European Central Bank holds rates, launches policy review

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Clouds drift over the European Central Bank, right, in Frankfurt, Germany, Saturday, Jan. 18, 2020. (AP Photo/Michael Probst)

FRANKFURT – The European Central Bank has decided to launch a top-to-bottom review of how it steers the economy in the 19 countries that use the euro currency. The review, the first since the global financial crisis, could include tweaking the bank's goal for inflation and finding ways to help fight climate change.

The bank’s 25-member governing council on Thursday gave the green light for the proposal from new ECB head Christine Lagarde, which follows a similar review underway at the U.S. Federal Reserve.

One main focus will be the ECB's inflation target of close to but below 2% annually. Under Lagarde's predecessor, Mario Draghi, the ECB struggled to reach the target despite despite massive stimulus measures - it lowered interest benchmarks below zero and pumped 2.6 trillion euros ($2.9 trillion) into the financial system through bond purchases.

A moderate level of inflation is considered to offer a margin of safety against deflation, a vicious circle of falling prices, investment and slow growth. Some inflation also helps indebted countries in the eurozone improve their price competitiveness compared with near trade partners. The central bank's current goal could be replaced by a range or a different formulation.

Lagarde's move comes as central banks in advanced economies are struggling to accelerate growth and inflation. Inflation, growth, and interest rates have been persistently low in Europe, the United States and Japan for a decade, even as central banks have slashed rates to very low or even negative levels, and purchased billions of dollars of financial assets. Fed Chair Jerome Powell has called it the "new normal" and launched his own policy review last year.

Economists say that several trends are behind the trend: Aging populations and slower population growth hold back the economy, while globalization and online shopping have forced companies to keep prices low, limiting inflation. And worldwide demand for safe investments, particularly government bonds, have held down interest rates.

Some central bankers worry they will have less room to cut rates the next time a recession hits. In the U.S., the Fed typically cuts its benchmark short-term rate by 5 percentage points during a downturn. But that rate is currently in a range of just 1.5% to 1.75%, leaving it with much less room to cut. The European Central Bank and Bank of Japan already have slashed their interest rates below zero.

Both the Fed and ECB appear to be focusing on how they might change their inflation targets to make them more credible. The Fed seeks inflation of 2%. If businesses and households become more confident that central banks can hit their targets, they will change their behavior in ways that will help. For example, if workers expect prices to rise 2%, they will demand raises at that level or higher, which in turn can force businesses to increase prices to offset the cost. That then pushes inflation closer to 2%.