Tuesday, July 5

The implications of the new ECB monetary policy framework

Last Thursday, the European central bank revised its inflation target, making it symmetric and more flexible around the same level of 2%. In the medium term, the ECB embarks on the project of incorporating the cost of home ownership into the price index. And finally, the monetary authority adds the fight against climate change explicitly to its general policy objectives. The ECB framework change it illustrates the fact that monetary policy is more political and less technocratic than previously believed. Maybe it was always like this.

On succeeding Mario Draghi as head of the ECB, Christine Lagarde set herself the main objective of reviewing the institution’s monetary policy framework for the first time in 18 years. The reasons were various.

The great financial crisis that began in 2007 and its aftermath, especially the euro crisis, had led to an environment of low interest rates and extraordinarily lax and interventionist monetary policy. During all these years, the horizon was a return to normality. However, in 2019, the eurozone was facing a looming recession. Mario Draghi ended his term by further relaxing monetary policy and raising the prospect that the low interest rate environment would last indefinitely.

Christine Lagarde was not an expert on monetary policy and needed a frame change to avoid obnoxious comparisons with the performance of her predecessor. Furthermore, making the inflation targeting symmetry and flexibility explicit in the new monetary policy framework can help Lagarde fend off the impatience of supporters to return to tighter monetary policy as soon as possible and at any cost.

More leeway not to put on the brakes too early

Inflation targeting symmetry will help the ECB not to put the brakes on too early or too sharply if inflation rises significantly. This is not new. During his tenure, Mario Draghi had been careful to emphasize that inflation can deviate both below and above the target. But the statement “below but close to” 2% implied a downward bias. This bias disappears by explicitly saying that the inflation target is symmetric around 2%. Most important, however, is the promise of greater flexibility. The ECB is no longer committing to stay “close” to 2%, for two reasons. The first is, again, giving yourself room not to react too early to higher inflation. And the second is that the ECB has been very far from its inflation target for many years, but below it. As can be seen in the attached graph, core inflation has been stuck at around 1% for almost ten years, while in the first decade of the century it was “below, but close to” 2%.

What can have a major impact on the future conduct of monetary policy is the decision to incorporate the cost of home ownership into the inflation index. But the ECB itself admits that it does not know very well how to do this, saying that “the complete inclusion of home ownership in the harmonized consumer price index is a long-term project.”

What we can say is that including the cost of home ownership in the inflation index has distributive effects. It favors the owners of their own habitual residence (69% of Europeans, according to Eurostat in 2016), at the expense of both renters and rental homeowners. It also favors eurozone countries where there is a higher proportion of home ownership, such as Spain, Italy, Greece or eastern countries, at the expense of Germany, France or northern countries.

Moderate real estate bubbles

Another long-term effect of including the cost of home ownership in the inflation index determined by monetary policy may be to moderate housing bubbles in the price of the home sale, but not in the cost of rent. According to Eurostat, at the European level, inflation in house sales is higher than that of rent, and is more correlated with the economic and financial cycle, having decoupled from the rental price since the euro crisis that began in 2011. Again , the differences between countries are significant, which can lead to comparative grievances.

Finally, the ECB explicitly includes the fight against climate change among its priorities. Implicitly it already was, since the mandate of the monetary authority includes supporting the political objectives of the EU. However, until now the European Central Bank had resisted incorporating “green” criteria into its monetary policy. From this moment, on the contrary, the ECB will incorporate climatic factors in its monetary policy estimates, including market information, risk estimates, and the corporate bond purchase program.

The latter was a demand of activists against climate change since the ECB started buying bonds of large private companies back in 2016. One of the arguments is that larger companies with better credit quality (“triple A”) tend to be older and in mature industrial sectors. This means that there is a bias in favor of “dirty” industries such as the extraction of fossil fuels or heavy industry that consumes a greater amount of energy, at the expense of more recent and sustainable industries such as renewable energy generation. .

The new ECB policy may allow the monetary authority to direct its asset purchases towards so-called green bonds. You could also use the recently introduced sustainability and environmental reporting obligations of large companies to select the bonds you buy regardless of your credit rating. Previously, the ECB hid behind the need to maintain neutrality in the market impact of its monetary policy

As can be easily understood, these changes in monetary policy cannot be without controversy, and will be criticized mainly by conservative politicians and economists. It will be important to monitor the distributional effects that monetary policy will have in the coming years, which will be different but equally significant than those it has had in the last decade.