The European school of central banking is no more


Last week the European Central Bank completed its strategy review ahead of schedule, to much less fanfare than the Federal Reserve’s equivalent update two years ago. But behind this subdued reception lies a notable normalisation of the eurozone institution.

Some financial sector analysts suggested “not much (had) changed”, in the words of Pictet’s ECB-watcher Frederik Ducrozet. ECB president Christine Lagarde has begged to differ: it changed “quite a lot”, she insisted in her press conference.

One can try to reconcile these perspectives — underwhelmed observers against Lagarde and her colleagues’ belief this is a big moment — by first noticing that the review sheds many of the idiosyncrasies that had made the ECB so different from other major central banks.

Gone is the “double-key” target of “close to but below” 2 per cent inflation, which is replaced by an explicitly symmetric two-per cent target. Gone, too, is the “monetary pillar” of the ECB’s analytical approach, which paid particular attention to money supply measures in a legacy from the pre-Maastricht Bundesbank. (The money supply will of course still be monitored, but as part of a wider integrated analysis.)

The endorsement is also clear that the unconventional tools adopted over the past decade are here to stay, and to be used as long as short-term interest rates are difficult to cut much further.

The review, in short, gets rid of many things that made the ECB stand out like a sore thumb among central banks — in particular those features that fuelled perceptions the Frankfurt-based institution had a deflationary bias. This is not your parents’ ECB — as is clear from the governing council’s 18-page detailed description of how it understands the economy and the role of monetary policy.

That document, which must have needed unanimous line-by-line approval, could in most respects have been published by the Federal Reserve, the Bank of England, or the Bank of Japan. The analysis of the economy, price dynamics and monetary mechanisms are the same; no longer is there a separate European school of central banking — more attentive to inflation than deflation, and inclined to worry that intervening in bond markets amounts to financing governments. All face the same challenge of “normal” interest rates consistently much lower than they used to be, and close to some effective bound on how low they can go.

As Lagarde expressed it, that challenge is to avoid a “trap” when negative shocks hit an economy where rates are already very low, and inflation expectations start drifting down because people think central banks have run out of ammunition. It is a challenge that has exercised central bankers and economists everywhere for some time, and all the proposed solutions are variations on a theme.

Ben Bernanke, former Fed chair, has proposed that central banks can switch from targeting inflation to targeting price levels for as long as monetary policy rates are the lowest they can be. The Fed itself chose a different approach: to target average inflation and worry more about undershooting than overshooting its target.

The ECB has gone another way, emphasising the symmetry of its target but declaring an asymmetry in how to achieve it: to stop inflation expectations from drifting below two per cent when policy rates are very low, Frankfurt promises to use its other instruments with additional force and persistence, even if that means inflation runs above two per cent for some time.

It is not quite a distinction without a difference. But the difference is only slight — at least in theory. Many are still sceptical, including Ducrozet who said he was “left with the uncomfortable feeling” that “the ECB will continue to be perceived as less aggressive and less credible than the Fed”.

The ECB would be more convincing with an explicit “tolerance band” for inflation to stay somewhat away from target, Maria Demertzis, Bruegel deputy director also argued on Twitter.

Much, then, hinges on how Lagarde lets the ECB’s new strategy inform her communications. She has struggled to convince markets in the past. She can now try again — and this time, with feeling.

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