Central Banks

European Central Bank sets its inflation target at 2% in new policy review

Key Points
  • In January last year, the central bank in Frankfurt embarked on its first policy review since 2003.
  • However, the outcome of this work had to be postponed in the wake of the coronavirus pandemic.
  • Speaking at a press conference on Thursday, ECB President Christine Lagarde said the new inflation target is "clear and easy to communicate."
The President of the European Central Bank Christine Lagarde delivers remarks during a joint press conference in Lisbon, Portugal.
Horacio Villalobos | Getty Images

LONDON — In a major policy review presented on Thursday, the European Central Bank decided to revise its inflation target and allow consumer prices to overshoot when deemed necessary.

In January last year, the central bank in Frankfurt embarked on its first policy review since 2003. However, the outcome of this work had to be postponed in the wake of the coronavirus pandemic. The idea has been to assess how to adapt the ECB's policies and tools to achieve its main goal of price stability.

The ECB currently works to achieve an inflation level of "below, but close to, 2%." Going forward, the official inflation goal will become 2% with overshoots allowed.

"The Governing Council considers that price stability is best maintained by aiming for a 2% inflation target over the medium term. This target is symmetric, meaning negative and positive deviations of inflation from the target are equally undesirable," the ECB said in a statement.

Speaking at a press conference on Thursday, ECB President Christine Lagarde said the new inflation target is "clear and easy to communicate."

She also said: "We know that 2% is not going to be constantly on target, there might be some moderate, temporary deviation in either direction of that 2% and that is okay. What we are very concerned about is any sustainable, durable, significant deviation from the target and that will require forceful action."

The first regular monetary policy meeting of the Governing Council applying this new strategy will be held on July 22. 

Lagarde also said there would be a new policy review in 2025.

What it means

"On paper, a shift from a de facto inflation target of just below 2% to a straight 2% target and the move from a cap just below 2% to a symmetrical approach, which explicitly allows for temporary overshoots, would raise the inflation target and thus signal an even softer policy stance," Holger Schmieding, chief European economist at Berenberg, said in a note.

"In practice, it will make no major difference in our view as the majority of council members has probably been aiming for that anyway. The new strategy is more in line with that of other major central banks," he added.

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The Federal Reserve in the United States last year also announced that it would allow inflation to run hotter than normal as a way to boost the labor market and economic recovery. This in practical terms means that the central bank is less likely to increase interest rates.

The ECB's latest efforts come after a prolonged period of low inflation and an aim to try to reverse that.

This is particularly relevant over the coming months with inflation set to ramp up as the euro zone resurfaces from the Covid-19 crisis.

In forecasts presented in June, the ECB said that inflation could reach 1.9% by the end of the year. Recent data has actually shown an overshoot in prices in the euro area. However, the ECB still believes these price increases are temporary and that inflation will remain below 2% over the foreseeable future.

Climate change

ECB President Lagarde has said climate change is an issue close to her heart and she has been keen to take the central bank on a greener path.

As such, the latest policy review also says the ECB will be adjusting its work to incorporate climate risks, including when deciding which corporate bonds to buy.

"The ECB will adjust the framework guiding the allocation of corporate bond purchases to incorporate climate change criteria, in line with its mandate. These will include the alignment of issuers with, at a minimum, EU legislation implementing the Paris agreement through climate change-related metrics or commitments of the issuers to such goals," the ECB said in a statement.

The central bank said it will also be disclosing climate-related information under its corporate asset purchase program by the first quarter of 2023.

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Marchel Alexandrovich, a senior European economist at Jefferies, said that corporate bonds only make up a portion of the ECB's full portfolio of quantitative easing.

"So these changes will not really make a major difference to the ECB overall policy stance, given that the overwhelming bulk of its asset purchase are concentrated in sovereign debt," he added.

However, the ECB will also consider relevant climate change risks when reviewing which assets can be considered collateral and said it will increase its capacity to include climate risk in all its macroeconomic assessments.