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ECB: Aligning Forward Guidance with New Inflation Target Framing

Summary:
After the June CPI and PPI surge, the Federal Reserve does not appear to have changed its tune.  The price pressures are temporary, and the labor market is still "a ways off" from the "significant further progress" necessary to reduce the bond purchases.  Federal Reserve Chair Powell warned in his semi-annual testimony to Congress that inflation will likely remain elevated in the coming months before moderating.  Treasury Secretary Yellen shared a similar view separately. The case for the transitional nature of the price increases stems from the narrow breadth of price increases greater than 2% (around 1/3 of the CPI basket),, and most can be traced to the re-opening and base effect, like airfare, lodging, food away from home, and apparel.  Used vehicle prices again accounted for about a

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ECB:  Aligning Forward Guidance with New Inflation Target Framing

After the June CPI and PPI surge, the Federal Reserve does not appear to have changed its tune.  The price pressures are temporary, and the labor market is still "a ways off" from the "significant further progress" necessary to reduce the bond purchases.  

Federal Reserve Chair Powell warned in his semi-annual testimony to Congress that inflation will likely remain elevated in the coming months before moderating.  Treasury Secretary Yellen shared a similar view separately. The case for the transitional nature of the price increases stems from the narrow breadth of price increases greater than 2% (around 1/3 of the CPI basket),, and most can be traced to the re-opening and base effect, like airfare, lodging, food away from home, and apparel.  Used vehicle prices again accounted for about a third of the monthly increase in CPI.  Part of this is related to the chip shortage impacting the availability of new cars. Part seems related to the economy re-opening and the lingering reluctance to return to mass transportation.  Surely, it is unreasonable to expect a year-old used car to sell for more than the new model on a sustained basis going forward. 

Of course, the Fed could be wrong, but economists collectively seem to agree.  Consider that the median Fed forecast sees the headline PCE deflator, which it targets at 3.4% this year and 2.1% next year.  The median in the Bloomberg survey puts the deflator at 3.1% this year and 2.3% next year.  More than that, several major central banks, including the European Central Bank, the Bank of England, and the Bank of Canada, have reached a similar assessment.  

The reason we are critical of the Fed's continued purchases of inflation-linked securities and Agency mortgage-backed securities is not due to some implication for the general price level. Instead, like the proverbial butcher with a finger on the scale, buying inflation-linked securities and then citing the break-evens as confirmation of its views, the Fed is not playing fair.  

News wires report that Treasury Secretary Yellen met with the Federal Reserve chief and other regulators last week to discuss a potential housing market bubble.  Buying MBS does not appear necessary to support a housing market that is being constrained by bottlenecks in residential construction (materials and labor), and where prices are rising at the fastest pace on record (nearly 14.6% year-over-year in May, according to S&P CoreLogic Case-Shiller US National Home Price Index).  One thing the Fed can do to reduce the risk of such a bubble is to stop feeding it by buying mortgage-backed securities.  In his congressional testimony, Powell denied a formal link between its MBS purchases and rising home prices, but the optics are poor in any event.  

The Fed will have another opportunity to change its stance at the July 28 FOMC meeting, but it is unlikely.  The formal and informal economic data available ahead of it are unlikely to have the gravitas to sway opinion.  The focus turns to the ECB meeting.  Expectations for the July 22 meeting were running low.  The central bank has already indicated that it would continue to buy bonds under the Pandemic Emergency Purchase Program at an elevated pace until at least the September meeting, when new forecasts will be available.  However, the seemingly inexplicable acceleration of its strategic review and its new inflation framework requires some adjustment in the ECB's forward guidance.  

At the most basic level, the ECB jettisoned the tortured framing of inflation it had adopted in 2003 that the goal was "close to but below 2%". Instead, it adopted a 2% symmetrical target, which means deviations in either direction are not desired.  Yet, the ECB was explicit that it is prepared to accept a temporary overshoot due to the persistently forceful monetary policy trying to achieve its target.  

Moreover, it was a unanimous decision.  Nonetheless, many observers insist that the ECB has abandoned its Bundesbank DNA.  With BBK President Weidmann explicitly endorsing the symmetrical bias, one has to wonder about the understanding of the central bank's DNA.  The real meaning of the policy lies in its implementation, and therein lies the challenge of this ECB meeting.  It is too early to argue that the ECB's credibility is on the line as it seems popular with the commentariat.  It is one of those claims that cannot be refuted because it cannot be isolated and measured.  A president firing central bankers for not easing policy undermines credibility in a palpable sense, but how can we test the hypothesis about the ECB's credibility?   

The fact of the matter is that the ECB has not raised interest rates since 2011.  And even then, the two hikes were likely a mistake, and in any event, were unwound quickly as Draghi, who previously had been referred to as the Prussian Roman, took the helm from Trichet.  The ECB, like other major central banks, continuously saw inflation undershoot its target. 

Leaving aside the rhetoric, the eurozone's CPI has averaged 1.6% over the past 20-years (monthly data), 1.2% over the past 10-years, and 1.1% over the past five years.   US CPI has run a bit hotter, averaging 2.1% over the past two decades and 1.8% over the past ten years.  Headline CPI has averaged 2.0% over the past five years.  The US PCE deflator that is now targetted at an average (unspecified period) of 2% has, in fact, averaged 1.8% over the past 20 years and 1.5% for the past decade.  The recent acceleration has helped lift the five-year average (60 months) to 1.7%.  

