Is the ECB Ready for its Credibility Test?

The European Central Bank’s first strategy review in 18 years is about to get its first credibility test.  

President Christine Lagarde has fired the starting gun for the implementation of the ECB’s new policy framework. Just over a week from now, it will issue updated forward guidance on policy rates. That will be in preparation for a fresh program of quantitative easing to replace the current pandemic sovereign bond purchases — which runs out in March 2022 — probably to be detailed in stages.

The centerpiece is the ECB’s revamped inflation target. The ECB removed the 2% upper inflation limit from its 2003 “below, but close to 2%” price stability formulation and substituted a new “symmetric 2% over the medium term” target. It said this requires “especially forceful or persistent monetary policy action to avoid negative deviations from the inflation target becoming entrenched.” And it allows for “a transitory period” of inflation above target.

The markets yawned when the metrics were announced last week. They aren’t wrong to be skeptical. In a likely attempt to achieve unanimity between the hawks and doves on the Governing Council, the ECB language has been left vague. We don’t know what “forceful or persistent monetary policy action” means, or how long the “medium-term” horizon for reaching the target will be — or the “transitory” period of inflation overshooting. We also don’t know anything about how the ECB plans to achieve its target.

But establishing a credible target for anchoring inflation expectations in the euro region is ground zero for rebuilding the central bank’s credibility. The cost of failure has been high. Core euro-zone inflation (excluding the volatile food, energy, tobacco, and alcohol components) has averaged just 1% over the past decade — less than half the ECB’s target and at the threshold of deflation risk territory. Worse, downward pressures on both headline and core inflation expectations have built up after the euro sovereign debt crisis.

During the ECB presidencies of Wim Duisenberg and Jean-Claude Trichet, a period from 1998 to 2011, the euro-zone medium-to-long-term inflation expectations were “firmly anchored,” a pronouncement that proudly appeared six times in the last ECB strategic review in 2003. That measure was dropped from the Governing Council’s policy statements during the sovereign debt crisis in 2015 and hasn’t made a return since.

Persistent expectations that the ECB wouldn’t meet inflation targets reflect the central bank’s consistent failure to move early and forcefully enough to counter deflationary risks in the debt crisis era. 

The remedy cannot simply be another firm target, not in a union of countries experiencing chronic demand shortages, excess savings and low inflation, that is set to emerge from the pandemic with near-record budget deficits and sharply higher debt levels. The ECB needs a credible policy framework to reach its inflation target and to remain in synch with the EU’s broader policies aimed at full employment, environmental protection and financial stability.

By shrugging off the Bundesbank’s legacy of excessive hawkishness, the policy review takes up the ethos of Lagarde’s predecessor Mario Draghi (he of “whatever it takes” fame) and creates much needed room for flexibility. By correcting the asymmetry in the inflation target, the ECB has been forced to tackle the asymmetry of its own tools, namely the inability to stimulate inflation when rates are already at the lower bound. To that end, while interest rates remain the primary policy tool, the extraordinary stimulus levers introduced since the financial crisis — bond purchases, long-term bank loans and forward guidance — are now considered “integral” features of the ECB’s toolkit. 

It is significant because Covid threw the ECB back into depths as dire as the debt crisis. The shock to growth and sharply rising public debt — at a time when inflation is so low that rate cuts could no longer stimulate — forced the central bank to adopt a dual objective: Easing financial conditions to counter the demand shock in real economies and to fight signs of fragmentation in European sovereign markets via direct bond purchases. The policy review and preparations for a new permanent format for QE stimulus from 2022 in effect recognize the significance of European sovereign bond yields and spreads for the ECB's price stability mandate.

After the memory of the bitter debates between the Bundesbank and Draghi during the debt crisis, it resets ECB policy for the post-Covid era. What’s left for the ECB’s hawks and doves is to decide how forcefully and sustainably they are prepared to act in the trade-off between more stimulus now versus a longer period of unconventional policy formulation to meet the ECB’s unanimously agreed new inflation target.

By preparing to keep monetary stimulus after the 1.85 trillion-euro ($2.2 trillion) pandemic emergency purchasing program ends, the ECB can buy some credibility by diverging from other central banks, like the Federal Reserve and the Bank of England, which are discussing tightening. This is significant as markets begin to assess the credibility of the ECB’s inflation target, and as the European Council begins to evaluate the conditions for fiscal and growth sustainability in the coming years.

Now, all the ECB has to do is deliver. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Lena Komileva is managing partner and chief economist at G+ Economics, an international market research and economic intelligence consultancy based in London.

©2021 Bloomberg L.P.

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