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What Lagarde’s ECB Review Can Tackle, From Inflation to Climate

Yuko Takeo and Piotr Skolimowski
What Lagarde’s ECB Review Can Tackle, From Inflation to Climate

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When European Central Bank President Christine Lagarde is quizzed by European lawmakers on Monday, her plans for the biggest reassessment of the institution’s mission in 16 years is likely to play a prominent role.

A strategic review could be announced within weeks, and Lagarde has signaled that it’ll almost certainly include climate change alongside the standard central-bank topics of inflation, financial stability and communication. Those issues open plenty of scope for debate, so much so that the 25-member Governing Council will likely struggle to agree on how to overhaul the organization.

Yet it’s a task that needs to be done. Years of failing to hit their inflation target -- despite ever-more innovative ways of pumping trillions of euros in the financial system -- has left ECB officials worried about their credibility. The U.S. Federal Reserve plans to complete its own strategic review in mid-2020.

So while ECB Chief Economist Philip Lane has warned against trying to guess the outcome of the assessment, Lagarde’s first testimony to the European Parliament will be closely scanned for clues on her intentions. Here are some of the issues that could be on the table:

1. Inflation Target

A fundamental question is whether the inflation goal is set at the right level. The ECB’s primary mandate from governments is to ensure price stability -- it was the central bank itself that decided in 2003 to interpret that as inflation “below, but close to 2% over the medium term.”

Now one argument is that the definition is too vague, leading to pressure to tighten policy as soon as consumer-price growth heads north of 1.5%. While that suggests a higher setting is needed, allowing loose monetary policy to run for longer, Austrian Governor Robert Holzmann has called for a lower goal, in recognition that global inflationary pressures will stay muted for the forseeable future.

There is also an ongoing debate over whether inflation should be allowed to overshoot the goal in good times to make up for the weak price pressures when the economy is feeble. Dutch Governor Klaas Knot has suggested a band around the current target.

With views so polarized, officials with knowledge of the matter say the most likely outcome is a small but important adjustment to fix the goal at precisely 2%.

Read more: ECB Review May Reset Inflation Aim to 2% But Struggle to Do More

2. Inflation Gauge

Another question is whether the official inflation gauge, prepared by the European Union’s statistics office, is appropriate. Economists have argued that the measure underestimates true price growth by failing to adequately include housing costs.

Any changes to how the ECB measures inflation will need to be handled carefully. Shift too abruptly, and the central bank could face criticism that it’s cherry-picking the data to help reach the target earlier.

Read more: Clues to ECB’s Inflation Dilemma Could Lie Very Close to Home

3. Mandate Gazing

The ECB’s primary mandate of price stability is baked into EU treaty law, though that doesn’t mean it can’t be changed if governments agree. Approaches differ elsewhere -- since 1977, the Fed has been tasked with achieving both stable prices and maximum employment.

If Lagarde doesn’t want to push things that far, she also has the option of putting more emphasis on the secondary mandate, to support the “general economic policies” of the EU. That could mean linking monetary tools more closely to financial stability ones, as Bank of France Governor Francois Villeroy de Galhau has suggested.

4. Climate Change

Climate change is emerging as a key point of focus, with Lagarde saying the review would be a good moment for the ECB to reflect on the role it can play in sustainability.

That’s a controversial area and policy makers have already voiced warnings against heavy-handed steps such as barring the bonds of climate polluters from their quantitative-easing program. Bundesbank President Jens Weidmann and Executive Board nominees Isabel Schnabel and Fabio Panetta are among those saying specific environmental goals for QE -- such as a preference for green bonds -- could create conflicts with the price-stability goal.

There is a growing recognition though that climate change will affect the conduct of monetary policy and central banks must step up their game. Options include incorporating the risks in their economic forecasts, pushing credit-ratings agencies to assess the impact on debt, and making their own investment portfolios greener.

Read more: ECB Officials Push Back on Call to Lead Climate Change Fight

5. Communication Dilemmas

A broader debate on how to better engage with the public is likely to be on the table, but discussions could also center on whether the Governing Council should emulate its major peers by making voting on decisions a standard procedure, with the votes of each policy maker published. It currently strives for agreement by consensus, and the policy account doesn’t put names to viewpoints.

The argument against is that the supposedly independent governors might come under political pressure to back decisions that favor their nations.

6. Instrument Appraisal

Draghi took the ECB into unprecedented territory with broad-based asset purchases, negative interest rates, and long-term bank loans. All of that could now come under scrutiny as policy makers judge side effects that the ECB’s own Financial Stability Review says are becoming ever more pronounced.

The ECB might want to revisit the limits it imposed on its bond-buying program to prevent slipping into monetary financing -- directly financing governments by buying their debt -- which would be illegal. If it wants to justify more flexibility, now might be the time to try.

Read more: Global Risk Binge Gives Central Bankers Cause to Shudder

To contact the reporters on this story: Yuko Takeo in Frankfurt at ytakeo2@bloomberg.net;Piotr Skolimowski in Frankfurt at pskolimowski@bloomberg.net

To contact the editors responsible for this story: Paul Gordon at pgordon6@bloomberg.net, Zoe Schneeweiss

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