ECB changes inflation target, leaving extra room to keep rates low
The European Central Bank has set itself a new 2 per cent inflation target and said it will tolerate temporarily exceeding this when needed, in a shift that gives policymakers more flexibility to keep interest rates at historic lows for longer.
The change, which was announced on Thursday as part of the Frankfurt-based institution’s first review of its strategy since 2003, marks an important break with the conservative monetary doctrine of Germany’s Bundesbank that formed the bedrock of the euro’s creation.
The Frankfurt-based central bank also announced plans to tackle climate change risks by tilting its asset purchases and collateral rules away from heavy carbon-emitting companies which are not aligned with the EU’s climate goals. It addressed soaring house prices by promising to incorporate the cost of owning a home into how inflation is measured.
ECB president Christine Lagarde said: “The new strategy is a strong foundation that will guide us in the conduct of monetary policy in the years to come.”
After years of failing to lift inflation up to its objective, the ECB has ditched its target of “close to, but below, 2 per cent”, which policymakers concluded was too opaque and implied a cap on price growth.
The central bank said its new target of 2 per cent was symmetric, “meaning negative and positive deviations of inflation from the target are equally undesirable”. The new target is a medium-term objective with flexibility to fluctuate in either direction in the short term.
The key change for investors is the ECB’s statement that after a period of persistently low interest rates and inflation expectations, such as in recent years, it may temporarily seek to lift inflation above its target.
“When the economy is operating close to the lower bound on nominal interest rates, it requires especially forceful or persistent monetary policy action to avoid negative deviations from the inflation target becoming entrenched,” the ECB said. “This may also imply a transitory period in which inflation is moderately above target.”
However the ECB did not go as far as the US Federal Reserve, which last year formally committed to a flexible average inflation target that means it will aim for price growth to exceed its target to make up for a period of running below it.
Konstantin Veit, a portfolio manager at Pimco, said: “At the crux of the challenge the ECB is facing, namely getting inflation up to 2 per cent, the review probably falls short as it doesn’t answer the question of how can monetary policy be configured to generate such . . . inflation targets.”
Andrew Kenningham, economist at Capital Economics, said that although “the immediate implications [for the path of monetary policy] are modest”, the decision was still “a historic shift for the ECB” and “the death knell for the Bundesbank tradition, which has always emphasised the risks of high inflation above all else”.
To tackle the risks of climate change, the ECB said it would “adapt the design of its monetary policy operational framework in relation to disclosures, risk assessment, corporate sector asset purchases and the collateral framework”.
Several of the measures are likely to take years to take effect. For instance it said the inclusion of the costs of owner-occupied housing in the official inflation calculation is a “multiyear project” but in the meantime it will take it into account in its wider price indicators.
The central bank said Brussels will need to legislate to allow it to demand disclosure of companies’ climate risks in order to assess whether their bonds are eligible for its asset purchase and collateral schemes. Therefore this is only expected to come into force in 2024.
Some economists were disappointed the ECB did not go further. Daniela Gabor, professor of economics at the University of the West of England, said on Twitter it was “letting down those of us who expected an ambitious approach”.
Analysts had anticipated the ECB could announce changes to its asset purchase programme to avoid hitting self-imposed limits on the amount of sovereign debt it can own. But this has been left to a separate decision on how to wind down its crisis-fighting policy measures later this year.
The central bank said it will carry out “periodic” reviews of its strategy, and the next one will start in 2025.