Europe Economy

ECB to launch first review since 2003 in a bid to tackle its inflation problem

Key Points
  • Monetary policy action in Frankfurt is not expected by some market watchers for the whole of 2020.
  • With inflation sluggish and no real economic rebound in sight, the majority of economists expect the ECB to adopt a "wait and see" approach.
04 November 2019, Berlin: Christine Lagarde, President of the European Central Bank (ECB), will give the laudation to President of the Bundestag Schäuble at the "VDZ Publishers' Night 2019
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Despite all the efforts by former President Mario Draghi, inflation in the euro zone is still yet to move back to the European Central Bank's target.

The central bank's first strategic review since 2003 will analyze why that is the case and whether that target, or how its calculated, needs to change.

"The main focus (of Thursday's ECB meeting) will be the question whether the current definition of price stability of close but below 2% is still appropriate," said Michael Schumacher from Natixis in a research note.

"The discussion is obviously at an early stage and we don't expect to get any further information at the upcoming meeting."

Monetary policy action in Frankfurt is not expected by some market watchers for the whole of 2020. With inflation sluggish and no real economic rebound in sight, the majority of economists expect the ECB to adopt a "wait and see" approach.

"There is still the risk that the lagged impact from the manufacturing slowdown on the labour market comes before a significant rebound in industrial activity," said Carsten Brzeski, chief Germany economist with ING, in a note. "As a consequence, the bottoming out phase could still last until the summer."

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Inflation has been running below target for many years and one prominent element of the strategic review is to find out why. Milton Friedman — the most well-known monetarist — famously said that "inflation is always and everywhere a monetary phenomenon." This conviction could be challenged given all the liquidity in the system for so many years which has had little effect on prices.

"The Phillips curve has shifted inward over time — that is, inflation today may be lower at every level of the output gap," Benoit Coeure explained in a speech on December 18 at the ECB.

"Such shifts typically relate to persistent and slow-moving changes on the supply side of our economies, where monetary policy has less traction. As such, they are difficult to detect, and even more difficult to prove, in particular when they coincide with weak aggregate demand," he said.

And at the same time there are structural changes, such as digitalization, which have massive impacts on pricing powers; the effects of ageing, globalization, and the rise of the service sector. All of the above have rather dampening effects on inflation.

There are different scenarios that the ECB could come up with in its strategic review which could impact its policy outlook.

"If the ECB, in line with the Fed and the BOE (Bank of England), shifted to a symmetric 2% target, we would probably push out our call for a first rate hike," said Florian Hense with Berenberg.

"Conversely, if the ECB were to adopt a flexible target range from 1.5% to 2.5% and de-emphasise the target of 2% the ECB could probably tighten policy sooner."

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