ECB’s Grasp on Inflation Weakens With Virus Slump

The European Central Bank made a stark admission last week as it announced a fresh round of policy measures; even three years from now, it’ll still be well short of its inflation goal of just under 2%.
ECB President Christine Lagarde’s announcement of a €500 billion ($606 billion), nine-month extension of the pandemic bond program, plus more long-term bank financing, left investors largely underwhelmed. Not only were those tweaks seen as relatively modest, they were presented alongside an inflation estimate for 2023 of just 1.4%, the lowest three-year forecast ECB has ever made, Bloomberg reported.
Such limited ambition is an acknowledgment that amid the historic growth slump because of Covid-19, one aim of central banks is to support the spending power of finance ministries by keeping their borrowing costs low. 
However, unless further monetary action is signaled in the months ahead, Lagarde risks relying ever more on fiscal policy to attain her price-stability mandate. 
“Any inflation-targeting central bank will need to be close to its target at the end of the forecast horizon or else it is doing something wrong,” said Anatoli Annenkov, senior economist at Societe Generale SA in London. “It is surprising to see such a low forecast.”
ECB has long defined its mandate to achieve price stability in the currency bloc as annual inflation of “below, but close to, 2% over the medium term”. That goal was designed for an era when prices were more likely to gain too quickly than the opposite.
Since the global financial crisis more than a decade ago and amid the disinflationary effects of a period of hyper-globalization and technological advance, the region has been plagued with the stagnating effects of too-low inflation. ECB has never sustainably met its target in the past decade.
In such a world, getting back to on-target inflation through monetary policy alone implies a massive expansion of stimulus. And given that policymakers and economists are already complaining that policies like quantitative easing are losing effectiveness, it’s hardly surprising that officials are not promising to bring out the big guns.
Thursday’s package was explicitly structured to preserve and not ease financial conditions, and linked to the health crisis.
The pandemic stimulus programs are temporary, but ECB’s original QE program that started in 2015 and traditional interest rates are permanently in the toolbox to be used to address the inflation shortfall. Still, by this time next year, ECB will already own nearly half of Germany and Italy’s bonds, placing real limits on how much further they can go without crushing the market.
Likewise, further cuts to interest rates – the benchmark deposit rate is -0.5% – would exacerbate the already-weak profitability of Europe’s sclerotic banking system. When pressed on rates on Thursday, Lagarde responded with a marked lack of enthusiasm, saying merely that a rate cut remains “part of our toolbox”.

Losing Effectiveness

Getting further easing of financial conditions from here is just very, very difficult, said Nick Kounis, the head of macro and financial markets research at ABN Amro Bank NV in Amsterdam. There’s a realization that “monetary policy is not really effective any more so what they’re trying to do is facilitate fiscal policy to do that job”.
The issue of whether and how ECB can be more convincing about reaching its inflation goal is a key part of an in-depth review of how the central bank operates. Some policymakers have called for the so-called makeup strategies to be examined, which would allow inflation to rise above the goal after an extended period of missing it. The Fed unveiled a similar approach in July.
But without new tools or an unexpected acceleration in pent-up price gains, ECB may be stuck waiting for fiscal policy to fill the gap by spending cash where the private sector can’t or won’t.
And while that front looks promising now—European Union leaders finally agreed a €1.8 trillion multi-year spending package last week—eventually European governments will have to rein in their ballooning debt somehow.
That leaves ECB in the subordinate position of trying to manage the cost of government borrowing, resembling the yield-curve control that the Bank of Japan openly engages in.
Eurozone monetary officials have vociferously denied they’re doing so. The distinction, according to Executive Board member Isabel Schnabel, is that ECB is attempting to “preserve financial conditions” and not commit explicitly to keeping yields at a specified level, come what may.