It's unclear what the European Central Bank wants to accomplish in the nearly yearlong strategy review it announced on Jan. 23, but the last thing a central bank wants is to be considered irrelevant. So, even though years of monetary stimulus have failed to push up eurozone inflation or growth, the ECB isn't about to admit it's out of policy ammunition; instead, it's set to make a big show about tweaking its de facto inflation target and pave the way for President Christine Lagarde to introduce environmental concerns into future assessments of financial stability and the ECB's remit. Given that the ECB has not reviewed its strategy since 2003, a new appraisal of its economic model raises hopes of possible major changes to the central bank's approach and instruments. No one, however, should expect significant changes in the bank's monetary operations this year or next given its existing accommodative policies, the reality of the current eurozone economic slowdown, low inflation expectations and sluggish economic projections for 2020. 

What Do Central Banks Do?

"Inflation is everywhere and always a monetary phenomenon," the economist Milton Friedman famously said. Inflation is defined as a sustained increase in the general price level that affects purchasing power over time, but it is an odd beast. Too much inflation creates uncertainty by distorting relative prices, which are signals by which market economies make economic decisions. Too little inflation — or even deflation — causes people to delay purchases in anticipation of lower prices, precipitating falling output, rising unemployment and financial instability.

Yet if inflation has negative effects, shouldn't eliminating it altogether be a policy goal? In practice, economists and central bankers believe a little bit of positive inflation is desirable to provide a margin of error for policy rate cuts and avoid the possibility of deflation. Accordingly, the major advanced economy central banks — the ECB, U.S. Federal Reserve, Bank of England and Bank of Japan — define price stability as low and stable inflation over the long run that promotes sustainable economic growth. For industrialized economies, the consensus in terms of optimal inflation is around an annual rate of 2 percent.

Rates above 2 percent compound faster over time and tend to accelerate. Rates below 2 percent, by contrast, leave economies vulnerable to unanticipated shocks that could tip over into destructive deflation. Ultimately, central banks strive to retain a buffer against future economic slowdowns by giving themselves some slack to cut nominal interest rates by large amounts — something they can't do if there is no inflation premium.

In inflation targeting, meanwhile, central banks set an explicit numerical goal for a future date, but it would be more accurate to call it inflation projection targeting. Regardless of the label, the utility of targeting focuses political debate about central banks on what they can do — which is control inflation — rather than trying to increase output permanently through expansionary monetary policies that do not boost long-term economic activity. It also increases the accountability of central banks by establishing a long-term standard to evaluate monetary policy.

Enter the ECB

Price stability is the ECB's primary mandate, according to the treaties that established the institution, but the central bank has the discretion to define what that means and how to accomplish it. The current definition, which has been in place since 2003, is a year-over-year, medium-term (three to five years) rate of increase of just under 2 percent in the eurozone's Harmonized Index of Consumer Prices (HICP).

In practice, the ECB falls far short of its objective, with the preferred inflation measure averaging just 1.43 percent from 2008 to 2019. During this period, it has not exceeded 2 percent since 2012, rising only as high as 1.8 percent in 2018. As it is, there is disagreement among ECB observers about whether the eurozone economy is showing signs of stabilization after "bottoming out." But according to the ECB staff forecasts from December 2019, there will be some slippage from 2019 as growth slows from 1.2 to 1.1 percent, while there will be an identical drop in inflation from 2019 to 2020. As for 2021, both growth and inflation are forecast to rise by 1.4 percent. But cumulatively, the effect of undershooting inflation undermines the ECB's credibility and commitment to its putative target. Forward-looking monetary policy, whose results only become apparent in the real economy 12 to 24 months after they go into effect, is plausible only if there is public faith in the central bank's effectiveness. The ECB and its peers in other advanced economies, however, are baffled as to how to achieve their goals in the current global economic environment.

Tweaks on the Way

As the ECB begins its review, there will be some things missing, including a comprehensive analysis of the changes in fiscal and structural policies necessary to complement monetary policy — but that can't happen without cooperation from resistant governments such as Germany. The ECB won't attempt to examine the theoretical foundations and current models of central banking, even though the current framework has proven to be more adept at reducing inflation than at increasing it to a more helpful and sustainable level. Also off the table will be questions as to whether monetary policy has anything other than a short-term effect on the economy and is neutral in the long term. 

