10/ The new monetary policy strategy of the Eurosystem: Part 2

11 November 2021 

Blog post by Gaston Reinesch, Governor of the BCL

This blog is the second part of a series of articles on the Eurosystem’s monetary policy strategy review launched in January 2020 and concluded in July 2021.[1] This blog article describes the outcomes of the review in relation to a) the Harmonised index of consumer prices (HICP) as the appropriate price measure for monetary policy purposes, b) the role of owner-occupied housing costs and c) climate change.

The HICP as the appropriate measure of prices confirmed

In 1998 the Governing Council decided to define price stability using Eurostat’s headline Harmonised Index of Consumer Prices (HICP) for the euro area as a whole, i.e. the consumer price index which is harmonised across the countries of the EU. The 2020/21 review revealed that the HICP remains the appropriate price measure for monetary policy purposes and when assessing the fulfilment of the price stability objective. Similar to the 2003 strategy review, this assessment is founded on four criteria, namely: timeliness[2], reliability (HICP data are typically not revised), comparability (the HICP gives comparable measures of inflation across countries and time) and credibility as perceived by the general public.

Already the 2003 strategy review confirmed the HICP provided a high quality price index at international standards. Since 2003, the quality of the HICP as an inflation measure for the euro area has been improved further (as evidenced, for instance, by the introduction of annual updates of household expenditure weights and the provision of flash estimates for all Member States).

The price stability objective is quantified in terms of headline inflation (covering all items), the measure that most closely approximates the price of a representative basket of consumption goods and services purchased by euro area households. That said, the Governing Council will continue to monitor a large set of price indicators, including various measures of “underlying inflation” that exclude certain volatile components which may help identifying inflation trends over the medium term.[3]

The role of owner-occupied housing costs

Fundamentally, the HICP covers household final monetary consumption expenditure, i.e. that part of final consumption expenditure incurred by a) households, b) in monetary transactions, c) on the economic territory of the Member State, and d) on products that are used for the direct satisfaction of individual needs or wants.[4] Referring to monetary transactions, the HICP generally includes transactions (whether in cash or in commercial bank money) involving an exchange of money.[5] As a consumer price index, the HICP covers expenditure on consumption products by the household sector (not those incurred by businesses and the government).

While the HICP remains the appropriate price measure for monetary policy purposes, there is scope and need for further improvement, in particular in the coverage of housing expenditures.

Currently, housing enters the HICP directly through actual rentals paid by tenants[6] as well through the cost incurred by regular maintenance and repair of the dwelling (e.g. materials and services used for interior decoration) and other running costs (e.g. expenditures for heating, electricity, water supply as well as refuse and sewage collection).[7]

The HICP, however, does not cover large parts of expenditures related to home ownership, i.e. the costs of housing services borne by owners when purchasing, maintaining and living in their own homes. While excluded from the HICP, such costs account for a significant share of household expenditures in the euro area.

Hence, incorporating costs for owner-occupied housing (OOH) in the HICP would increase the representativeness of the HICP, improve its comparability across countries with different home ownership rates and reflect the calls of citizens for a broader coverage of housing costs expressed during the Eurosystem’s listening events.

As a result of the strategy review, the Governing Council – in favour of accounting for the cost of owner-occupied housing in the HICP since long – finally decided to respond to such concerns. That said, there are different methodological approaches to quantify OOH costs, each with their advantages and disadvantages.

The ECB, as well as Eurostat, consider the net acquisition approach to be the preferred method for including OOH costs in the HICP[8], based on the transaction prices that households actually pay for the acquisition of homes. Under the net acquisitions approach prices are recorded at full market price and are fully allocated to the time of purchase, irrespective of the time, the means of payment as well as the use made of the good (unlike common consumer products, a house is a major durable used over many years).

Apart from expenditures on the acquisition of dwellings, OOH costs should include other expenditures that OOH owners incur and are not part of the HICP, i.e. major repairs and maintenance, insurance connected with dwellings as well as local authority and other fees related to the purchase or the construction. The principle of net acquisitions implies that only transactions between the household sector (the target population of the HICP) on the one hand and other sectors on the other hand are in scope. House purchases within the household sector are excluded since such transactions net to zero.[9]

