ECB Strategy Review: A Tweak, A Leap, And A Missed Opportunity

The ECB caught up with BoJ and Fed, nodded to the climate priority, but missed a critical mention, writes Paul Sheard.

<div class="paragraphs"><p>Christine Lagarde, president of the European Central Bank, arrives at a European Leaders summit in Brussels, Belgium. (Photographer: Valeria Mongelli/Bloomberg)</p></div>
Christine Lagarde, president of the European Central Bank, arrives at a European Leaders summit in Brussels, Belgium. (Photographer: Valeria Mongelli/Bloomberg)

The European Central Bank has released the results of its 18-month monetary policy strategy review. Abandoning its previous woolly one, the ECB has adopted a symmetric 2% inflation target and it is formally incorporating climate change considerations into its policy framework. But the ECB missed an opportunity to hammer home that increasingly expansionary monetary policy needs to be buttressed by expansionary fiscal policy.

The ECB’s adoption of a symmetric 2% inflation target, symmetric in the sense that deviations from the target in either direction are considered equally undesirable, represents a further milestone in the evolution of its conceptualisation and operationalisation of price stability, and brings the central bank more in line with standard international practice.

In 1998, the Governing Council of the ECB defined “price stability” as consumer price inflation of less than 2%; in 2003 the Governing Council announced that henceforth it would aim to achieve inflation of “below, but close to, 2 percent" over the medium term.

The ambiguous “below, but close to” formulation begged the question of what exactly the number was: was 1.7% on target? What about 1.5%?

In tandem with the underlying 0-2% range for the definition of price stability, it also gave the impression that the inflation target was not symmetric, and that the ECB was more averse to overshoots than to undershoots of its target.

These two flaws undercut the whole point of an inflation targeting framework: to anchor the inflation expectations of the public by the central bank clearly communicating its inflation target to it.

Good on the ECB for striking a blow for clarity.

BoJ And Fed Lead

Ironically, however, while the ECB catches up, some leading central banks move forward. Both the Bank of Japan (since September 2016) and the Federal Reserve (since August 2020) have tweaked their 2% inflation targets to incorporate commitments to overshoot in order to make up for past undershoots.

The ECB does make a nod in this direction when it states that the “especially forceful or persistent monetary policy measures [that may be required] to avoid negative deviations from the inflation target becoming entrenched [when the economy is close to the lower bound] may also imply a transitory period in which inflation is moderately above target.”

Pressed on this in her press conference, ECB President Christine Lagarde was at pains to explain that such a mooted overshoot was in the category of a possibility, even likelihood, not an element of the inflation targeting framework per se.

ECB’s Lagarde Foresees July Policy Shift, 2022 ‘Transition’

Climate Change – Inflation Link

The landmark part of the new strategy is the prominence it gives to addressing climate change: “Within its mandate, the Governing Council is committed to ensuring that the Euro-system 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.”

“Within its mandate” are always key words in ECB-speak.

In the past, the ECB has been happy to give the impression, and let the impression stand, that, unlike the Fed and other major central banks, it has a single mandate: to maintain price stability. This is not, and has never been, the case.

Rather, as the ECB prominently reminds us in its strategy statement, as long as it does not compromise the pursuit of price stability, the ECB is bound to support the general economic policies in the Union with a view to contributing to the achievement of such Treaty-specified objectives as “balanced economic growth,” “full employment,” and “a high level of protection and improvement of the quality of the environment.”

In putting climate change considerations front and center, the ECB invoked the rationale of climate change “[having] profound implications for price stability.” The ECB should already be taking account of anything influencing price stability, by virtue of the primacy of that mandate. But the treaties allow, if not require, the ECB to address climate change as an issue in its own right, in as much as doing so does not compromise its pursuit of price stability. Expect the ECB to start to adopt this more expansive rationale over time.

In keeping with the new central banking consensus, that structurally lower “equilibrium real interest rates” mean that monetary policy will more often be constrained by the “effective lower bound,” the ECB puts much store on the need for its monetary policy in such circumstances to be “especially forceful or persistent.” Exhibit A: the ECB has increased its balance sheet since the pandemic struck by 69% or €3.2 trillion.

Central bank purchases of government debt securities swap one asset in private sector portfolios for another close substitute, without creating any new purchasing power, and work indirectly through “portfolio rebalance effects;” long-term financing operations just expand both sides of the banking system’s balance sheet with little easing effect.

The bark of central bank balance sheet expansion unfortunately is much worse than its bite.

The real lesson of recent decades (starting with Japan in the 1990s) is that, when interest rates are already very low and the shortfall in aggregate demand is large, fiscal and monetary policy need to work together, with fiscal policy not monetary policy doing the heavy lifting.

On this score, the euro area, being a monetary union but not a fiscal union, and fiscal policy being shackled by design, is hamstrung.

“Fiscal and monetary policy in a monetary union” was one of 13 workstreams in the review. The ECB recognised the importance of fiscal policy and monetary policy “complementing one another in times of crisis” and that “an expansionary fiscal policy is particularly effective when interest rates are near the lower bound,” points emphasised by President Lagarde in her press conference.

Oddly, however, no mention of fiscal policy was made in the strategy statement. This was a missed opportunity.

The ECB has recognised that monetary policy, operating chronically at the effective lower bound, will often need help from expansionary fiscal policy; the European Union treaties give the ECB both the mandate and the mechanisms to coordinate closely with euro area governments.

It is a shame that the ECB did not give this point as much prominence in its strategy statement as it gave to the need to address climate change. But, in time, expect this to come.

Paul Sheard is a research fellow at Harvard Kennedy School. He was formerly vice chairman of S&P Global and prior to that chief economist at S&P, Nomura Securities, and Lehman Brothers.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.

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