ECB Insight: New Forward Guidance Relies on Elusiveness of Underlying Inflation

20 August 2021

By David Barwick – FRANKFURT (Econostream) – Although the European Central Bank’s strategy review may have led to an inflation target that is clearer than its predecessor, it appears to be relying on a lack of clarity about another concept, namely underlying inflation.

Breaking two months of public silence, Chief Economist Philip Lane used a blog post published Thursday on the website of the ECB to explore the new forward guidance, updated on July 22 with respect to interest rates to reflect the revised monetary policy strategy framework.

As he called to mind, one of the conditions for key ECB interest rates to rise is that the Council ‘judges that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at 2% over the medium term.’

Like other major central banks, the ECB employs a variety of measures of underlying inflation, some relatively complex, reflecting the fact that no single measure is always optimal. Still, in public communication, the ECB has never been shy of referring simply to ‘underlying inflation’ or ‘underlying price pressure’.

When it has elaborated, it has almost invariably given the impression that what was meant was those measures that permanently remove persistently volatile, well-known sub-components, although this is only one subset of underlying inflation measures.

For example, at the press conference to introduce the new monetary policy strategy on July 8, ECB President Christine Lagarde spoke about monitoring underlying inflation as the effort ‘to disentangle what is volatile, oil-related, food-related’.

In a speech less than a week before that, Executive Board member Isabel Schnabel also spoke of underlying inflation, which an accompanying chart revealed to be consumer price inflation excluding food and energy.

On April 26, Board member Fabio Panetta also referred to underlying inflation in remarks backed up by a graph showing – as usual - HICP excluding food and energy.

Such straightforwardness was notably absent from Lane’s exposition. ‘It is important to keep in mind that “underlying inflation” is a broad concept and refers to the persistent component of inflation that filters out short-lived, reversible movements in the inflation rate and provides the best guide to the medium-term inflation developments’, he wrote.

In truth, underlying inflation is inarguably a broad concept, at the ECB as elsewhere, but Lane’s sudden insistence that it ‘is not proxied by any single indicator’ might lead one to think that it is partly a story of monetary authorities simply wanting to create a certain amount of vagueness for the sake of policy leeway.

Lane reinforces that very impression with the next line of his piece, in which he suggests that determining the state of underlying inflation will naturally be a matter of subjective interpretation.

‘It follows that some judgement is required both in terms of the choice of indicators and the assessment of their signals,’ he wrote.

One might justifiably wonder how forthcoming and transparent the ECB will be about that process when, as is hoped, inflation developments eventually fuel the debate about the right moment to start hiking interest rates.

For now, the elusiveness of the concept of underlying inflation appears to serve the Eurotower’s purposes better.