The European Central Bank will consider following the lead of the US Federal Reserve by committing to let inflation overshoot its target after a period of sluggish price growth, it has said for the first time.
ECB president Christine Lagarde told an ECB conference in Frankfurt on Wednesday that “the usefulness of such an approach could be examined” as part of the central bank’s strategy review.
“The wider discussion today . . . is whether central banks should commit to explicitly make up for inflation misses when they have spent quite some time below their inflation goals,” she said, speaking by video link.
“If credible, such a strategy can strengthen the capacity of monetary policy to stabilise the economy when faced with the lower bound,” she said. “This is because the promise of inflation overshooting raises inflation expectations and therefore lowers real interest rates.”
But she added: “Make-up strategies may be less successful when people are not perfectly rational in their decisions — which is probably a good approximation of the reality we face.”
The ECB kicked off a review of its strategy in January but the pandemic put the review on pause in March, and it only restarted recently, so it is not due to be completed until September 2021.
US Fed president Jay Powell last month announced a strategic shift in the central bank’s policy to an average inflation target, which would see the Fed tolerate inflation overshooting its 2 per cent target for a period of time, to make up for a period of undershooting it.
Some analysts believe this dovish shift by the Fed has contributed to the dollar’s fall against the euro and puts pressure on the ECB and other central banks to do the same or risk being perceived as having a less accommodative monetary stance.
The idea is likely to prove contentious among some ECB policymakers.
Speaking at the same event Jens Weidmann, president of the Bundesbank and ECB governing council member, sounded a warning note about the prospects of changing the central bank’s policy.
“The more widely we interpret our mandate, the greater the risk that we will become entangled with politics and overburden ourselves with too many tasks,” he said.
Ms Lagarde said the strategy review would consider various options including whether to change from the current target of below, but close to, 2 per cent to a “symmetric” one that is as concerned about undershooting its target as overshooting it.
The ECB has consistently failed to achieve its target and the eurozone has fallen into deflation since the coronavirus pandemic hit, although the central bank expects this will only be temporary.
“To underpin inflation expectations, we need to ensure that our aim is perceived to be symmetric by the public,” she said. “So we should have an inflation aim that the public can easily understand.”
In addition, she said the way inflation was measured could be changed to take greater account of owner-occupied housing costs and called for greater emphasis to be given to underlying inflation, which excludes more volatile elements such as energy and food prices.
“We need to keep track of broad concepts of inflation that capture the costs people face in their everyday lives and reflect their perceptions, including measures of owner-occupied housing,” she said. “This is not about moving the goalposts for monetary policy. It is about future-proofing how we measure inflation.”
Structural changes — including globalisation, digitisation and demographics — have lowered the natural rate of interest, calling into question “what should be the standardised toolkit for a world where unconventional policy is ‘normal’,” she said.