How the ECB’s New Inflation Goal Will Shape Economy

The European Central Bank has adjusted its sights for the first time in 18 years. The central bank for the 19 countries that use the euro has raised its goal for inflation, and acknowledges that price increases might exceed that target for a while. It’s an attempt to address shortcomings in the ECB’s armory in a region where economic performance was lackluster even before the Covid-19 crisis. The move also echoes a shift by the U.S. Federal Reserve following a decade in which extraordinary monetary policy did little to spur inflation.

1. What’s changed?

The ECB’s inflation target since 2003 had been “below, but close to, 2% over the medium term.” Now, 2% becomes the actual target and is no longer an upper limit. The ECB said it will seek “symmetric 2% (inflation) over the medium term” -- meaning that too-low and too-high price growth are equally undesirable. It also said that when interest rates are about as low as they can go, it will need to be “especially forceful or persistent” with monetary stimulus, which could “imply a transitory period in which inflation is moderately above target.”

2. What was wrong with the old target?

ECB President Christine Lagarde said it was seen as “too elaborate” and the new version “removes any possible ambiguity and resolutely conveys that 2% is not a ceiling.” Some monetary officials felt the old target had produced premature calls for policy tightening such as reducing, or tapering, the central bank’s bond purchases.

3. What does ‘especially forceful’ mean?

That is not clear yet. Policy makers will have to translate the strategy into concrete actions at their regular meetings, starting with the debate on how to transition away from emergency measures such as the 1.85 trillion-euro ($2.2 trillion) pandemic purchase program. Since the global financial crisis, the ECB has added tools that include bond purchases (or quantitative easing), long-term bank loans and issuing forward guidance to its main monetary policy weapon of adjusting interest rates.

4. Why the change?

The ECB for years has struggled to reach its inflation goal. Core inflation (excluding the volatile food, energy, tobacco, and alcohol components) averaged just 1% over the past decade. Critics say persistent expectations that the central bank wouldn’t meet inflation targets reflect its consistent failure to move early and forcefully enough to counter the risk of deflation -- whereby people hold off making purchases in anticipation of lower prices, thereby damping economic growth. The ECB’s primary mandate is to keep prices stable, meaning inflation should not be significant and deflation should be avoided.

5. How does the new approach differ from the Fed’s?

The Fed announced in 2020 that it would seek to achieve inflation that averages 2% over time -- a shift from simply targeting 2%, and one that implies an automatic overshoot after periods of weak prices. The ECB stopped short of a similar commitment to let the economy run hot after a recovery and will just allow a temporary overshoot when it’s needed to get the economy back on track. Lagarde said the ECB’s new stance differed in that it makes possible an “especially forceful” response to an economic shock.

6. Will it make a difference?

Central banks are engaged in the most sweeping rethink of their role in decades, spurred in part by improved coordination with governments, which are committing to huge spending to counter the pandemic crisis. “Counter-cyclical, good fiscal policies, when they take place at the same time as monetary policy, can actually amplify the effects of monetary policy,” Lagarde said. Critics await details of how the ECB plans to achieve its target and clarity on the language in the policy goal, such as how long a “transitory” blip in inflation lasts.

The Reference Shelf

  • A Bloomberg report on the ECB’s new strategy and an article on how the review took place during the pandemic.
  • A Bloomberg story on the ECB’s crisis response in the wake of a shifting Fed.
  • Bloomberg QuickTakes on the Fed’s Framework and central bank climate policy.

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