Instead, the core of the review will be technical, centering on further refining the ECB's mandate of price stability, studying the effectiveness of current policy instruments and exploring potential new ways to stimulate aggregate eurozone demand. In this, the strategy review will not be totally devoid of utility. The most immediate task for the ECB is to clarify its definition and measure of price stability over the medium term. Choices include determining a specific point target, setting an acceptable band for inflation of between 1.5 and 2 percent or lowering the target. Announcing a target that is substantially less than 2 percent, for instance, would not be credible, as it would leave the ECB vulnerable to charges of moving the goalposts after failing to accomplish its objectives despite years of trying. Instead, the ECB is more likely to remove the ambiguity of the 2 percent objective, probably establishing that as an average over time that allows for under- and overshooting.

The bank could also adjust the preferred inflation measure. The HICP headline number does not include the imputed cost of owner-occupied housing, as does the U.S. Fed's index of personal consumption expenditures, and it remains unclear whether that practice leads to an underreporting of inflation figures. Already, some ECB Governing Council members are criticizing the inclusion of estimates of imputed housing costs as a gimmick to drive up the inflation measure and make the ECB look better. In addition, while the ECB already informally considers "core" inflation, which excludes volatile food and energy prices, it's unclear if that will become a more formal signpost. The cast of characters at the ECB is entirely different than when the 2003 strategy review rejected core inflation for not accurately reflecting the inflation experienced by the public. There's no indication, however, that the ECB will use more eclectic inflation indices this time around.

The review will also not include the study of alternative "nominal" anchors that central banks could use so as to demonstrate that its decisions are not arbitrary.

As for policy instruments, the ECB's main policy interest rate is already zero. The ECB also makes three-year, low-interest loans to eurozone banks under its Targeted Longer-Term Refinancing Operations (TLTROs) to try to encourage credit extension to non-financial corporations and households.

The ECB's quantitative easing policies, meanwhile, consist of purchases of public and private bonds. Since 2007, the ECB's assets have increased from around just $1.5 trillion to the current figure in excess of $5 trillion, which the bank has monetized by printing more money. The coming review, in turn, will determine whether the ECB can expand its asset purchases by much more than the current level without incurring large added risk. That's because the ECB is running out of sovereign bonds to buy as it reaches self-imposed limits and the European investment-grade corporate bond market is small. Former President Mario Draghi declared that limits on quantitative easing were subject to change, but the controversial program is unlikely to grow much further because of fear among some Governing Council members that it would be tantamount to the monetary financing of budget deficits and create a moral hazard for governments and private-sector borrowers. Also unlikely — yet still a topic open for discussion — is so-called "helicopter money" through which the ECB would make direct payments to the public to try to spur increased aggregate demand.

A Greener ECB?

Certainly, the most pressing issue for Lagarde will be how the ECB can incorporate climate change as a threat to financial stability into its operations to mitigate financial sector risk, as that ties into the ECB's secondary mandate to support the European Union's "general economic policies," albeit without compromising on price stability. But amid the European Union's push for a greener economy, Bundesbank President Jens Weidmann has questioned the relevance or feasibility of a green central bank, suggesting that it would embroil the ECB in politics. 

Finally, the strategy review will consider the way the ECB goes about decision-making and communications, broaching the possibility that the Governing Council's monetary policy statement or the minutes could also record how members voted on various issues — an important topic amid questions of whether unelected technocrats can be held accountable. There is no current formal voting procedure in the Governing Council, as decisions depend on the president molding a consensus. Formal votes would give dissenters more weight in public statements, as would the possibility of releasing "dot plots" similar to what the Fed does in showing member projections of future policy, thereby helping policymakers' thinking become more transparent.

The Upshot

In its recent update to the world economic outlook, the International Monetary Fund estimated that expansionary monetary policies had added half a percentage point to tepid global growth in 2019, as well as its 2020 projection. Nevertheless, monetary policies may have reached their effective limits in advanced industrial countries, meaning other sources of growth will be necessary. 

Since the global financial crisis, monetary policy not has not been "normalized" at traditionally neutral levels — 2 percent plus an inflation premium. Given that, there is little, if any, additional scope for monetary policy to pull the world economy out of a potential downturn. Monetary policy does not offer a magic wand, as it takes time — as much as 12 to 24 months — for its effects to percolate through the economy. That implies its greatest effect is on expectations underlying economic decisions, meaning that continued failure to achieve targets undermines long-term credibility. The ECB's review is long overdue, but it will need to keep up the image of constant activity and the ability to respond effectively when the next crisis comes, as it inevitably will.