ECB Insight: New Strategy to Give Doves Some Breathing Room on Thursday

20 July 2021

By David Barwick – FRANKFURT (Econostream) – Thursday’s meeting of the European Central Bank’s Governing Council will be a matter more than anything else of taking a first and important stab at the question of how the new strategy is to shape monetary policy. The answer is less likely to please the hawks, but the doves should take care not to overplay their hand.

Though ECB President Christine Lagarde suggested that concern about leaks motivated the accelerated publication of the revised framework, it would be naïve to think that the earlier-than-expected outcome of the review had nothing to do with the critical nature of the present juncture.

The account of the June monetary policy meeting makes clear that the Council hawks have grown yet more restless. This is not surprising in view of the increasing incompatibility between the ongoing positive data flow and the unaltered extreme degree of monetary accommodation. The euro area economy is at – or past – an inflection point, whilst monetary policy suffers from arrested development.

The role of the new strategy in this context is simple: to provide the Council doves with the breathing room they need to withstand stiffening opposition based on facts inconvenient for them and to maintain as much accommodation as possible for the highly indebted euro area member states that tighter policy would hit hardest.

The question for Thursday then becomes: how much can they get away with?

The more-is-better faction on the Governing Council may be full of hope as they contemplate vistas that appeared out of reach just weeks ago. Lagarde is on their side and in a marked departure from previous practice has indicated an explicit willingness to arrive at decisions that result in discord.

Meanwhile, the hawks have allowed themselves to be painted into a bit of a corner. Although they may see their (nominal) acceptance of the review’s outcome as having forestalled worse possibilities, the resulting unanimity does not work in their favour – not for nothing have the doves repeatedly underscored the putatively universal support for the new strategy.

Substantial changes to the format are a given; being less about substance than appearance, this may be the only consequence of the new strategy that does not inspire conflict and thus the only low-hanging fruit.

The other most likely change involves forward guidance, which Council members have repeatedly indicated would need adjusting. Portugal's Mario Centeno for example called it ‘very important that the forward guidance is adapted to this new framework, otherwise it would lose credibility.’

At a minimum, the new guidance needs to take into account the revised inflation objective. A further possibility would be a nod to the need near the lower bound for ‘especially forceful or persistent monetary policy measures to avoid negative deviations from the inflation target becoming entrenched.’

As there has already been no dearth of forcefulness on the part of ECB monetary policy and the question now is rather of duration, a simple reference to the appropriateness of persistence should do it. On balance, this seems a likely outcome; its omission would arguably justify the question of what all the fuss over the strategy review was about, and would probably leave the doves feeling cheated.

The ECB could go further yet and echo the theme of overshooting. As Board member Isabel Schnabel observed some time before the strategy review concluded, the ECB’s existing forward guidance already signalled a willingness to overshoot ‘to a certain degree, because we say that we will not raise our policy rates until we see that the robust convergence to our inflation aim has been consistently reflected in underlying inflation dynamics.’

Lagarde’s willingness to countenance decisions that make some Council members unhappy should not be over-interpreted. It naturally remains the case that unity is preferred, and not every battle must be fought. A more explicit reference to overshooting would be somewhat controversial, but the risk is there.

After all, for Lagarde, ‘the transitory period during which we recognise that our policies may imply a moderate deviation above target’ is one of ‘those keywords’ that ‘we should really not undermine or underrate’. In one form or another, she will wish to drive home the possibility of overshooting.

As to the overall tone at the press conference, the uncertainty due to virus mutations, in particular the delta variant, will loom large, larger than the strengthening recovery. The mutations are a new risk, ‘and we still have no idea how this is going to play out’, Schnabel said recently. Covid-19 case numbers have ‘spiked quite dramatically’ in some countries, but ‘it’s still too early to tell what this will mean’. For Lagarde, evidence that caution is warranted and the crisis phase persists.

Lagarde will observe that price stability remains distant, emphasise the euro area’s different situation vis-à-vis the Fed and reject discussions that would have been premature before the new strategy framework and are now untimely a fortiori. Those hoping for clarity about the future of the pandemic emergency purchase programme (PEPP) are likely to have to wait, if only a month ago it was indeed still, as Lagarde then said, ‘far too early to debate these issues.’

Even so, in the absence of new staff forecasts, this meeting appears set to be much more interesting than anyone would have thought mere weeks ago. How able the doves are to exploit the new strategy so as to keep the monetary floodgates open wide will have implications that go well beyond July.