Current ECB president Christine Lagarde is facing pressure to change the ECB’s monetary policy and its inflation target of 2%, as the policy tools are deemed ineffective in stimulating growth, given that the inflation target has not been met since October 2018.  In this article, we present the views of both those in favour and those opposing the current monetary and inflation policies and assess the implications of a change in policy on the EURUSD.

Senior ECB members were infuriated at the former ECB president Mario Draghi for announcing monetary policies earlier this year before consulting with them.  In fact, a third of ECB members oppose the measures that Draghi took in September, which included restarting the quantitative easing (QE) programme.

Other important players who are opposed to Draghi’s recent decision are the heads of the German, Dutch, Austrian and French central banks. Their hopes for change were replenished when Lagarde announced in her first speech that the ECB will soon conduct and publish a strategic review of the ECB’s monetary policy tools and objectives, which has not been done since 2003.  It is worthy to note that the US Federal Reserve announced the need for such a study last year, stating that the US economy has changed in material ways.  The Fed’s review started this past summer and it estimates that the results will be made public during the first half of 2020.  Since the ECB’s 2003 study was conducted over 6 months, we expect the ECB’s findings to be published during the same period as the Fed’s or slightly thereafter.

Former ECB members also criticized the current “ultra-loose [monetary] policy”, stating that it was originally put in place during the 2008 crisis to mitigate the threat of deflation, and that since that threat is no longer present, there is no reason behind setting an inflation target that is higher than the recent inflation rates. The red line of Chart 1 below shows that inflation in the Eurozone started its dive below the 2% target slightly before the end of last year. The green line shows the US CPI, which also has a 2% target.

Chart 1: Inflation and Inflation Targets of the EU and the USA from mid-2014 to end of 2019

Moreover, Fitch issued a report on Friday indicating that because the Eurozone has very high levels of debt and struggles to maintain a steady inflation rate, the economy is at risk of following in the deflationary footsteps of Japan. This fear of “Japanification” was previously voiced in August by economist and former US Secretary of the Treasury Lawrence Summers. He stated that all central bankers are facing a “black-hole problem” in that all interest rates are stuck at or below zero with no possible hikes in sight, coupled with a long-term (i.e. secular) stagnation of economic growth. “Something is going on, and that’s causing a total rethink of central banking and all our cherished notions about what we think we’re doing. We just have to stop thinking that next year things are going to be normal.” said James Bullard, president of the St Louis Federal Reserve at this year’s annual global central bankers meeting.

On the other hand, many arguments have been made by those in favour of the ECB’s current monetary policies. Some say that by lowering the target, the ECB would just be “moving the goalposts to where the ball is”. They argue that the ECB’s 2% target is the result of a framework that was carefully designed to take into account the differences between the Eurozone’s northern and southern members.  This 2% embodies an implied distribution of income between the economy’s debtors (southern members) and its creditors (northern members).  Lowering the target would increase the real value of the debts to the debtors and result in a redistribution of income in favour of the creditors, therefore increasing the burden on the already struggling southern countries.  The unintended consequences of such a cut would likely be to encourage the rise of the populist movement in southern Europe, particularly in Italy.

Some say that the opponents of Draghi’s monetary policy have their own self interests in mind, and that the former ECB members who criticized the 2% target are from the northern countries which would benefit from a cut to the target.  Given that QE was put in place to encourage domestic consumption in order to elevate prices, stopping it would result in a decrease in domestic demand and a relative increase in exports. Therefore, opposing the 2% target is argued to make the economy more exposed to US protectionism against Europe and to a US-China-like trade war.

Taking into consideration the views of both sides on ECB’s inflation target, along with the remarks made by central bank members at their annual meeting, and factoring in the anomaly of how the strong wage growth in the EU is not being reflected in inflation, it is clear that the variables usually studied by central banks and their dynamics should be re-examined. The mid-2020 results of the Fed’s and the ECB’s study on their monetary policy tools are likely to uncover more anomalies and should be used to determine the new normal. These results will likely lead to higher FX volatility, which would be a change from the current surprisingly low vols being seen in EURUSD (Chart 2).

If Lagarde does decide to lower the target, it would lessen the need for monetary stimulus. Less money in the economy should result in a lower aggregate demand, which would lead to less imports, entailing less demand for foreign currencies, and therefore should increase the value of the euro.

Chart 2: 1-month implied volatility of EURUSD from 2015 to end of 2019