The European Central Bank's (ECB) massive bond purchases starting in 2015 brought the central bank criticism, legal trouble, and a record loss last year. Despite this, the monetary policymakers appear intent on sticking with the instrument of quantitative easing (QE) during times of low inflation and interest rates. This intention is emerging as part of the ECB’s ongoing strategy review. In early May, the ECB Governing Council held a two-day meeting in Portugal. The revised strategy is expected to be presented in the summer – possibly as early as the beginning of July – during the ECB Forum in Sintra, one of the world’s most important central banking conferences.

Alexander Krüger, Chief Economist at Hauck Aufhäuser Lampe Privatbank, emphasizes that QE can be a crucial ECB tool: „What would have been the alternative to QE in 2010?“, he asks. Without those billions in bond purchases, a financial crisis might have erupted. However, Krüger criticises the prolonged use of the tool: „QE should be a time-limited measure for crises – like a financial crisis or the risk of slipping into deflation.“ By deflation, Krüger doesn’t mean a few months of falling consumer prices, but a longer period of declining prices and shrinking credit volumes.

„When market participants get used to the ECB buying bonds on a large scale, the disciplining effect of capital markets on governments diminishes“, says Krüger.

„QE should not lead the ECB to buy bonds that no one in the market wants“, adds Alessandro Tentori, CIO Europe at Axa Investment Managers. ECB Governing Council members like Pierre Wunsch and Isabel Schnabel also caution the bank to use QE more sparingly in the future. Over prolonged periods, they argue, the costs outweigh the benefits.

The strategy review also raises the question of what lessons the ECB has learned from the inflation surge starting in 2021. The bank long misjudged the price increases as „temporary“ and responded too late with rate hikes. One reason for the delayed response was the ECB’s earlier communication: the central bank had publicly stated that interest rate hikes would only be considered after bond purchases had ended. Economists identify this self-imposed constraint as one reason for the delay.

The ECB no longer uses forward guidance. Instead, it now stresses that it doesn’t commit to any specific course ahead of time, and decides meeting by meeting based on data. „In that sense, the ECB has learned from its mistake“, states Krüger. Still, the central bank cannot entirely refrain from giving some indications about future monetary policy, as financial markets need orientation.

Since inflation is expected to be more volatile in the coming years than in the past, and overall uncertainty is higher, the ECB is likely to increasingly rely on scenario analyses. „But the ECB should explain how likely it considers each scenario“, says Tentori. He also proposes that the ECB take a page from the Bank of England’s book when it comes to inflation forecasting. The BoE publishes fan charts, showing how inflation might evolve over the next two years.

These charts include a baseline scenario – what the central bank sees as the most likely outcome – surrounded by shaded areas, each representing 10% probability. Thus, the likelihood of inflation falling within the innermost band is 10%, the two closest bands together account for 20%, and so on. „As a market participant, I would also welcome that tool from the ECB“, says Tentori.

He is less enthusiastic about the Fed’s dot plots. In those, individual US central bankers publish their estimates of where the key interest rate will be at year end. ECB Executive Board member Isabel Schnabel has floated the idea of adopting this approach in the Eurosystem, but her colleagues seem largely unenthusiastic.

At the „ECB and Its Watchers“ conference in March, there were calls for the central bank to scale back its communications. With so many statements being made, important information can get lost. Krüger agrees: „I’d prefer central bank heads to show more restraint rather than constantly speaking out. Not every nuance needs to be publicly dissected.“ Still, he generally praises the ECB’s communication under President Christine Lagarde: „The largely unified messaging under her leadership is welcome. Public quarrels like in the past are not helpful.“

Artificial intelligence (AI) is also gaining importance for the ECB and national central banks. Besides analysing communications, AI is already being used in forecasting models. „AI is especially useful for estimating non-linear relationships“, notes Tentori. „This makes it easier to predict second-round effects on inflation.“

A working group in the strategy review is reportedly also examining the long-term drivers of inflation. Many economists believe signs are mounting that inflation will be structurally higher than in the years before the pandemic. Factors such as population aging and the green transformation of the economy could add upward pressure on prices. Against this backdrop, an era of extremely low inflation seems unlikely for now.