ECB’s Green New Deal?

The ECB’s first strategic review in more than 16 years is now officially underway. The findings will shape the future of monetary policy, most likely with an amended inflation target and improved communication.

The inclusion of climate change in the review was duly confirmed, triggering some euro weakness on concern this could be used to engineer further expansion of monetary policy.

But for now, President Christine Lagarde will take comfort in the moderate improvement in growth and inflation dynamics that allow the current policy parameters to remain firmly on hold.

 

Already Incorporating Climate Measures

Lagarde is starting to make her mark on the ECB. The strategy review announced on Thursday was undoubtedly overdue, with the last (and only) review in 2003. But it could well be a conduit to important policy and communication changes for 2021 and beyond.

The inclusion of climate change was well telegraphed in advance. But the details on the broad approach to this triggered some weakness in the currency. Lagarde mentioned that the ECB is already incorporating climate change where possible – the ECB pension fund, risk assessment models and increasing the share of green investment in the Bank’s paid-up capital and reserves portfolio. But what really matters is whether or not the corporate bond portfolio under the APP will be expanded to focus on green investments. Such a shift would require broad agreement from the Governing Council, however, and will only become clear at the end of the review.

 

Define and Deliver

The task to define and deliver price stability is at the review’s core. The current, slightly clunky and opaque, definition of stability is maintaining HICP inflation below, but close to 2%. But that’s likely to change. For one thing the Governing Council do not appear to agree on what exactly below 2% means. And the use of the word ‘below’ created the perception of downward bias.

While the ECB has increasingly emphasised the symmetry of the current inflation target the review is expected to make this more formal. Joining the Fed, BoE, BoJ and other global central banks with a 2% point target is one possible outcome. But we do not entirely rule out a move to a band, with +/- 0.5pp around a 2% midpoint.

Former Executive Board Member Benoît Cœuré, called for a tolerance band in his final ECB speech in December. In his view, this “recognises the large and inherent uncertainty surrounding price and wage decisions” while retaining the anchor of the midpoint. Dutch Governor Klaas Knot also said last year that a symmetric band “would have merit”.

Lagarde refused to comment on a band versus point target during Thursday’s press conference but stated she did indeed have a view. We expect this will be an integral part of the discussions over the coming months.

The decision on how to modify the target will determine the policy implications and could allow the ECB to exit from its current forward guidance. Moving to a 2% target, or a “close to” 2% target, as suggested by some analysts, is seen as an efficient way to raise inflation expectations. But a tolerance band around a clearly defined 2% midpoint should also lift expectations while potentially making communication easier, as there should be less need to explain the rational for any short-term deviations from the mid point.

The measurement of inflation, and the absence of owners equivalent rent in Eurostat’s measure of HICP, is not fully in the hands of the ECB. This will nevertheless remain an important question, most likely beyond the timeframe of the review. Whether HICP, or instead core inflation, is the most appropriate measure to use will likely be discussed. ECB policies can of course influence core more than headline inflation. But given the focus on modifying the target, switching to an alternative measure of inflation, could seem confusing.

 

Existing Toolkit Likely to Pass the Review

Lagarde’s December comment that we will “re-examine the effectiveness [and] appropriateness of each and every single instrument that we’ve used in the past” was reinforced in Thursday’s statement. It is, however, difficult to see the review adopting any radical departure from the ECB’s earlier line that a four-pronged approach (negative rates, forward guidance, asset purchases and TLTROs) is “complementary and mutually reinforcing”.

The ECB have so far downplayed any negative side effects from the policies. The reversal rate has not yet been reached as lending growth remains positive, something the ECB frequently remind us. And more generally, ECB policies have contributed to higher growth and inflation than would otherwise have been the case. Again, it is difficult to see any significant reversal of this position with political factors also playing a role.

 

Scope and Timetable as Expected

The wide scope of the review had been discussed in advance with the ECB expected to include academics, the European Parliament and everyday society in its review. Lagarde pointed to the Fed Listens events as an example of what the ECB could do, but she makes the point that the 19-country Euro Area is a very different landscape than the US.

There were no surprises on the timetable either with Thursday’s statement sticking to the earlier mention of a one-year review. Lagarde said she hoped to be able to communicate the findings in December. This wide scope yet relatively short timetable seems somewhat ambitious. By contrast, the Fed’s monetary policy review was announced in November 2018 with the findings due to be released in the first half of this year.

Other aspects under review are financial stability and employment. Financial stability will presumably focus on to what extent the current monetary policy tools amplify such risks. We expect climate risks will also feature prominently within financial stability. We will leave a discussion on the merits of ECB expertise being diverted towards climate policy to another day.

 

 

 

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