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ECB still needs to put theory into practice 

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European Central Bank updates

The writer is head of macro research at the BlackRock Investment Institute

The European Central Bank achieved the first important step of its strategic revamp when it launched its new monetary policy framework in early July.

Its governing council meeting this week offers a chance for the ECB to communicate how the new framework will be implemented in practice, particularly when it comes to guidance on its asset-buying programmes that are intended to stimulate the economy by keeping bond yields low.

The ECB’s persistent undershooting of its inflation target over the past decade has led to eurozone inflation expectations becoming unanchored and falling well below the central bank’s inflation objective. Against this backdrop, it is perhaps unsurprising that markets have previously been pessimistic about the ECB’s ability to deliver on its mandate.

Under its new framework, the ECB embraces a “symmetric” inflation target of 2 per cent with undershoots and overshoots considered equivalent. When the policy rate is close to the effective level below which interest rates cannot be reduced further, the ECB will tolerate a temporary overshoot of its inflation target. This is partly because policy support can be stronger than it otherwise would have been under the previous 2003 strategy framework.

At its late July policy meeting, the ECB governing council took a first practical implementation step by changing its forward guidance for interest rates. For now, this also implies a change for the duration of its asset purchases, subject to a future debate on the council.

By committing to keep interest rates at current or lower levels until inflation is forecast to return to 2 per cent on a sustained basis, the ECB caused many forecasters to push out further their projection of a first rate rise.

But the ECB still needs to follow through with a decision on the pace of its asset purchases. To be clear, this is not about the quarterly review of the pace of its programme tied to its emergency response to the Covid-19 pandemic. It is about its “regular” asset purchase programme.

Given that staff inflation projections still show inflation rates over the medium term well below the new inflation objective of 2 per cent, it seems clear that the pace of the APP needs to be stepped up as it takes over from the pandemic programme that is due to expire in March.

The APP is determined by the medium-term economic outlook of the governing council. The decision on the pace of the pandemic programme, by contrast, is more about the near-term prospects and is finely balanced given the improved financial conditions over the summer and a slightly upgraded inflation outlook.

There is a risk that markets interpret an operational decision to reduce the pace of the pandemic support as a tapering decision by the ECB, even though it is not intended to be a monetary policy signal. Such an interpretation could cause financial conditions to tighten.

The new policy framework clearly calls for further easing, which needs to come through a higher pace of the APP. Slowing pandemic programme purchases would send the wrong signal before the new framework has even been fully put into practice.

The ECB’s concern over inflation should be that it looks to be too low in the medium term, not that pandemic-related distortions are driving it temporarily higher. For its new framework to become credible, eventually the ECB’s own staff projections would need to show inflation temporarily moving above 2 per cent.

Additional fiscal policy support might be needed. While European fiscal policy support has broadly stabilised household disposable incomes during the pandemic, US households’ incomes were materially boosted by a range of public policy measures.

Until the ECB has better visibility on the extent to which it can count on fiscal policy in the coming years, ahead of reform discussions next year, it cannot let up in pursuing its price stability objective.

The ECB has been struggling to steer inflation back to its price stability objective since the financial crisis. As a result, the equilibrium level of interest rates has fallen further, eroding the space for monetary policy responses to events.

It is thus vital that the governing council demonstrates how its new framework will change how it reacts to macroeconomic conditions. The new strategy gives the ECB more room for bold policy action, not least in the current low rate environment. The July policy meeting showed this was the case for forward guidance on interest rates. Now is the time for the ECB to do the same with the pace of its asset purchases.

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