ECB Watch – The outcome of the strategy review

There are two key elements: changes to its inflation framework (see here) and a climate action plan (see here).

The new goal – The ECB has raised its inflation target to 2% from ‘below, but close to, 2%’ previously. The ECB notes that ‘price stability is best maintained by aiming for two per cent inflation over the medium term. The Governing Council’s commitment to this target is symmetric. Symmetry means that the Governing Council considers negative and positive deviations from this target as equally undesirable’.

Overshooting – In addition, the ECB has stated that it is prepared to allow periods of inflation overshooting the goal in circumstances where interest rates are close to the lower bound (as they are now) to prevent the disanchoring of inflation expectations. It notes that ‘when the economy is close to the lower bound, this requires especially forceful or persistent monetary policy measures to avoid negative deviations from the inflation target becoming entrenched. This may also imply a transitory period in which inflation is moderately above target’. Despite the fact that President Christine Lagarde was repeatedly asked about this point in the press conference, it is unclear exactly how this policy would look in practice. What is clear, is that given the current policy environment and low inflation expectations, the ECB expects to be more frequently in situations where it makes sense to err on the side of doing too much than too little.

Housing – Third, the ECB confirms that HICP is the appropriate measure of inflation to assess ‘the achievement of the price stability objective’. However, the Governing Council would ideally like to see the inclusion of the costs related to owner-occupied housing (OOH) in the HICP over the coming years. In  the meantime, the Governing Council will ‘take into account inflation measures that include initial estimates of the cost of owner-occupied housing in its wider set of supplementary inflation indicators’. In earlier comments, the ECB has suggested that the inclusion of OOH into HICP would add 0.2-0.3% to the inflation rate.

Lower for longer – Overall, we think the changes put in place following the review imply an even longer period of accommodative monetary policy. This is because the gap, between where the ECB wants inflation to be over the medium term and where it is projecting that it will be, is now larger. In addition, given we are very close to the lower bound in interest rates and inflation expectations are historically low, the ECB has signalled its willingness to see a moderate overshoot of inflation in order to re-anchor inflation expectations. The consideration of OOH in its inflation assessment only partially offsets the other elements in terms of the monetary policy direction.

Climate action plan – The ECB’s announced a plan with a roadmap (see here) to further incorporate climate change considerations into its policy framework. There are six key elements:

1. The stepping up of the ECB’s macroeconomic modelling of climate change and related policies for the economy as well as assessing the implications for monetary policy transmission. This will be carried out during 2022 and 2024. However, the ECB will already introduce technical assumptions on carbon pricing for forecasting in the staff macroeconomic projections by next year.

2. The development of new experimental indicators, covering for instance the carbon footprint of financial institutions and their exposures to climate-related physical risks (2021-2022).

3. Introduction of disclosure requirements for private sector assets as a new eligibility criterion or as a basis for a differentiated treatment for collateral and asset purchases (2023)

4. Climate stress tests of the Eurosystem balance sheet to assess the Eurosystem’s risk exposure to climate change (2022)

5. Climate change risk assessment when reviewing assets mobilised as collateral by counterparties for Eurosystem credit operations (2022-2024)

6. Adjustment of framework for allocating corporate bond purchases to incorporate climate change criteria. EU legislation implementing the Paris agreement through climate change-related metrics or commitments of the issuers to such goals will form the basis of this adjustment (From 2022H2). On the basis of speeches by ECB officials, this will be done without prejudicing the central bank’s primary price stability objective.

The ECB’s action plan represents a comprehensive approach to incorporating climate-related risks to every element of the central bank’s activities in our view. However, a lot of the details – for instance on how it will change the collateral framework and the allocation of corporate bond purchases – are still of course to be decided.