What to expect from the ECB’s strategy assessment in 2025 ?

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The latest strategy review of the ECB took place in 2021. This was only the second review since the start of the EMU, following the previous exercise of 2003. Since the 18 years in between these two reviews was considered too long, the ECB also stated in 2021 that the next exercise was expected to take place in 2025. According to ECB President Lagarde, the outcome should be expected in the second half of 2025. She also made it clear that this exercise will be an assessment of the broad 2021 strategy review, rather than another new in-depth review.

The symmetrical inflation objective will almost certainly be confirmed

One of the main innovations of the 2021 strategy review was the introduction of the symmetric nature of the 2% inflation objective. At the start of the EMU in 1999, the original inflation objective only referred to an inflation rate of less than 2%. In the historical context of that period, emphasis was one-sidedly put on keeping too high an inflation rate under control. Potentially deflationary scenarios were implicitly considered to be very unlikely.

A first attempt to correct this inherently disinflationary bias was made in the 2003 review, when the inflation objective was changed to “below, but close to 2%”. This clarified that, for example a 0% inflation rate is not considered to be compatible with the ECB’s idea of what price stability means, but nevertheless the asymmetric disinflationary bias remained in place. After the experience of the 2010s with stubbornly low inflation in the euro area and corresponding low inflation expectations (see Figure 1), the ECB finally decided in its 2021 strategy review to explicitly eliminate this asymmetry, removing any remaining bias that an inflation overshooting the 2% objective would be considered to be more undesirable that an undershooting. The stated intention was to help anchoring inflation expectations around (and not below) the 2% medium-term objective.     

In July 2024, ECB president Lagarde made it clear that this symmetric inflation target is out of scope of the 2025 strategy assessment (“not on my watch”). Indeed, there is no apparent reason to change the definition, which is in line with other main central banks (Fed, Bank of England and Bank of Japan). Any change now by the ECB would almost certainly destabilise longer-term inflation expectations and jeopardise the credibility of the ECB’s monetary policy strategy.

Roadmap towards a broader HICP

A second major element of the 2021 review was linked to the way the ECB thinks that inflation should be measured best. In that context the ECB discussed the potential inclusion of the full component ‘owner-occupied housing (OOH)’ cost in the HICP. The HICP is the official harmonised consumer price index published by Eurostat, on which the ECB’s 2% inflation objective is based. The rationale for such a potential inclusion was the following. Although parts of OOH costs expenditures are already included in the HICP, such as for example insurance, electricity, waters supply and waste water removal, an important part of OOH cost, for example the estimated cost of living in an owner-occupied dwelling (‘imputed rents’) are not yet included in the HICP.  If the goal is to measure inflation by a price index that is as complete as possible, such excluded OOH costs should be taken into account in a new version of the HICP.

Such an inclusion would also bring the HICP more in line with the composition of the CPI and PCE in the US, and would make an international inflation comparison more meaningful. Moreover, from a theoretical point of view, there is even a case to include the price evolution of broader assets, such as equity and bonds, in the definition of an appropriate price index (see also KBC Economic Opinion of 7 February 2020). Intuitively, the reasoning is that inflation measures the loss of value of money, and that therefore an appropriate price index should not only measure the price of current consumption, but also the price of planned future consumption. This would imply that the more expensive financial securities such as bonds and equities are, the more expensive it becomes to ‘purchase’ today a given future consumption basket. This would be done by purchasing today the future cash flow to pay for it. Put differently, the more expensive e.g. bonds are, the lower the appropriate discount factor (interest rate) will be and the more expensive the current price of future consumption will be.    

Although there appears to be a strong theoretical case for including asset price inflation in the policy-relevant price index, it would be a significant statistical challenge to come up with a robust construction of the corresponding price index. Indeed, given the statistical difficulties that already exists for ‘only’ introducing reasonable estimates of OOH in the HICP, the ECB felt its 2021 strategy review that it could not launch a new HICP right away, but that it needed to ask Eurostat to follow a roadmap consisting of four stages, with no firm deadlines. The first stage envisages the construction of an analytical index for internal purposes, which includes OOH with approximated weights. In a second stage, an experimental quarterly HICP would be published including OOH costs. In a third stage, an official quarterly index would become available, which could then, in a fourth stage, be used to include OOH costs in the HICP at a monthly frequency. The ultimate aim is to use a new version of the HICP, including OOH costs, as the main index to base monetary policy on.

