ECB Watch – Lagarde suggests 2% will become new aim, while other changes still up in the air

The one clear change that looks very likely is the formulation of the ECB’s inflation aim. Ms. Lagarde notes that the current formulation of ‘below, but close to, 2%’ was ‘appropriate at a time when the ECB was seeking to establish credibility and too-high inflation was its main worry’. She notes that ‘in the current environment of lower inflation, the concerns we face are different’ and ‘we need to ensure that our aim is perceived to be symmetric by the public. So we should have an inflation aim that the public can easily understand’. In our view she is making a very clear case for a symmetric goal of 2%.

The ECB President then raises a number of other potential changes, however in each case she mention pros and cons, suggesting that the debate is ongoing and no clear decision has been reached.

First, how to define the policy horizon. A long policy horizon allows the ECB to look through supply shocks, but on the other hand she notes that long periods of inflation away from the goal can dislodge inflation expectations, which makes the case for a shorter horizon.

Second, on whether the horizon should also include a backward-looking element, so that the ECB would make up for previous inflation misses (in line with the strategy now adopted by the Fed).  Ms. Lagarde notes that  ‘such a strategy can strengthen the capacity of monetary policy to stabilise the economy when faced with the lower bound. This is because the promise of inflation overshooting raises inflation expectations and therefore lowers real interest rates. While make-up strategies may be less successful when people are not perfectly rational in their decisions – which is probably a good approximation of the reality we face – the usefulness of such an approach could be examined.

Third, the ECB will examine the measure of inflation it targets. She notes that ‘we need to keep track of broad concepts of inflation that capture the costs people face in their everyday lives and reflect their perceptions, including measures of owner-occupied housing’. On the other hand she warns that ‘we also need to recognise that adjustments will present issues in terms of reliability and frequency of the data’. On a separate point, she flags a bigger role for ‘more cyclical and less volatile measures of inflation, such as underlying inflation’ in the ECB’s analysis.

Finally, the ECB would reflect on macro policy. It will examine the transmission channels of its different monetary policy tools, and evaluate their relative side effects, both intended and unintended, as they work their way through the economy.

In a new element, the ECB would also examine ‘interactions between monetary and fiscal policies’. She notes that ‘when central banks have to use balance sheet policies extensively, there is an inevitable strengthening of the interplay between monetary and fiscal policies’. Indeed, ‘one explanation for the superior inflation performance of the United States relative to the euro area in recent times is that monetary and fiscal policies were more aligned’. Although an extremely interesting topic, Ms. Lagarde does not go into how such a framework could work in practice and the legal and political issues it raises, as it would probably need EU Treaty changes. In any case, our sense is that she putting the onus on a change to the EU’s fiscal framework, rather that an MMT-based construct.

Overall, it seems likely that the ECB is heading for a symmetrical 2% goal. While it is open to considering many other changes, it is unclear at this stage whether there is a majority in the Governing Council for any of the other potential innovations.