The European Central Bank (ECB) left monetary policy unchanged last week even as its president, Christine Lagarde, launched the first strategic review of the central bank's targets and tools in 16 years. The bank aims to complete the review, including its inflation target, by the end of the year. Most analysts took this to mean changes would be modest.
The review comes as global central banks wrestle with unprecedentedly low interest rates and sluggish economies that challenge assumptions on how the economy responds to monetary policy. The U.S. Federal Reserve is also conducting a strategic review over a period closer to two years.
In the meantime, other central banks are treading water. The Bank of Japan kept its benchmark rate unchanged at minus 0.1 percent and its guide for long-term rates at 0. It is continuing its asset purchase program. The Bank of Canada left its benchmark rate unchanged at 1.75 percent but lowered its economic forecast, tilting in favor of a cut in interest rates.
China’s central bank also left its benchmark rate, the one-year loan prime rate, unchanged at 4.15 percent in spite of hopes it would lower the rate to spur growth. The five-year LPR was also unchanged at 4.8 percent.
Inflation is the main bugbear for central banks. Even as the Fed talks wistfully of its belief that inflation will near its symmetric 2 percent target, the ECB is likely to focus on its target of below 2 percent as part of the strategic review. If changes are modest, as expected, it may mean only that it will accept a rate of 2 percent, giving it slightly more leeway to keep monetary policy loose.
But if there is a fairly large contingent in the governing council that follows the Bundesbank’s hawkish line, it may be difficult to find any consensus or compromise. Lagarde cautioned last week that with all the willingness to listen to alternative views, the council ultimately has to reach a decision. Absent a consensus, that decision will be reached by majority vote.
Sustainable Finance: New Source of ECB Friction
Lagarde’s insistence, for example, on bringing green investment into the central bank equation is sure to be a source of friction, as the purists on the council believe climate change is the purview of politicians, not central bankers.
They are fighting a rising tide of views around the world that central banks cannot abdicate responsibility for what many see as an existential challenge for mankind. There is a Network for Greening the Financial System, which includes both the German central bank and financial regulator among its 54 members, which aims to promote sustainable finance.
Lagarde last week specified that the central bank will increase the portion of green investment in its €20 billion of own funds, and will look at the €200 billion of corporate bonds in its asset purchase program for ways to increase green investment. That is a relatively small sliver of its overall portfolio of more than €2 trillion. Analysts tend to view the whole debate as a distraction.
The problem is that the asset purchase program as a whole is controversial among the policymakers. Central banks have not been able to demonstrate that buying bonds or cutting rates is doing anything to raise the level of inflation near their targets.
Many, taking their cue from former U.S. Treasury Secretary Larry Summers that we are in a period of secular stagnation, see lower growth as the new normal, with central banks sidelined by zero-bound interest rates.
President Donald Trump is a cheerleader for the other side. He used the World Economic Forum at Davos to boast about the U.S. economy with his typical hyperbole, describing it as an economic boom “the likes of which the world has never seen before.”
Trump, who doesn’t worry about inflation but focuses on growth, is still a big believer in monetary stimulus. He said U.S. growth would be even higher if not for the lingering effects of what he sees as the Fed’s ill-advised rate hikes in 2018.