Isn't this the confidence game?  After years of missing its point target, the Federal Reserve says that the 2% is still valid, but it is an average, meaning it will purposely seek above-target inflation to offset the persistent undershoot. Likewise, the ECB says it will now embrace the 2% target, which it has habitually missed, as a symmetrical target and could tolerate a temporary overshoot.   

With the new target, the ECB is going to adjust its forward guidance. However, while the new target may help prevent early tightening, it is not clear that the ECB is ready to introduce a new instrument, such as yield curve control, to its arsenal.  In addition to interest rates, a traditional tool, it has also developed two others through the recent crises: purchasing bonds and paying banks to lend, as in the Targeted Long-Term Refinancing Operations (TLTROs).  

The new inflation framing can allow the ECB to shift from "convergence" to the inflation target to meet or slightly surpass the 2% target before raising interest rates.  Is this significant?  Probably not.  The market has already taken that view.  The Overnight Index Swaps show a rate hike has not been discounted at all for at least the next three years, which is the extent of the ECB's staff forecasts.  

The pace of ECB bond purchases has not dictated the direction of the euro or eurozone interest rates.  The issue is not the current pace as it deploys the 1.85 trillion euro "envelope" of the Pandemic Emergency Purchases Program.  The variation does not appear significant with other perturbations,  the maturing issues, the issuance calendar, and seasonal adjustments.  If the staff forecasts help drive the pace of the purchases rather than simply provide cover for what officials desire to do in the first place, then little has taken place in the past month that would suggest an important shift in forecasts.  The euro is slightly weaker, oil prices are little changed net-net, and the survey data suggest that the regional economy is accelerating, even if unevenly, along the lines it anticipated.

Still, the new formulation of the inflation target gives the doves a new tool to push their advantage.  The PEPP is flexible (e.g., issuer limit of 33%), and the hawks argue that the economic emergency is winding down.  Yet, the ECB was buying bonds and making long-term loans before the pandemic struck.  It is those policy levers that the ECB will likely use after next March when the PEPP concludes, but that fight is not next week's. 

A challenge is that the non-emergency facility, the Public Sector Purchases Program, is running against its self-imposed limits.  It may be tempting to give the program the flexibility of the PEPP, but the rub is that Germany's Constitutional Court ruled that the issuer limit keeps the program inside the ECB's mandate in which it is prohibited from monetary financing of governments' deficits.  Leaving aside the German court's standing to overrule a European Court of Justice, it may be preferable to launch a new but similar facility after PEPP's envelop expires. Thus, the ECB's balance sheet looks to be a semi-permanent use policy tool.

Three additional initiatives by the ECB will also likely be the subject of discussion. First, the ECB will include climate change considerations in its asset purchases and broader policy decisions.  What does this really mean when the "green" still is ill-defined (to say the least, perhaps like organic was for decades after it was first introduced to consumers in the 1940s). Perhaps, it will find the Bank of Japan's approach to lending to banks to lend to projects they judge as green, as in a green TLTRO. 

Secondly, Lagarde indicated that owner-occupied housing costs will be included in the harmonized inflation measure.  This would seem to potentially add slightly to the HICP measure.  That said, in the UK, which adopted a CPI measure that includes owner-occupied costs as its preferred measure in 2017, the new measure has dipped below the  EU harmonized measure (2.4% vs. 2.5%) for the first time since last March.  Until now, the logic had been that homeownership was an investment, not a consumption decision. What changed? 

The third initiative is the formal launch of the investigation phase of a digital euro. This period may take around two years.  The digital euro is meant to complement, not replace, current payment systems.  Discussions over design, distribution, the role of wholesale and retail, privacy will be hashed out.  An eco-system around a digital euro also needs to be thought through. After the investigation and design, the implementation preparations are projected to take around three years. This means that a digital euro could be launched in 2026-2027. 

Yet, it seems that many EMU members have already digitized, not using cash, and buying things internet. Europe also has an internal payments system, SEPA, like the ACH (Automated Clearing House) in the US, that quickly and efficiently settles credit and debit transactions in large batches.  The UK's version is called BACS.  For international transactions, SWIFT is used.  Can they be made more efficient?  Probably.  That is a work that is always in progress, but it is not clear what a digital euro will give Europe that it does not already have.  

While the same could be said for many high-income countries, it obviously does not hold in some emerging market countries. For example, it is clear what China secures, command, and control functions from the introduction of a digital yuan.  Like supporting green efforts without defining them, the ECB could be putting the cart before the horse with the digital effort by sidestepping the question of the goal, problem, or challenge that will be met with a digital currency.  This is not an argument against one, but it seems more like an evolution of existing practices than the revolution some suggest.   



Disclaimer 

Marc Chandler
He has been covering the global capital markets in one fashion or another for more than 30 years, working at economic consulting firms and global investment banks. After 14 years as the global head of currency strategy for Brown Brothers Harriman, Chandler joined Bannockburn Global Forex, as a managing partner and chief markets strategist as of October 1, 2018.

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