ECB says it has learnt lesson on premature rate rises

The last time the European Central Bank raised interest rates was just as the eurozone debt crisis began in 2011 — a move its officials now acknowledge was a big mistake.

Its first new strategy for nearly two decades, unveiled on Thursday, is designed to avoid the risk of such premature policy tightening in the future. It shifts the Frankfurt-based institution to a 2 per cent inflation target and pledges to tolerate any slight overshoots.

“We have learnt from history and we have observed what has worked and what has not worked,” Christine Lagarde, ECB president, said as she presented the review’s results. “Now we need to demonstrate we mean what we say.”

The ECB has persistently failed to lift inflation to its previous target of “below, but close to, 2 per cent” for much of the past decade. Analysts said the new strategy would make it easier to maintain interest rates at their historic low levels for longer, to achieve its legal mandate of price stability. “Lagarde is leaving the door open for further forceful action,” said Annalisa Piazza, analyst at MFS Investment Management.

Carsten Brzeski, head of macro research at ING, said it “clearly marks a gradual trend towards more, even if it is subtle, dovishness”.

By ditching its previous inflation target, the ECB aims to banish what Lagarde called “ill-founded speculation” that it preferred inflation to run below its target than above it.

While Lagarde said the bank’s new target was symmetric, meaning that it “considers negative and positive deviations of inflation from the target to be equally undesirable”, she added that it would be less worried about above-target inflation in certain circumstances.

She said the ECB would use “especially forceful or persistent monetary policy action” when interest rates are close to their lower limit and inflation remains below its target. The shift “may also imply a transitory period in which inflation is moderately above target”.

This does not mean it will actively seek to drive inflation above its target, as the US Federal Reserve has shifted its strategy to do, to make up for a low-inflation period. Lagarde said the new ECB strategy was “very squarely” not the same as the Fed’s average inflation policy. Jens Weidmann, head of Germany’s central bank and one of the ECB’s more conservative council members, emphasised this yesterday, saying: “We do not make our monetary policy dependent on past target failures. Our strategy remains forward-looking and takes into account the new challenge of the effective lower limit of interest rates.”

That leaves the Fed with a more accommodative stance than the ECB. However, inflation is higher in the US and the Fed is expected to start tightening policy sooner. The ECB’s new strategy makes it more probable it will keep rates lower for longer, which is likely to push the euro down against the dollar and keep eurozone bond yields low.

“Historically, monetary policy divergence between key central banks has caused foreign exchange volatility to increase, and appreciation to occur in the currency which is tightening policy,” Citigroup strategists said, predicting the euro could fall from above €1.18 to €1.16 against the dollar.

Other ECB council members, however, said the bank’s new strategy put it in a similar position to the Fed. “My interpretation . . . is that if similar shocks were hitting both the US and euro area the monetary policy reaction functions on both sides of the Atlantic would not be that far apart,” said Olli Rehn, governor of Finland’s central bank and an ECB council member.

The biggest question left by the ECB’s announcement was what it would mean for its monetary policy as the eurozone recovers from the coronavirus. Minutes of last month’s meeting of the governing council revealed that more conservative “hawks” called for asset purchases to be scaled back in response to the brighter economic outlook and improved financing conditions. More “dovish” proponents of loose monetary policy resisted.

“A broad consensus” emerged in favour of maintaining the current level of monetary stimulus being delivered by its €1.85tn pandemic emergency purchase programme, the minutes reported. That makes it likely the issue will be revived at the next policy gathering later this month, ahead of the meeting in September.