Chart of the Week: ECB set to tolerate moderately above-target inflation

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Since its inception, the European Central Bank (ECB) had appeared more concerned by inflation overshoots than undershoots, defining price stability in 1998 as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP)…of below 2%”, before modifying that only slightly in 2003 to an inflation rate that is “below, but close to, 2%”. All that changed last week when the ECB joined both the US Federal Reserve and the Bank of England in adopting a symmetric inflation target of 2%. More importantly, perhaps, the ECB acknowledged that it would tolerate a transition period in which inflation was moderately above target.

The single currency bloc has experienced several periods of outright deflation since the Global Financial Crisis. In the ten years up to June 2021, the targeted measure averaged just over 1%, as our chart shows. With policymakers struggling to reach even the old target, is now really the time to target higher inflation? In Fathom’s view, yes. Euro area inflation is running at 2.0%, on the latest figures, and is set to rise further as economies reopen, and pandemic savings are spent. In the coming months, inflation is likely to move materially higher across the major economies. Rather than tighten aggressively, risking a correction in bond and equity markets, in our latest Global Economic and Markets Outlook we argued that policymakers should move the goalposts, and opportunistically raise their inflation targets above 2%. Last week’s modest relaxation from the ECB may not be the final word on the matter.