European Banks Strategy: The monetary policy cacophony

BOfAML | The ECB is about to set off on an official debate about the when, where, and how of its policy. Price stability is its mandate. In recent years, the governing council has defined this to be inflation “below but close to 2%”. What the ECB under president Lagarde is going to now discuss, through at least 1H 20, is whether that formula is the one it wishes to stick with. If not, it could aim for higher inflation – say, 3%. Or lower inflation, perhaps at 1%. Or a longer time frame could be added; or a commitment to “make up” historical under-achievement of the 2% goal. Finally, it could be agreed to make the 2% goal (or some other goal) symmetrical, as previous president Draghi insisted latterly that it was and others on the governing council disputed.

The context for this discussion is that euro area inflation is well below 2%, at 0.7% in October 2019. Market expectations are drifting south, now just above 1.1% five years from now. In the ECB world of decimal points, 1.1% is distant from 2%. Indeed, Chief economist Philip Lane stated in late November that even inflation of 1.6% would not be acceptable. There is clearly work to do, somehow, to raise euro area inflation.

This shortfall in inflation and inflation expectations is in spite of, or to some, because of, the exceptional monetary looseness of the recent past. And as the central banks’ Central Bank has stated,

“The longer central banks extend extraordinary measures and the further they take them, the smaller the benefits and the larger the costs.”
Claudio Borio, Chief Economist, Bank for International Settlements, November 2019

We see this as an immensely complex period for ECB watchers, not least because as according to the vice-president:

“The most important component of the package is forward guidance. Luis de Guindos, vice president, November 2019”

It is difficult for forward guidance to be credible when the institution is discussing whether any of its tools or targets are likely to be around in a few months. Embarking on a wide ranging discussion about monetary policy targets, communication and tools, with 25 relevant ECB board members, guarantees a cacophony. Volatility lies ahead for sure, we think.