The ECB’s Strategy Review Likely Yields Little New

In the days since it concluded last Thursday, many financial commentators we follow have hailed the European Central Bank’s (ECB’s) 18-month strategy review seeking more effective monetary policy as a big shift. Many cite the ECB’s new twist on inflation targeting and a plan to help fight climate change as landmark achievements. But we think if you tune down the rhetoric to look at reality, you will see the new strategy is pretty hard to distinguish from the old.

The chief change to the ECB’s target inflation rate appears almost imperceptible to us. Instead of seeking an inflation rate “close to, but below” 2% y/y, now it is a “symmetric” 2% target.^[i] According to the ECB’s announcement, this means inflation above and below 2% are “equally undesirable.” That may be, but we think markets are more interested in what the central bank would do about them. Many commentators we follow assumed the ECB would tolerate above-target inflation for a while if it was below before, like the US Federal Reserve’s (Fed’s) new inflation targeting approach.^[ii] But that doesn’t seem to be the case. As German Bundesbank head Jens Weidmann—1 of 25 members on the ECB’s Governing Council—noted, the new strategy doesn’t try to make up for past undershoots with above-target inflation.^[iii] We think it simply gives policymakers theoretical cover for trying to lift inflation toward the 2% y/y target, should it fall below that mark. The differences between this and the extraordinary monetary policy of the last seven or so years when inflation ran sub-target seems pretty semantic to us.

In our view, that verbal cover underscores the ECB’s inability to hit its target. This isn’t to knock the ECB specifically. According to our research, there is little evidence any central bank can reliably hit inflation goals, whether it is the ECB, Fed, Bank of England or Bank of Japan.

Consider the Fed. Since it set its 2% y/y inflation target in 2012, there have been only a few months when its chosen gauge—the personal consumption expenditures price index—has hit it.^[iv] It came closest in 2018, when it hovered within a couple tenths of a percentage point of 2% for most of the year, but otherwise it has been far off.^[v] Similarly, the ECB hasn’t been too successful. Exhibit 1 shows the results of the ECB’s efforts. Whilst it struggled to keep inflation “close to, but below” 2% y/y, mostly overshooting in the decade following its inception, the ECB undershot its target over the next decade plus.

Exhibit 1: The ECB’s Control Over Inflation Seems Spotty

Source: FactSet, as of 12/7/2021. Harmonised Consumer Price Index, January 1998 – June 2021.

Now, we think there is little doubt central banks have influence over inflation, which Nobel laureate Milton Friedman famously taught was a monetary phenomenon. But the degree of precision implied by these targets—and the verbiage changes around them—seems irrational to us. Following Friedman’s logic, inflation is driven by too much money changing too few goods and services. But we think the money supply and velocity measures—which aim to tally how fast money changes hands economy-wide—central bankers use are fallible. The idea a central bank understands these factors completely and can forecast where they are heading well enough to boost or lower inflation by fractions of a percentage point seems unlikely to us. A shift in strategy by itself probably doesn’t make the ECB any more capable of controlling inflation. It also doesn’t automatically clear up the central bank’s decision making for investors. Human beings set monetary policy and they are wont to change their minds and act in manners displaying bias, from time to time.

As for the ECB’s climate change policies, it has committed to “include climate change considerations in its monetary policy framework.”^[vi] Chiefly, in our view, this presently means the ECB will require companies issuing bonds to make climate change risk disclosures for them to be eligible as collateral or for quantitative easing (QE) asset purchases. Perhaps they eventually exclude big polluters from purchases, which many commentators we follow seem to suspect. But for now, that isn’t the case. Nor do we think it an enormous issue, considering the ECB’s QE programme overwhelmingly targets government bonds.^[vii] It is also possible this move politicises ECB policy, but that doesn’t seem like an issue in the here and now, either. The same goes for another new policy twist: adding climate risk to bank stress tests, examinations designed to assess the risk of a bank failing in a recession or financial crisis. Stress tests were already opaque and arbitrary, and this doesn’t change that, in our view.

For investors, we think the ECB’s new strategy should be dealt with the same way as before: Wait and assess the implications of its actions after the fact. Attempting to figure them out beforehand is futile—and unnecessary, in our view. Based on our research, monetary policy hits with a lag and markets, which incorporate all widely available information—including expectations for central bank policy moves—near instantaneously, have no pre-set reaction to it anyway.