Saturday, June 3, 2023

Learning from history? ECB shifts strategy to avoid premature rate rises


The last time that the European Central Bank raised interest rates was just as the eurozone debt crisis began in 2011 — a move its officials now acknowledge was a major mistake.

Its first new strategy for nearly two decades, unveiled on Thursday, is designed to avoid the risk of such premature policy tightening in the future. It shifts the Frankfurt-based institution to a 2 per cent inflation target and pledges to tolerate any slight overshoots.

“We have learnt from history and we have observed what has worked and what has not worked,” Christine Lagarde, ECB president, said as she presented the review’s results. “Now we need to demonstrate we mean what we say.”

The ECB has persistently failed to lift inflation to its previous target of “below, but close to, 2 per cent” for much of the past decade. Analysts said the new strategy would make it easier to maintain interest rates at their historic low levels for longer to achieve its legal mandate of price stability.

Annalisa Piazza, analyst at MFS Investment Management, said: “Lagarde is leaving the door open for further forceful action”.

Carsten Brzeski, head of macro research at ING, said that it “clearly marks a gradual trend towards more, even if it is subtle, dovishness”. 

By ditching its previous inflation target, the ECB aims to banish what Lagarde called “ill-founded speculation” that it preferred inflation to run below its target than above it.

While Lagarde said its new target was symmetric, meaning that it “considers negative and positive deviations of inflation from the target to be equally undesirable”, she added that it would be less worried about above-target inflation in certain circumstances.

She said that the ECB would use “especially forceful or persistent monetary policy action” when interest rates are close to their lower limit and inflation remains below its target — as they have been for several years. The shift “may also imply a transitory period in which inflation is moderately above target”.

This does not mean it will actively seek to drive inflation above its target, as the US Federal Reserve has shifted its strategy to do in order to make up for a period of low inflation. Lagarde said the ECB’s new strategy was “very squarely” not the same as the Fed’s average inflation policy.

Jens Weidmann, head of Germany’s central bank and one of the ECB’s more conservative council members, emphasised this on Friday, saying: “We do not make our monetary policy dependent on past target failures. Our strategy remains forward-looking and takes into account the new challenge of the effective lower limit of interest rates.”

That leaves the Fed with a more accommodative stance than the ECB. However, inflation is higher in the US and the Fed is expected to start tightening its policy sooner. The ECB’s new strategy makes it more probable that it will keep rates lower for longer, which is likely to push the euro down against the US dollar and keep eurozone bond yields low.

“Historically, monetary policy divergence between key central banks has caused foreign exchange volatility to increase, and appreciation to occur in the currency which is tightening policy,” Citigroup strategists said, predicting that the euro could fall from above €1.18 to €1.16 against the dollar.

Other ECB council members, however, said the ECB’s new strategy put it in a similar position to the Fed. “My interpretation . . . is that if similar shocks were hitting both the US and euro area the monetary policy reaction functions on both sides of the Atlantic would not be that far apart,” said Olli Rehn, governor of Finland’s central bank and ECB council member. 

The biggest question left by the ECB’s announcement was what it would mean for its monetary policy as the eurozone economy recovers from the coronavirus crisis — something it excluded from its discussions.

“We made a very clear distinction between work on the strategy review and regular work on monetary policy operations,” said Gabriel Makhlouf, governor of the Irish central bank and a member of the ECB council. 

“We are going to discuss any implications for monetary policy at our regular meeting, the next one being in two weeks,” Makhlouf said. “Of course, the issue that dominates our current discussions is the impact of the pandemic and I expect that to continue in the near term.”

Some analysts pointed out that the change to the ECB’s inflation target was partly offset by its promise to give greater weight to the cost of owning a home in the official price growth calculation. Frederik Ducrozet, a strategist at Pictet Wealth Management, said this would add about 15 basis points to the headline inflation figure, which is already expected to exceed 2 per cent this year.

Others said that in the long run the biggest impact of the ECB’s new strategy would come from the measures aimed at climate change, even though many will not take full effect until 2024. 

The central bank said it would develop new models of the financial impact, stress test its own exposure to global warming, require better disclosure of climate risks from companies and adjust its corporate asset purchases and collateral policy to take account of security issuers’ carbon emissions. 

“Where the review is groundbreaking are the climate change aspects,” said Paul Diggle, deputy chief economist at Aberdeen Standard Investments. “Other central banks are going to be reading this and thinking hard about how they can show a similar commitment to greening monetary policy.”

When the ECB council met this week, most of its 25 members, including Lagarde, broke away from discussions to watch Italy play Spain in the semi-final of the European football championship.

Given how divided the council was when Lagarde took over from Mario Draghi in late 2019, there were fears that her decision to launch a strategy review would fuel the tensions. Instead, the unanimous agreement on the new strategy months ahead of schedule is a success for her self-professed tactic of team building, aided by collegiate gatherings such as this week’s.

But the real test of the council’s unity is likely to come when it decides how to implement the new strategy, for example how quickly to wind down its €1.85tn emergency bond-buying programme. 

“The framework alone buys the ECB little,” said Krishna Guha, vice-president at Evercore ISI. “It will gain credibility only through the determined deployment of instruments to advance the stated aims.”

Additional reporting by Eva Szalay in London

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