ECB will tackle fundamental questions regarding strategy assessment

The European Central Bank has launched a new strategy assessment that will cover some major questions about its workings - such as whether massive bond purchases remain an effective policy tool or what role they should play in fighting climate change.

The following are likely to be reviewed before the final report is due in mid-year, which could lead to incremental changes in policy.

BOND BUYS

In the decade prior to the pandemic, quantitative easing or bond purchases were a major part of ECB's policy. However, some policymakers have openly questioned its benefits.

The ECB purchased trillions of euro worth of debt to boost inflation when prices were too low. However, 4 trillion euro of these assets remain on the books years after the stimulus program ended because it takes time to unwind.

Isabel Schnabel, a member of the ECB's board, said that asset prices would remain distorted as bond holdings could only be unwound gradually. It means that starting QE is harder than it was in the past.

ECB officials are being urged to recognize that while quick purchases of bonds can be effective during pandemics, the costs of long-term purchases outweigh the benefits.

While profits may not be a core business, the massive QE has also led to record losses for the ECB, denying governments dividend income.

Since the ECB has made it clear that it will intervene on markets if policy transmittal is impaired, some policymakers also call for a more clear distinction between instruments to combat inflation and those aimed a market stability.

SPECIALLY FORCEFUL MEASURES

The review will not question the ECB’s primary goal to target inflation at 2%, but it could raise whether falling short of this threshold in future is so severe that it would require extraordinary measures.

The ECB strategy calls for "especially strong" action when the inflation rate is too low. This suggests that undershooting may be a greater problem than overshooting.

Evidence suggests that prices are rigid on their way down and only large shocks can lead to deflation.

Even in the decade of ultra-low inflation before the pandemic began, households and firms continued to expect modest price increases.

Some argue that if the ECB really believes its 2% inflation goal is symmetrical, there shouldn't be a distinction made between undershooting and overshooting.

A particularly forceful approach, which usually involves a large number of bond purchases, can also cause financial distortions.

CLIMATE

The ECB has committed to a "ambitious climate action plan" by 2021. The results have been modest.

The government shifted corporate reinvestments to firms that had better climate performance, but these reinvestments are long gone.

The bank has promised to adjust its remaining portfolio of corporate bonds based on climate concerns, but it faces a deeper existential question about what role it should have in climate policy.

The U.S. Federal Reserve left the Network for Greening the Financial System recently because its work went beyond the Fed's original mandate. ECB head Christine Lagarde defended NGFS, but others, such as Belgian central banker Pierre Wunsch, called on the ECB limit its role in climate policy to avoid interference with policymaking.

DIRECTION FORWARD

In its last review, in 2021, the ECB included forward guidance or commitments regarding future policy actions as a tool in its toolbox. This guidance, however slowed the bank's reaction to the rapid increase in inflation in 2020, as it had already committed to a looser policy.

Since then, policymakers have argued that the ECB shouldn't use forward guidance unless interest rates are at their lowest effective levels. (Reporting by Balazs Koranyi, Editing by Alexandra Hudson)

(source: Reuters)