Given the statistical challenges, the ECB did not commit to a precise timetable, and not much information about the project has been published since. We expect that in its 2025 assessment, the ECB will confirm the aim and the roadmap during the 2025 strategy assessment and give an update of the timetable of the roadmap. In the meantime, the formal reference index for monetary policy remains the current HICP, but the ECB policy makers will also take into account already existing inflation measures that include initial estimates of the cost of OOH.

Which role of quantitative policies in the ‘standard’ toolkit ?

A third major element of the ECB’s 2021 strategy review was the acceptance of quantitative policies in the ECB’s standard policy toolkit. More specifically, the ECB explicitly stated in its new updated strategy that “[…] when the economy is close to the [effective] lower bound [of the policy rate], this requires especially forceful or persistent monetary policy measures to avoid negative deviations from the inflation target becoming entrenched.”

This part of the 2021 strategy review is the only one that is likely to be controversial in the 2025 strategy assessment. The reason is that the previously called ‘non-conventional policies’ not only had positive impact on the real economy, inflation and financial stability, but they also had a number of undesired side-effects (see also KBC Economic Opinion of 10 December 2021). This controversy has existed for a long time. For example, in 2011, ECB Chief Economist Stark resigned in protest of the ECB’s Securities Market Programme (SMP), even though compared to later programmes such as the APP, the SMP still was a relatively conventional policy tool. For example, any purchases made by the ECB under the SMP were sterilised in order to neutralise any impact on the money supply.   

Because of the side-effects that quantitative policies have probably caused throughout the years, it is important for the ECB to weigh the costs and benefits again during the 2025 strategy assessment. This year is a good moment for the ECB to reflect on its future use of QE, since in 2025 the last remaining bit of QE has ended. Passive QT (i.e., without active selling) is now at full speed after the end of any reinvestments of the PEPP portfolio (see figure 2) and the repayment by banks of the remaining outstanding amount of TLTROs in December 2024. 

ECB policy maker Schnabel set the tone in this debate by claiming that asset purchases can be a powerful tool when financial markets are in turmoil, but outside these periods, central banks need to carefully assess whether the benefits of asset purchases outweigh the costs. In other words, this trade-off (and hence the policy decision) is state-dependent, and likely to become more important the larger the size of the policy intervention becomes.

Schnabel mentions four examples of potential side-effects of QE. According to her, likely side-effects of QE include the risk of moral hazard for debtors, for example when the ECB injected liquidity to avoid adverse self-fulfilling prophecies as during the height of the euro area sovereign debt crisis in 2012. A second risk is that QE increases the risks of future central bank losses after QE ends. According to Schnabel, although these losses need to be viewed against the profits central banks made during QE itself (see also KBC Economic Opinion of 17 April 2023), they nevertheless may weigh on the central bank’s reputation and credibility. Third, a long period of QE may adversely affect market functioning because it creates a scarcity and hence distorts prices of government bonds, which are often required as collaterals in e.g., market repo operations or swap transactions (see Figure 3).

Fourth, QE may poses financial stability risks by favouring excessive risk-taking (‘search for yield’) and may exacerbate wealth inequality. According to Schnabel, although monetary policy always has distributional effects, the portfolio rebalancing process as part of QE may amplify these effects.

A possible outcome of the 2025 strategy assessment may be that the reference to ‘forceful and persistent’ policy measures is confirmed in principle, but changed in a few important nuances. More specifically the potential future use of QE by the ECB may be more targeted and selective, i.e., restricted to crisis moments and periods of acute undershooting of inflation and inflation expectations. Moreover, the strategy assessment may drop the reference to ‘persistent’, indicating that future QE interventions will probably end as soon as possible after they have reached their aim. Moreover, the role of targeted LTROs may become again relatively more prominent for the ECB compared to other major central banks, since corporate financing in the euro area is more loan-based and less financial market-based than e.g., in the US.