Jonathan Marriott, Chief Investment Officer
For the last eighteen months, the European Central Bank (ECB) has been conducting a comprehensive strategy review. Given the financial crisis and changes that have taken place, it is surprising that the last review of this type was conducted in 2003. It is less surprising that they have set the next review for 2025.
The change most likely to be the subject of discussion is in the way the ECB targets inflation. The ECB has a target for stable prices. This was previously defined as “below but close to 2% over the medium term” and was deemed unclear. The ECB now targets just 2%, implying a symmetrical view of outcomes either side of this and suggests that they would be prepared to tolerate inflation above 2% for short periods of time. That said, they have not gone as far as the Federal Reserve, who have said they will target an average of 2% but are more in line with the Bank of England. While this change indicates that the ECB may be more tolerant of inflation, in practice, it makes little difference.
Core inflation, for the last eleven years, has been stubbornly well below 2%, even pre-pandemic when unemployment was relatively low. Ageing populations, automation and other technological shifts have made it difficult for prices to rise. In the short term, we may see some inflation due to bottlenecks in supply and a pick-up in demand as we recover from the pandemic. However, the deflationary influences are not going away and this change may enable the ECB to keep interest rates stable if this occurs. In practice, we expect the ECB official rates to be zero or below for an extended period.
Source: Bloomberg, Eurostat, LGT Vestra
While the Harmonised Index of Consumer Prices (HICP) remains their preferred measure of inflation, the ECB has suggested that this should be altered to include the cost of house ownership. As house prices have risen, this would have increased the rate of inflation. If low interest rates continue to stimulate asset prices, with this revision in place, it may make it slightly easier to eventually hit the target. The calculation of HICP is done by Eurostat, so it is not in the direct control of the ECB, hence any change in this measure may be slow to arrive. If house prices rise in the meantime, it may be a case of locking the stable door after the horse has bolted.
Risk of climate change
A large part of the review is taken up by the impact of climate change. The ECB will not only look at this from an economic perspective, but will build it into almost everything they do. They will incorporate climate change risks for collateral and asset purchases and will conduct climate change stress testing for the Euro-system balance sheet. In addition, the carbon footprint of financial institutions and portfolios will be more closely considered, allowing for development in how the impact of climate change is measured and assessed. This is likely to take time to develop and reflects the serious nature of the threat to the global economy and, over time, we may well see similar moves from other central banks around the world.
The changes are subtle, and we see little impact on markets in the short term. Given the failure to meet the inflation target for over ten years, it is disappointing not to see something stronger but getting unanimous agreement is difficult. We would argue that this does not increase their credibility as a central bank but could in fact achieve the opposite. Germany has had a long history of fighting inflation and may have been uncomfortable going any further. In the long term, climate change measures may turn out to be more important than the way they target inflation.
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