Analysing the European Central Bank Monetary Report: October 2021
By Ciarán Heelan, Annie Wang, Peredur Morgan and Michelle Tian
To make monetary policy decisions, the Governing Council aims for price stability and economic growth within the Eurozone, analysing indicators such as the Harmonised Index of Consumer Prices (HCPI) and Real GDP to track their progress. As established in the Treaty on the Functioning of the ECB, price stability is its primary objective (ECB 2021a).
In order to track its progress on achieving price stability, the ECB examines the HICP — the Governing Council’s preferred measure of inflation in the Eurozone. It is similar to the more widely used Consumer Price Index, but harmonised to account for different members of the Eurozone accounting for differing shares of total expenditure, thus calculating a more accurate rate across the Eurozone (ECB 2021b).
The HICP tracks all consumer goods and services bought via monetary transactions. Following the Governing Council’s Strategy Review in 2021, soon it will also include accommodation costs. The HICP is a Laspeyres type of price index, meaning that it defines a basket of goods and services in a base year to form a basket of goods for a representative household, and then tracks the change in the price of this basket over time. The products within the basket may change over time as consumption behaviour changes. For example, changes may account for new technologies which now form a key part of a household’s expenditure but were perhaps not available a few years ago.
HICP is ‘harmonised’ so that consumer prices can be compared in different member states of the Eurozone. In practice, this means that categories within the basket are the same across each state (such as food, clothing etc.), but due to different preferences across different countries, the exact products within each category may differ. For example, wine in France may have a higher weight for the alcohol and tobacco category than in Belgium.
The HICP, as the benchmark for inflation for the ECB, aims to be close to, or under 2% (ECB 2021c). Once this top priority target is met, the ECB can then pursue other economic objectives such as economic growth and full employment.
The Governing Council also considers money supply measures, as money supply provides significant information on future inflation (Altimari, 2001). There are three distinct measures for money supply — M1, M2, and M3. M1 sums the amount of currency in circulation and overnight deposits; M2 adds M1 with deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months; M3 combines M2 with repurchase agreements, money market fund shares/units and debt securities with a maturity of up to two years (ECB, 2021d).
Output and growth:
The ECB tracks economic growth through the measure of Real GDP (ECB 2021e). Real GDP growth rates measure growth in living standards, obtained by measuring the growth in goods and services consumed within the Eurozone.
Firstly, nominal GDP is calculated — which is the sum of the total value of goods and services consumed in the Eurozone for a given period, measured in current prices. However, this alone would be insufficient as a way to interpret the growth in living standards, as nominal GDP fails to account for an increase in the price level of these goods and services. If inflation were higher than the growth in nominal GDP, then the economy is effectively consuming less than in the previous period. As such, the ECB discounts by the rate of inflation to find the Real GDP, and in doing so measures how total consumption within the economy has really changed by keeping the price levels constant (Ganti 2021).
As a further way of analysing changes in economic activity in the Eurozone, the Governing Council also examines industrial production through the measure of new industrial orders in the Euro area (de Bondt et al, 2013a). This measure estimates the number of orders received by businesses in industries from textiles to chemicals for a given time period and has traditionally been good at anticipating turning points in the business cycle (de Bondt et al, 2013b).
After attaining its inflation target the Governing Council aims to maximise Real GDP — among other objectives. As well as the economy (and households) being able to consume more goods and services given a fixed price level, higher Real GDP may also lower unemployment (Okun 1962) — greater consumption demand will increase the demand for labour to ensure that these goods and services can be produced, and as such may lower unemployment further.
Exchange rates can have a significant impact on the economy. For example, a strong euro would make producer’s products more expensive while making it cheaper for consumers to buy outside the Eurozone — which would lower Real GDP. As such, the Governing Council keeps track of the exchange rate. In the past year, the euro has depreciated against the dollar from around €1.20 at the start of 2021 to €1.13 as of the 8th of December, which is good for the economies of the Eurozone.
