The European Central Bank (ECB) today finalized the results of its Strategy Review, the first since 2003. Progress had been suspended for six months by the pandemic, but the final communication came a bit impromptu via a quickly organized press conference. As ECB President Christine Lagarde said, “When something is ready …”
On content, the ECB revised—unanimously—its inflation target interpretation to be symmetric, around 2%, over the medium term. Lagarde explained several times that the symmetry implies that deviations from 2% are viewed as equally undesirable to the upside and the downside. More importantly, she also elaborated that in a low-rates environment, the effective lower bound forces the ECB to take “especially forceful or persistent measures” to prevent inflation expectations from getting entrenched below the target. In that context, she noted that this reaction could imply a transitory and moderate overshoot of inflation above the 2% target. She was quick to clarify, however, that this overshoot is not a target, just a corollary—in other words, no average inflation targeting, Federal Reserve style.
The ECB also wants to include owner-occupied housing costs (the consumption part) in its measure of inflation in response to complaints by consumers. But, as this is a multi-year project for Eurostat, the ECB for now will use in-house measures to gauge this effect, which is in any case cyclical and minor as noted by Lagarde.
On the analytical side, the ECB re-invented the monetary pillar, and moved on from the monetarist approach in some quarters (before the ECB existed) as the importance of monetary aggregates in determining the inflation outcome has faded over time. Instead, the ECB is looking to complement the economic analysis with a more integrated monetary and financial analysis—simply a reflection of the state of the art in central banking to pay increasing attention to macrofinancial linkages. The most obvious implication of this change will be a revamped and simplified opening statement at the next ECB meeting, which is also reflective of a renewed effort on communications.
Finally, Lagarde also previewed the actions to include climate change considerations into its policy framework.
We believe that the immediate market implications of the Strategy Review conclusions are quite limited—both because the de facto numerical changes to the inflation target are minor but also because the ECB was for long periods—and will be again come next spring—so far below target that the precise formulation of the inflation target is almost secondary. The ongoing inflation overshoot is unlikely to be a good test of the new strategy, but we would argue that the clean symmetric target will make monetary policy more efficient to achieve expectations in line with the target in the long run.
We interpret the ECB President’s comments on forceful and persistent reactions to inflation undershoots using unconventional monetary policy tools as an introduction to a more direct non-linear reaction function—stronger measures could be taken more quickly than in the past. That said, we still believe that the ECB will taper its purchases under the Pandemic Emergency Purchase Programme (PEPP) in September, and we believe that there is a need for additional communication on how the new reaction function—if there is one—applies seamlessly to the current situation.
Over the medium run, the ECB’s green strategy is likely to have a catalytic impact on the market and issuers over the next few years since the institution is a major purchaser of bonds, both outright but also, in normal times, via its open market operations.
One of the more important messages, in our view, is the timing of the next review in barely four years (2025). We think there is a potential risk of adjusting the strategy too often, but some of the issues laid out today will be due for another discussion at that point, including the green strategy (the ECB’s self-imposed timeline for implementation goes to end-2024) and Eurostat’s progress on broader inflation measures.
Some of the trickier questions, including issuer limits, have not been tackled in this review—presumably a vote in favour of speed and unanimity versus breadth given the delays.
We expect fixed-income yields to gradually drift higher, and the Strategy Review outcome has not changed that picture. In fact, it might have lengthened the runway somewhat even though it may not have changed the path of policy rates as Lagarde tried to assure participants of the press conference.