No near term policy change, but radical review

Market flash

Lagarde more positive on growth and inflation but still very cautious
Policy review to check aims, instruments and broader impacts of monetary policy ECB notes ‘profound structural changes’ affecting world economy
Unconventional policies to be normalised? Low is lasting?
Could the ECB’s mandate be stretched too far?

There was little expectation that ECB president, Christine Lagarde, would deliver any signal of market significance at the press conference that followed the first ECB Governing council meeting of 2020. Indeed, so low were expectations that one reporter asked Ms Lagarde whether it might have been better for her to skip the ECB press conference and attend the World Economic Forum in Davos instead.

The main reason that markets see no early policy change is that, both in terms of growth and inflation, the Euro area economy is showing some improvement but this pick-up is modest and still tentative and it is coming from readings that until very recently were far too low for comfort. So, markets see no grounds at present for the ECB to move in either direction by easing further or, on the other hand, to consider unwinding some of the current very accommodative monetary policy. 

Still far from where GDP/CPI should be 

There was no indication of any material change to the ECB’s assessment of the Euro area economy that might suggest even a faint inclination towards adjusting policy. Although signs of improvement were acknowledged, the ECB was careful to largely offset these by indicating continuing constraints. Hence, the press statement pointed to ‘ongoing, but moderate growth’ but qualified this by noting that ‘the manufacturing sector remains a drag’ and also indicated that while employment growth is continuing, it is ‘decelerating’. 

In the same vein, the statement repeated the judgement that the current monetary policy stance is ‘underpinning favourable financing conditions for all sectors of the economy’ but it omitted December’s reference to a ‘substantial monetary stimulus’ perhaps because the ECB statement also acknowledges both slower loan growth to companies in November and signs of weaker corporate loan demand in the bank lending survey released earlier this week that it suggests likely reflects ‘some lagged reaction to the past weakening in the economy’.

Similarly, price trends are judged to be sufficiently improved not to hint at any need for further stimulus but not nearly robust enough to warrant any suggestion that tightening might be contemplated. Inflation which increased to 1.3% in December is now seen ‘likely to hover around current levels in coming months ’ having picked up as the ECB had signalled in its December statement. While ‘further indications of a moderate increase’ in underlying inflation are noted, this is ‘ in line with previous expectations’ and tempered by the judgement that ‘Measures of underlying inflation have remained generally muted.

While there was little new in the ECB press conference, the generally cautious tone and careful attempt not to overstate any signs of improvement in the Euro area may have contributed to some marginal easing in term interest rates and the exchange rate of the Euro in circumstances where financial markets were a little edgier on concerns about potential negative spill-over impacts from the Coronavirus. 

Review could have broad implications

At the margin, it could also be the case that market thinking was also influenced by the thrust of the press release that formally set out a previously signalled review of its monetary policy strategy by the ECB. That release suggested the ECB will contemplate the implications of a much changed world for monetary policy. 

It remains the case that less troubling but still lacklustre growth and inflation in the Euro area are the critical factors seen keeping the ECB on the policy sidelines for some significant time. However, there has also been some commentary suggesting that the ECB might also be constrained somewhat by a wide-ranging review of its monetary policy strategy that it formally launched yesterday.

As Ms Lagarde again indicated that the ECB’s policy review is expected to take most of the coming year to complete with the ECB president hopeful that the results of the review might be communicated in November or December. The significant timeframe envisaged for the review seems warranted by the broad sweep of its ambit. The press release notes that the

• Review will encompass quantitative formulation of price stability, monetary policy toolkit, economic and monetary analyses and communication practices
• Other considerations, such as financial stability, employment and environmental sustainability, will also be part of review
• Expected to be concluded by end of 2020
• Review will be based on thorough analysis and open minds, engaging with all stakeholders

This specification implies a root and branch evaluation of the ECB’s aims and instruments and their possible application to a notably broader range of goals than price stability. The press release went on to describe a range of ‘profound structural changes’ in the global economy have driven rates down and are ‘ reducing the scope for the ECB and other central banks to ease monetary policy by conventional instruments in the face of adverse cyclical developments’. Significantly, in this new normal, addressing low inflation is different from the historical challenge of addressing high inflation’. 

The thrust of this press release might suggest that the ECB is focussed on the prospective policy challenges of an economic environment where the mantra of ‘lower for longer’ in relation to interest rates might need to be modified to ‘lower is lasting’ and a related normalisation of the ECB’s unconventional policy instruments. The sense that thinking in Frankfurt is moving even tentatively in this direction could come to present a significant restraint on any movement towards markedly higher term rates.

Lessons from the 2003 ECB review?

While the review of monetary policy now outlined by the ECB is altogether more far-reaching than that undertaken in 2003, it might be noted that in that previous episode a change in the inflation target might be regarded as reflecting a response to the experience of the previous couple of years. 

In 2003, difficulties in striking a balance between credibly achieving the existing inflation target and not needing to implement a very restrictive policy stance in circumstances of faltering economic growth prompted an effective easing of the inflation target.

As inflation only dipped below 2% in one month between mid-2000 and the completion of the review in May 2003, the ECB amended the inflation target from the initial goal of ‘below 2% ‘to ‘below, but close to 2% . As the diagram above illustrates, the new target was close to the average inflation rate seen between the beginning of EMU and that point. It should also be noted that the ECB eased policy during the period of the policy review, notwithstanding a spike in inflation, implying exceptional and unexpected developments could translate into a policy adjustment even if this seems extremely unlikely for the coming year.

An additional complication in terms of the policy review now beginning is that the ambition for monetary policy set out in the second bullet point in the ECB press release is now notably greater than that envisaged in the past and outlined by the previous French ECB president Jean Claude Trichet who noted ‘we have only one needle in our compass. That needle is price stability,’.
Formally reconciling potentially conflicting requirements of these various considerations may leave scope for some disappointment in regard to what the ECB might credibly achieve. A range of questions at the press conference suggests the particular positioning of climate change in the ECB’s future monetary policy deliberations is likely to be a very high profile element in the upcoming review.

While Ms Lagarde relatedly emphasised the importance of this issue, she wouldn’t be drawn on the specifics of what it might mean in terms of policy settings. The thrust of this questioning and the potentially far-reaching implications of the policy review suggest that even if the ECB remains on the sidelines in relation to policy changes in coming months, it is most unlikely to stay out of the spotlight.

Austin Hughes, KBC Dublin




Any opinion expressed in this KBC Economic Opinions represents the personal opinion by the author(s). Neither the degree to which the hypotheses, risks and forecasts contained in this report reflect market expectations, nor their effective chances of realisation can be guaranteed. Any forecasts are indicative. The information contained in this publication is general in nature and for information purposes only. It may not be considered as investment advice. Sustainability is part of the overall business strategy of KBC Group NV (see We take this strategy into account when choosing topics for our publications, but a thorough analysis of economic and financial developments requires discussing a wider variety of topics. This publication cannot be considered as ‘investment research’ as described in the law and regulations concerning the markets for financial instruments. Any transfer, distribution or reproduction in any form or means of information is prohibited without the express prior written consent of KBC Group NV. KBC cannot be held responsible for the accuracy or completeness of this information.

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