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ECB Set to Tweak Guidance to Reflect Its New 2% Inflation Target

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  • The European Central Bank's new inflation target and its possible effects on monetary policy will be the key topic of this week's meeting in Frankfurt.
  • The ECB hiked its inflation target from "below but close to 2%" to a symmetric 2% target over the medium term, which would allow consumer prices to overshoot when deemed necessary.
  • While some expect more than just tweaks in the ECB's forward guidance this week, others expect a real sea change to come later this year once there is more clarity about the region's economic trajectory.

The European Central Bank's new inflation target and its possible effects on monetary policy will be the key topic of this week's meeting in Frankfurt.

Hopes are high that the euro zone's central bank will come up with a dovish surprise as President Christine Lagarde keeps stressing the need for a forceful policy response to avoid a de-anchoring of inflation expectations.

"We recognize very specifically that the proximity to the effective lower bound requires forceful or persistent monetary policy action," Lagarde said during a question and answer session when presenting the new strategy on July 8.

The ECB effectively hiked its inflation target from "below but close to 2%" to a symmetric 2% target over the medium term, which means that both overshooting and undershooting is allowed but "not desirable."

The Federal Reserve in the United States last year also announced that it would allow inflation to run hotter than normal as a way to boost the labor market and economic recovery. This in practical terms means that the central bank is less likely to increase interest rates.

Since the euro zone's financial crash, consumer price growth has averaged at just 1.2%. In other words, despite all the extraordinary measures deployed amid the sovereign debt crisis, inflation has not achieved the ECB's target over the last decade.

What does this mean for monetary policy? The jury is still out. 

While some expect more than just tweaks in the ECB's forward guidance this week, others expect a real sea change to come later this year once there is more clarity about the region's economic trajectory and the evolution of the coronavirus pandemic.

"We think policymakers' commentary over the past week suggests that the ECB will go beyond just changing the forward guidance at its meeting on 22 July," said Luigi Speranza, chief global economist at BNP Paribas, in a recent research note.

"Our bias is to think that we will get greater clarity on the post-PEPP environment as well, underscoring the ECB's message of persistent accommodation," he said.

Others have more muted expectations.

"The key message could thus be that there is no rush to signal tighter policy, even at the September/October meetings," said Anatoli Annenkov of Societe Generale. 

"We only expect a better understanding of the possible end of the crisis phase of the pandemic late this year, suggesting that the key decisions on PEPP may only come then," he added.

The ECB put forward an emergency bond-buying program in March of 2020 to deal with the economic shock from the pandemic. This program, known as the PEPP, is currently set to last until March 2022 and total up to 1.85 trillion euros ($2.2 trillion).

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