The ECB’s strategy review

July 11, 2021

 

 

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The ECB has released the outcome of its strategy review. It is a half-full glass. Enough forward steps to make the review useful but too many missing steps to claim that the job is done. The media lauds Chairperson Christine Lagarde for having succeeded in gaining unanimous approval from the Governing Council, which is good, of course, but comes at a price, the half-empty glass.

 

The main step forward is to replace the previous inflation goal of “below but close to 2%” with a symmetric 2% objective to be achieved in the long run. This change had been very widely advocated ever since it was formulated. Critics complained about the asymmetric (“below 2%”) and ambiguous (“close to 2%”) objective. Even so, the objective has not been achieved as evidenced in the figure below. The figure, which displays the distribution of monthly inflation rates since January 1999, measured against over the last 12 months, indicates that the most frequently observed range is between 1.9% and 2.1%. It also shows that the distribution is highly asymmetric, tilted toward rates below 2%; indeed 40% of the rates are less than 1.5%. It remains to be seen whether, in the future, the ECB will achieve a more symmetric distribution around 2% but, at least, il will now be its objective.

 

 

Frequency distribution of monthly inflation rate – January 1999-June 2021

(Price increases over previous 12 months)

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Source: ECB

 

 

That is where the second change in strategy matters. The ECB announces that the new strategy “implies a transitory period in which inflation is moderately above target”. It probably is the most important outcome of the strategy review. The ECB now accepts to temporarily overshoot the 2% target, a relaxed view that several national central bank governors used to consider as unacceptable. Thus, moderate overshoots will not have to be systematically met with strongly pressing on the brake. This statement is a welcome step as it should help in future deliberations of the occasionally divided Governing Council. However, the statement is vague. Lack of precision likely was a condition for achieving agreement on the statement, but this may be a Pyrrhic victory if vagueness will allow for divisions in the future.

 

Without saying so, the ECB almost follows the US Federal Reserve’s own new Average Inflation Targeting (AIT) strategy. Almost, though. While the Fed wants to be judged on average inflation over an unstated – for which it has been rightly criticized – duration, the ECB seems to be aiming all the time at 2%, only accepting temporary deviations. This may seem like neat picking, but it is not. The merit of the Fed’s strategy is to get close to price level targeting. If the Fed is successful, you can anticipate price levels over the long run to move along a 2% growth trend, which provides a high degree of precision, because bygones are not meant to be bygones. In the case of the ECB, the strategy is much less precise, creating a significantly larger level of long-run uncertainty. This uncertainty is not only affecting firms and possibly households, it also is likely to impact long-term interest rates.  

 

The rest is rather meek. The two pillars of analysis , economic and monetary, are reasserted although the logic has always been doubtful simply between the distinction is highly superficial. The ECB’s claim that it now recognizes “that financial stability is a precondition for price stability” merely accepts a well-known fact. If it is meant to suggest that it was so far disputed, then it is cruel indictment of the previous strategy. The ECB’s announcement that it intends to retain its nonstandard instruments in use since 2008 may be needed for completeness, but it will hardly surprise anyone. Finally, quite some space is devoted to the importance of acting against climate change, but it seems to only concern the associated financial risks. Hopefully, it merely represents an effort at being politically correct and not a commitment to use monetary policy to pursue objectives that lie outside of its capacity.

 

The strategy review could have been more ambitious on several of issues. A first key question concerns its lending in last resort to governments and banks. During the global financial and public debt crises, it did end up carrying out this responsibility, but late and with all sorts of potentially harmful safeguards. This issue is controversial because it may lead to significant transfers among member countries. This is probably why it is not even mentioned. Yet, the issue will resurface when the next crisis comes. Hiding the difficult issues until they must be confronted as a matter of emergency cannot be a good strategy.

 

The same can be said about the bank resolution framework. The ECB now shares responsibility for bank resolution with national authorities, leaving the Eurozone with a cumbersome process to be activated in emergency. It might be argued that clarifying the framework lies outside the strategy review since it is not for the ECB alone to decide. However, the review has been conducted for quite some time, enough time for the ECB to press member countries toward adopting a better framework. It may be that it tried and failed, or it may be that it did not try. Anyhow, this is too important an issue to be swept under rug.

 

In recent years, macroprudential policies have become an increasingly important part of the overall monetary policy frameworkx. In the Eurozone, this instrument remains in the hands of national central banks. Yet, financial stability is unlikely to be preserved in the monetary union if one country faces acute instability. As with bank resolution, potential transfers among member countries complicate the search for an agreement. The ECB could, and should, have an important say in how these policies are designed and implemented at the national level. Various possibilities exist, none is mentioned.

 

Compared to other central banks, the ECB is special in that it faces not one but 19 governments. There is no doubt that this particularity seriously complicates its task since any central bank must reach explicit and implicit agreements with its government(s). Divergences of views among the 19 governments on issues like lending in last resort and bank resolution stand in the way of the ECB’s policymaking. This probably explains why the strategy review is underwhelming.