ECB changes inflation target, leaving extra room to keep rates low

The European Central Bank has set itself a new 2 per cent inflation target and said it will tolerate temporarily exceeding this when needed, in a shift that gives policymakers more flexibility to keep interest rates at historic lows for longer.

The change, which was announced on Thursday as part of the Frankfurt-based institution’s first review of its strategy since 2003, marks an important break with the conservative monetary doctrine of Germany’s Bundesbank that formed the bedrock of the euro’s creation.

The central bank also announced plans to tackle climate change risks by tilting its asset purchases and collateral rules away from heavy carbon-emitting companies which are not aligned with the EU’s climate goals.

It addressed soaring house prices by calling for the cost of owning a home to be reflected in how inflation is calculated.

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Strategy

ECB president Christine Lagarde said: "The new strategy is a strong foundation that will guide us in the conduct of monetary policy in the years to come."

ECB policymakers decided to revisit their strategy shortly after Lagarde took over from Mario Draghi as its president in November 2019. While the process was delayed by the coronavirus pandemic, the results have been announced two months earlier than expected.

After years of failing to lift inflation up to its objective, the ECB has ditched its target of “close to, but below, 2 per cent”, which policymakers concluded was too opaque and implied a cap on price growth.

The central bank said its new target of 2 per cent was symmetric, “meaning negative and positive deviations of inflation from the target are equally undesirable”.

The new target is a medium-term objective with flexibility to fluctuate in either direction in the short term.

“When the economy is operating close to the lower bound on nominal interest rates, it requires especially forceful or persistent monetary policy action to avoid negative deviations from the inflation target becoming entrenched,” the ECB said.

“This may also imply a transitory period in which inflation is moderately above target.”

Changes

Andrew Kenningham, economist at Capital Economics, said that although "the immediate implications [for the path of monetary policy] are modest", the decision was still "a historic shift for the ECB" and "the death knell for the Bundesbank tradition, which has always emphasised the risks of high inflation above all else".

However, the ECB did not go as far as the US Federal Reserve, which last year formally committed to a flexible average inflation target that means it will aim for price growth to exceed its target to make up for a period of running below it.

Some analysts expected the ECB would also announce changes to its asset purchase programme to avoid hitting self-imposed limits on the amount of sovereign debt it can own. But this has been left to a separate decision on how to wind down its crisis-fighting policy measures later this year.

Copyright The Financial Times Limited 2021