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The New Euro Area Inflation Indicator and Target: The Right Reset?

Core Content

This paper evaluates the European Central Bank's (ECB) revised inflation target and framework, focusing on its alignment with international practices and its potential impact on monetary policy. It also examines the role of financial stability in the ECB's medium-term orientation and the implications of incorporating owner-occupied housing (OOH) costs into the inflation indicator.

Main Features of the ECB's Revised Inflation Target

• The ECB's monetary policy strategy review in 2021 introduced a clear 2% symmetric inflation target, replacing the previous ambiguous objective.
• The symmetric target implies that both inflation above and below 2% are considered equally undesirable.
• The inflation indicator (HICP) is expected to be augmented with OOH costs in the future.
• The framework includes:
  • A formal inclusion of financial analysis as a pillar of monetary policy.
  • A recognition of climate change as a factor affecting price stability and macroeconomic indicators.
  • A revised communication strategy to better reach the public.

Key Changes from the Previous Framework

• Inflation Objective: Previously defined as inflation below 2%, with a non-precisely defined "close to" 2%. The new target is clear and symmetric, aiming to avoid perceived asymmetry that may have influenced inflation outcomes.
• Forecasting: The ECB's previous forecasts were systematically biased, especially in the period 2014–2019, where core inflation remained below 1%. This has led to lower inflation expectations, which could further depress economic activity.
• Monetary Tools: The ECB continues to use interest rates as the primary instrument but also retains non-conventional tools like forward guidance and asset purchases.
• Time Horizon: The medium-term remains the preferred horizon for monetary policy decisions, though the inclusion of financial stability considerations adds complexity.

Comparison with Other Central Banks

• The Federal Reserve adopted average inflation targeting to stabilize long-term inflation expectations, while the ECB opted for a symmetric target.
• The ECB's decision not to adopt average inflation targeting was not clearly explained, despite the potential benefits of such a regime.

Implications of Including OOH Costs in the Inflation Indicator

• The ECB is considering two approaches for including OOH costs:
  • Net acquisition (favoured by Eurostat and ECB): This may involve an asset price component, potentially increasing the HICP.
  • Rental equivalence (used in the US): This method is expected to have little to no impact on the HICP.
• A calculation suggests that using the net acquisition approach would have increased annual inflation by about 0.23 percentage points from 2016 to 2020.
• The inclusion of OOH costs is expected to improve the representation of inflation for households, but the impact on policy is still under discussion.

Financial Stability and the Medium-Term Horizon

• The medium-term horizon for monetary policy decisions is still in place, but the inclusion of financial stability introduces an additional layer of complexity.
• While financial stability is a key concern, it is not explicitly defined in terms of how it influences the time horizon.
• The synergy between monetary and financial stability policies is acknowledged, but the tools for each remain distinct.
• The lack of clarity on the influence of financial stability on monetary policy decisions raises questions about accountability and transparency.

Forward-Looking Elements of the New Framework

• The new framework includes forward-looking elements such as:
  • Incorporation of climate change considerations.
  • Formal inclusion of financial analysis.
  • Revised communication strategy.
• The next review is scheduled for 2025, providing a buffer in case the framework proves inadequate.

Conclusion

• The ECB's new framework is not entirely novel, as it builds on past analyses and existing practices.
• While the symmetric inflation target is a clear improvement, the impact of OOH costs and the role of financial stability remain areas of uncertainty.
• The systematic forecasting errors from the past decade highlight the need for more robust models and transparent communication.
• The inclusion of OOH costs may help align the inflation indicator with household experiences, but its effectiveness depends on the methodology used.
• The future-proofing of the framework hinges on the ability to maintain inflation close to 2% and the ongoing assessment of its implications.

Key Information

• The ECB's inflation target was revised to 2% symmetric in 2021.
• The new framework includes financial stability and climate change as key considerations.
• The inflation indicator may be augmented with OOH costs, which could influence inflation outcomes.
• The forecasting accuracy of the ECB has been questioned, with systematic errors noted.
• The Federal Reserve's average inflation targeting is not adopted by the ECB, though the new target is similar to the Fed's previous approach.
• The next ECB strategy review is set for 2025, offering a checkpoint for potential adjustments.

References

• Darvas, Z., & Martins, C. (2021). The New Euro Area Inflation Indicator and Target: The Right Reset?
• ECB (2021b): ECB staff report on monetary policy frameworks.
• Paloviita et al. (2020): Analysis of ECB inflation responses.
• Rostagno et al. (2019): Asymmetric inflation reactions.
• Maih et al. (2021): ECB behavior before and after 2014.
• Jerome H. Powell: Explanation of average inflation targeting.