ECB tweaks inflation target, carves out climate role

The European Central Bank set a new inflation target on Thursday and carved out a major role in the fight against climate change, as Europe’s most powerful financial institution embarked on the biggest overhaul in its 23-year history.

With inflation having undershot its target for nearly a decade, ECB President Christine Lagarde has driven an 18-month deep dive into the inner workings of the bank, challenging even fundamental principles of central banking in the hopes of resetting strategy and bolstering credibility.

In the key conclusion of the review, the central bank of the 19 countries that share the euro set its inflation target at 2% in the medium term, ditching a previous formulation for “below but close to 2%”, which had created the impression it worried more about price growth above the target than below it.

Pioneered in the early 1990s by smaller central banks in New Zealand and Canada, inflation-targeting is widely credited with taming price growth and ushering in a period of stable prices, with the youngest generations having no experience with real inflation.

But the results of the experiment have been mixed, particularly over the past decade when some of the biggest central banks like the ECB and the Bank of Japan struggled with excessively low inflation that has forced them to cut interest rates into negative territory and cast doubts on the power of central banks.

This persistent undershooting had raised the possibility of seeking an inflation rate above the target, but the ECB ultimately concluded that price growth above and below its target were both undesirable and it would not aim to overshoot even after longer periods of low inflation.

“This target is symmetric, meaning negative and positive deviations of inflation from the target are equally undesirable,” the ECB said.

OVERSHOOTING

The bank conceded that in certain situations, when especially forceful or persistent monetary support is needed, inflation could moderately exceed its target for a transitory period.

But the new policy stopped short of committing to an inflation overshoot after longer periods of low price growth, possibly disappointing investors who were looking for such a pledge, which would ensure stimulus well into the recovery.

Acknowledging that inflation could still temporarily overshoot its target was nevertheless seen bolstering the ECB’s credibility with markets that its target is indeed symmetric and policymakers do not perceive 2% as a cap, a difficulty the bank had faced with its previous target.

The ECB also said it was unhappy with the current measure of inflation compiled by the EU’s statistics agency as it omitted large chunks of housing costs, but said any fix would take years so policymakers will also look at other measures of inflation.

“The Governing Council in its monetary policy assessments will take into account inflation measures that include initial estimates of the cost of owner-occupied housing to supplement its set of broader inflation measures,” the ECB said.

In perhaps the biggest change, the central bank said it will do more to help the fight against climate change and will include climate change considerations in monetary policy operations in the areas of disclosure, risk assessment, collateral framework and corporate sector asset purchases.

“The ECB will adjust the framework guiding the allocation of corporate bond purchases to incorporate climate change criteria, in line with its mandate,” it said.

The bank will also start disclosing climate-related information of its corporate sector asset purchase programme by the first quarter of 2023, it added.

Taking on a climate role, the ECB follows the U.S. Federal Reserve in a foray into social policy. The Fed after its own similar review last year said it would allow the jobs market to run hotter in the future to help low-income families, possibly tempering inequality.

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