The European Central Bank still needs to put theory into practice
European Central Bank Update
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The author is the head of macro research at BlackRock Investment Research Institute
The European Central Bank takes an important first step in its strategic reform New monetary policy framework Early July.
This week’s board meeting provided the European Central Bank with an opportunity to discuss how the new framework will be implemented in practice, especially with regard to guidance on asset purchase programs aimed at stimulating the economy by maintaining low bond yields.
The European Central Bank has consistently fallen below its inflation target for the past decade, causing inflation expectations in the euro zone to become unstable and far below the central bank’s inflation target. In this context, it may not come as a surprise that the market had been pessimistic about the ability of the European Central Bank to perform its duties.
Under its new framework, the European Central Bank adopted a “symmetric” inflation target of 2%, which is lower and higher than the inflation target considered to be equal. When the policy interest rate is close to the effective level that cannot further reduce the interest rate, the European Central Bank will tolerate the temporary overshoot of the inflation target. Part of the reason is that policy support may be stronger than under the previous 2003 strategic framework.
At the policy meeting in late July, the European Central Bank Management Committee took the first step in actual implementation by changing its forward-looking guidance on interest rates. For the time being, this also means that changes in the period of asset purchases depend on future board debates.
The European Central Bank promised to maintain interest rates at current or lower levels until inflation is expected to continue to rise to 2%, which has caused many forecasters to further postpone their forecasts for the first rate hike.
But the European Central Bank still needs to make a decision on the pace of asset purchases. To be clear, this is not a quarterly review of its planned speed in relation to the Covid-19 pandemic emergency response. This is about its “regular” asset purchase plan.
Given that the employee inflation forecast still shows that the medium-term inflation rate is well below the new inflation target of 2%, it seems obvious that APP needs to speed up the pace as it takes over due to expiration in March.
APP is determined by the board’s medium-term economic outlook. In contrast, the decision on the pace of the pandemic plan is more about the near-term outlook, and considering the improvement in summer financial conditions and a slight increase in inflation prospects, this decision has been well balanced.
The market may interpret the operational decision to reduce the pace of pandemic support as a gradual reduction by the European Central Bank, even if it is not intended to be a monetary policy signal. This interpretation may lead to tightening of financial conditions.
The new policy framework clearly requires further easing, which needs to be achieved through a higher pace of APP. Before the new framework is fully implemented, the purchase of pandemic mitigation plans will send the wrong signal.
The European Central Bank’s concern about inflation should be that it looks too low in the medium term, not that distortions related to the pandemic are pushing it temporarily higher. In order to make the new framework credible, eventually the ECB’s own staff forecasts need to show that inflation is temporarily above 2%.
May need additional fiscal policy support. Although European fiscal policy support has broadly stabilized the disposable income of households during the pandemic, a series of public policy measures have greatly increased the income of American households.
Until the European Central Bank has a better understanding of its fiscal policy reliance in the next few years, it cannot give up pursuing its price stability goals until next year’s reform discussions.
Since the financial crisis, the European Central Bank has been trying to guide inflation back to its price stability target. As a result, the equilibrium level of interest rates fell further, eroding the room for monetary policy to respond to events.
Therefore, it is crucial for the management committee to show how its new framework will change its response to macroeconomic conditions. The new strategy provides the European Central Bank with more room for bold policy actions, especially in the current low interest rate environment. The July policy meeting indicated that this is the case for forward-looking guidance on interest rates. Now is the time for the European Central Bank to take the same measures on the pace of its asset purchases.