Both the Fed and the ECB face inflation continuing to persistently languish below their inflation targets and coincidentally both central banks are undertaking reviews encompassing inflation targeting, policy tools and communications.
The ECB’s strategic review of monetary policy, under the tenure of its new President, Christine Lagarde, is expected to be completed by the end of 2020. Importantly, this includes a review of its inflation target; inflation has undershot the ECB’s target of ‘below but close to 2%’ for the last 7 years. But in addition to the suitability of the target itself (with commentators debating whether a target of 2% would for example be clearer) there is also the issue of the representativeness of the constituents of the index of consumer prices.
The ECB’s current approach of using the harmonised index of consumer prices takes a very constrained view of housing costs by only including what is paid from a tenant to a landlord when only around one third of the population are tenants with the majority being owner occupied dwellings. Currently, rental costs comprise ~6.5% of the basket to calculate Eurozone inflation which is below the share of income most people spend on it. Yves Mersch, a member of the ECB Executive Board, noted in a speech in January that “For many, rents alone or mortgage payments easily exceed a third of their take-home pay.” Furthermore, “the United States, Japan, Sweden and Norway already integrate owner-occupied housing into their reference inflation indices. If it were to be included in the HICP, it could raise measured inflation rates in the euro area by around 0.2 to 0.5 percentage points in some periods.” Philip Lane, the ECB chief economist commented this week: “We at the ECB would agree that there should be more weight on housing - but there is a difficulty and this has been looked at several times before”.
Admittedly, if such a change were eventually made it can be criticised for coming at a time when inflation is trending below the ECB’s target of ‘below but close to 2%’. However, Lane also warns “But let me emphasise that sometimes it goes the other way. Housing is quite cyclical, so in a downturn the inflation rate would fall more quickly because if you have a negative shock, if you look at the proxy measures that are being generated, they do fall more quickly in a recession”.