2014, and in the subsequent negative interest rate experiment. However, this has not translated into a significant recovery of credit growth in the post-GFC and post-Sovereign debt crisis era.

Climate awareness or Greenwashing?

Ever since she was appointed at the head of the Frankfurt-based institution, Christine Lagarde has been a vocal advocate of broad societal issues like climate change and gender equality. This seems to have paid off. Indeed, here is what can be read in the new monetary policy strategy statement regarding climate change: “Within its mandate, the Governing Council is committed to ensuring that the Eurosystem fully takes into account, in line with the EU’s climate goals and objectives, the implications of climate change and the carbon transition for monetary policy and central banking. Accordingly, the Governing Council has committed to an ambitious climate-related action plan. In addition to the comprehensive incorporation of climate factors in its monetary policy assessments, the Governing Council will adapt the design of its monetary policy operational framework in relation to disclosures, risk assessment, corporate sector asset purchases and the collateral framework.

Central Banks have a technical legitimacy when it comes to including climate related risks as part of their overall risk assessment. There is now a broad consensus that climate-related tail risks – so-called “Green Swans” – carry potentially severe financial, economic and social consequences. However, Central Banks have no legitimacy to spearhead the policy choices and strategies aimed at mitigating climate change.

After all, Central Bankers are civil servants. They are not democratically elected representatives of the people(s). There is a risk of political backlash when technocratic institutions claim to interpret the will of the people beyond what is ascribed to them by their official mandates.  The Governing Council is bound by the ECB’s primary mandate of price stability as enshrined in Article 127(1) of the Treaty on the Functioning of the European Union. In the absence of changes to its core policy mandate, which is enshrined in the Treaty, the ECB has no delegated authority to position itself as a front-runner in the fight against climate change. Any initiatives it would take on this account would face serious legal challenges, beyond the snub inflicted in 2020 by the German Constitutional Court to the European Central Bank in relation with its large-scale assets purchase programme.

Summing it up

It would be easy to showcase the ECB’s new policy strategy as “the monetary emperor’s new clothes”. Some critics would say that the changes are actually minimal or that they are long overdue. However, it is important to recall that the European Central Bank is embedded in a constrained institutional environment. At times, it has managed to successfully tweak and overcome those constraints, by encapsulating its policies in a technocratic jargon and a muted communication style.

In the short term, the unambiguous inflation target is likely to provide a minor albeit welcome boost to inflation expectations and consequently to sovereign bond yields – especially to the 10-year Bund yield which remains in negative territory. Longer term, the departure from strict monetary orthodoxy by allowing the inflation to move above target for some time gives the ECB more leeway to concentrate on lifting growth and reducing unemployment rates. Hence without changing its core mandate, the ECB’s reaction function needs to be updated in models used for projecting the path of short term interest rates and unconventional measures such as assets purchases, which are now considered as fully part of the ECB’s instruments toolkit. This falls short from the Fed’s dual employment and inflation mandate but, again, the institutional setting is different.