May have any kind of ‘Someone’ watching you, pointing out a battle vision and new approaches to ‘light up’ the tunnel || The New Euro Area Inflation Indicator and Target

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This paper clarifies the main features of the European Central Bank’s revised inflation target in light of international practices, discusses the role of financial stability in the medium-term orientation of monetary policy decisions, and quantifies the possible impacts of the inclusion of the costs related to owner-occupied housing on the inflation indicator which is subject to the inflation target. This paper was provided by the Policy Department for Economic, Scientific and Quality of Life Policies at the request of the committee on Economic and Monetary Affairs (ECON) ahead of the Monetary Dialogue with the ECB President on 15 November 2021.

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·       The 2021 European Central Bank’s (ECB) monetary policy strategy review resulted in useful changes to the monetary policy framework, informed by numerous thorough analyses done by ECB staff.

  • The ECB’s justification for the monetary policy review was significant structural changes in the economy since the previous review of These changes include a declining equilibrium rate of growth and lower equilibrium interest rates, which reduce the scope for interest cuts in a cyclical downturn. In our view, the ECB’s systematic forecasting failure was an even more important justification for a review and revision of models.
  • The most important change arising from the review has been the replacement of the earlier ambiguous inflation objective by a clear 2 % symmetric inflation target. The previous objective might have been perceived as asymmetric, resulting in more forceful monetary actions in case inflation overshot 2 % than when inflation fell short of 2 %. In fact, both actual inflation and expected long-term inflation were close to 2 % for about a decade after the previous review in 2003, suggesting that the 2014-2019 inferior inflation outcome cannot be attributed to perceived asymmetry
  • While the US Federal Reserve (Fed) decided for average inflation targeting in its 2020 monetary policy review, the ECB has not. The ECB’s new target resembles the Fed’s previous The Fed’s main justification for an average inflation target is the anchoring of long-term expectations. ECB staff research presented an analysis of average inflation targeting, yet it is unclear why the ECB Governing Council did not opt for average inflation targeting.
  • The strategy review maintained the medium-term horizon for maintaining price stability, but did not define what “medium term” means, and added an extra layer to the Financial stability concerns could be a factor influencing the actual time horizon of the medium term. While there are synergies between monetary andfinancial stability policies, the two policy areas need different tools. More clarity is needed on the influence of financial stability concerns on monetary policy and its time horizon, also to ensure ECB accountability.
  • The ECB plans to include costs related to owner-occupied housing (OOH) in the inflation indicator. In the US, the “rental equivalence” method is used to include OOH costs, while Eurostat and ECB seem to favour the “net acquisition” The latter might involve an asset price component in the inflation indicator. We calculate that adding an OOH price index which is based on the net acquisition approach to the HICP would have increased annual inflation by 0.23 % points on average from 2016 to 2020, but adding an OOH price index which is based on the rental equivalence method would have left HICP practically unchanged.
  • Whether the revised inflation target will be future-proof depends primarily on whether inflation can be kept close to 2 %. Nevertheless, the new framework has many forward- looking elements, including the incorporation of OOH in the inflation indicator, the formal inclusion of financial analysis, the incorporation of climate factors in monetary assessments and in the design of certain instruments, and the revised communication strategy to reach the wider The date set for the next review (2025) is a form of insurance for changes if the newly-adopted framework proves to have deficiencies.

1.          INTRODUCTION

Despite the European Central Bank’s (ECB) deployment of a massive monetary policy arsenal, inflation in the euro area has remained relatively low in the past decade. The period from 2014 to 2019 – following the euro area crisis and before the outbreak of the COVID-19 pandemic – was characterised by strengthened growth and job creation, yet annual inflation was 0.9 % on average, below the values observed in the United States and the United Kingdom (Table 1). While there was some ambiguity in the ECB’s inflation objective (as we discuss in section 2), actual euro area inflation outcome was clearly below that objective.

Table 1: Average annual inflation in 2014-2019


  Headline inflation Core inflation
Euro area (HICP) 0.9 % 1.0 %
United States (CPI) 1.6 % 2.0 %
United Kingdom (CPI) 1.6 % 1.7 %

Source: OECD, Eurostat.

Note: For comparability, we use the consumer price index (CPI) for the United States, even though the Federal Reserve targets the price index of personal consumption expenditures (PCE). See section 3 for a comparison of US CPI and PCE.

Low actual inflation has possibly contributed to a decline in inflation expectations, risking a vicious circle between lower inflation, lower inflation expectations and lower economic activity. Thus, a review of the ECB’s monetary policy strategy, which was started in January 2020, was warranted.

Besides low inflation, the ECB’s systematic forecasting failure also justified a review of the monetary strategy – a crucial factor in our view, which was not emphasised in the outcome of the strategy review. Figure 1 shows that since 2014, when the ECB started to publish its core inflation forecasts, these forecasts turned out to be systematically biased. Between 2014 and 2019, ECB staff repeatedly predicted that core inflation would start to rise quite substantially, but this did not happen; the rate of core inflation remained stuck at close to, and often below, 1 %.


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