Current vs. projected state of the economy
Firstly, current inflation in the Eurozone is at 3.4%, up from 3.0% in August (ECB 2021e). This is largely due to increases in commodity prices and supply-chain disruptions (ECB 2021f). However, the ECB sees these as temporary and expects them to decline next year. Moreover, inflation is expected to be 2.2%, 1.7% and 1.5% for 2021, 2022 and 2023, respectively (ECB 2021g). These rates were revised upwards by 0.4 percentage points from previous inflation forecasts last quarter due to disruptions in the supply chain lasting longer than anticipated. Medium-term inflation is still below the ECB’s target of 2%, and the 5-year inflation expectation is 1.7% per year. This indicates that forecasters did not see the risk of short-term inflation rising to the long-term as being particularly high. Therefore, due to the deviations from a target of medium-term inflation of 2%, the Governing Council felt that monetary policy needs to remain expansionary.
Since then, baseline projections for inflation have been low, which suggests that the models used by the ECB to calculate inflation could be flawed and that inflation expectations may have been underestimated (ECB 2021g). A possible consequence of this is the Pandemic Emergency Purchase Programme (PEPP) potentially being scaled-down, to take into account the rise in expected inflation partially due to the rise in short-term inflation. This could give the ECB more flexibility to react to the short-term changes in inflation outlook and changing financial conditions. This is what the Governing Council eventually decided on.
However, one downside to decelerating PEPP is that a slower pace may lead to a tighter than expected monetary policy. This may result in tighter financial conditions, which could drive interest rates higher and decrease inflation expectations in the long run. This would have the effect of moving the ECB further away from its target inflation rate (ECB 2021g).
The economy grew by 2.2% in Q2, which is 0.8 percentage points above the predicted value. Consumer demand rose, unemployment fell, and most activities are expected to return to pre-pandemic levels by Q4 2022 (ECB 2021f). GDP growth projections have also been revised upwards, mainly due to the continuous increase in consumer demand (ECB 2021c). However, growth rates still have not reached the pre-crisis level, and the economic outlook still remains uncertain due to the continuing presence of the Delta and Omicron variants. Because of the latter, in the coming weeks and months, restrictions may be reimposed in certain countries (BBC 2021), leading to a slowdown in economic activity. Furthermore, 2 million fewer people are employed than at the start of the pandemic, and supply bottlenecks continue to hold back economic growth. There is room for some normalisation of monetary policy, but it still needs to remain accommodative to respond to these uncertainties.
What decisions did the Governing Council make?
On 28 October 2021, the Governing Council confirmed its monetary policy decision on the following measures:
Key interest rates: The interest rate on the main refinancing operations, the interest rates on the marginal lending facility and the deposit facility remain 0%, 0.25% and -0.5% respectively (ECB 2021g). In order to achieve the 2% inflation target in the medium term, the Governing Council will keep these rates at this level or further decrease them until the inflation target of 2% is achieved (ECB 2021h).
Asset Purchase Programme (APP): Net purchases under the APP will continue at a monthly pace of €20 billion. This is expected to run for as long as possible to keep ECB monetary policy accommodative, due to the uncertainties discussed previously. It will only be reduced once interest rates are raised (ECB 2021h).
Pandemic Emergency Purchase Programme (PEPP): The Governing Council will continue to conduct net asset purchases under the PEPP with a total envelope of €1,850 billion until at least the end of March 2022. The pace of purchase is lower compared to Q2 and Q3 this year (ECB 2021h).
This gradual reduction in the pace of PEPP is in line with the assessment of the improvement of the economy, financial conditions and inflation outlook. However, the Governing Council made it clear that this did not imply tapering or an end to asset purchases under the PEPP. The council will purchase flexibly in order to ensure financial conditions are not tightened and to prevent the ECB from missing its inflation target (ECB 2021h).
Finally, the Governing Council will continue to provide ample liquidity through its refinancing operations. In particular, it will provide the third series of targeted longer-term refinancing operations (TLTRO III) to support bank lending to firms and households (ECB 2021g).
Overall, the Governing Council emphasised that it is ready to adjust its instruments to keep inflation stable at 2% over the medium term.
This article was written by: Ciarán Heelan (Head of ECB Monetary Policy Research), Annie Wang (Research Associate, ECB Monetary Policy Research), Peredur Morgan (Research Associate, ECB Monetary Policy Research) and Michelle Tian (Research Associate, ECB Monetary Policy Research). This article was reviewed by Roberto Patiño (Head of Monetary Policy Research).
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