For many years the European Statistical System has been working towards the development of a stand-alone OOH price index (OOHPI) based on the net acquisition approach, as provided for in the Commission Regulation (EU) No 93/2013 establishing OOHPIs and the articles 1, 2 and 3 of the Framework Regulation (EU) 2016/792. Eurostat publishes OOHPIs for individual euro area countries (except Greece) at a quarterly frequency. These indices measure changes in the transaction prices of dwellings purchased for own-use that are new to the household sector and changes in the cost of all goods and services that households purchase in their role as owner-occupiers of dwellings.[10]

Importantly, house transaction prices (as collected for the purpose of the OOHPI published by Eurostat) are distinct from OOH costs. For instance, house prices typically reflect a consumption component (related to current housing services) and an investment component (related to the store of value and the future flow of housing services). The investment purpose is particularly obvious when purchasing property to be rented. But even owner-occupied dwellings are not always acquired exclusively for the purpose of housing, but also with the aim of storing wealth or saving/investing.

As a consumer price index, the HICP is meant to exclude capital and investment expenditure, incurred for instance when purchasing financial assets (asset transactions are defined as non-consumption in the HICP framework). Monetary policy does typically not respond directly to developments in prices of specific assets, as these should be addressed primarily by macroprudential policies (with more targeted tools).

Often subject to significant volatility and relatively long cycles, including asset prices might complicate decision-making and communication, for instance if the investment component would move in the opposite direction than consumer price inflation more generally. Hence, for the time being, the Governing Council plans to account for the consumer component of OOH costs.

Distinguishing between the consumer component and the investment component of house prices is a major challenge in practice. The methodology to disentangle the two components (and the implications for the weights to be assigned to OOH costs) in the framework of the HICP need to be determined in the coming years.

As a first approximation, the non-consumable part of a property is often considered to be represented by the land component on which the construction is situated.[11] One way to take out the investment component from transaction prices under the net acquisition approach would consist in excluding the land component from the prices and from the weight used to derive the overall HICP.

In practice, disentangling the land price form the transaction price is far from straightforward since the land and the structure resting on it are often purchased as a bundled product for a single price. Moreover, parts of the total transaction price might not be easily and exclusively attributed to either the price of land or the construction (e.g. access paths/roads and garden infrastructure).[12]

Admittedly, by disentangling land prices from the price of the structure a non-negligible part of the total prices actually paid would not enter the HICP. Moreover, it would imply that the OOH costs accounted for in the HICP in future are not identical to the property prices households are most familiar with. OOH costs in this case, however, would closely follow a construction cost index and, once included in a future HICP, the consumer component of house prices would account for the evolution of the prices of structures. A rise (decline) in the price of structures would be reflected in an increase (decrease) in the OOH costs (and in the future HICP) in a comprehensive and timely manner.

At the time of writing, the most recent data published by Eurostat report a 4.5% year-on-year growth of owner-occupied housing costs in 2021Q2, a rate significantly higher than the rise in the HICP over the same period (i.e. slightly above 1.8%). All else equal, it stands to reason that accounting for OOH costs currently would have contributed to a higher inflation rate. Importantly, however, the OOH price index currently published by Eurostat in principle does not distinguish between the consumption and investment component of a dwelling transaction.[13] Hence, in their current format, and supposing that the final objective would be to only take account of the consumption component, the OOHPIs published by Eurostat, would not be an appropriate built-in component of the HICP as index for quantifying the price stability objective for the euro area and the price index used to measure euro area inflation for monetary policy purposes.

The Governing Council recognizes the significant implementation challenges related to the need to separate between a consumption component and an asset price component, but also due to the lower frequency and the lags at which the OOHPIs are currently published by Eurostat[14]. Mindful of such challenges and as a result of the strategy review, the Governing Council recommended a multi-year roadmap for the inclusion of OOH in the HICP under the lead of Eurostat.

The roadmap recommended by the Governing Council includes four steps for moving to an HICP incorporating OOH costs as the main index for monetary policy purposes.

In a first step, the Eurosystem will construct an analytical index of consumer prices including OOH for internal purposes using approximate weights for OOH. In parallel, the related legal work will be started and Eurostat intends to carry out further work on the statistical compilation of OOH weights, with a view to publishing in a second stage – likely in 2023 – an experimental quarterly HICP including OOH costs.

In a third step, likely to be completed by 2026, an official quarterly index will become available.

In the last stage, the aim would be to include OOH costs in the HICP at a monthly frequency and in a timely manner. Ultimately, the inclusion of OOH costs, it stands to reason, would lead to more cyclicality (for both down- and upswings) of headline inflation. Over time, they may temporarily contribute to higher inflation as well as lower inflation. Owing to the significant labour share of OOH costs (related to repair and maintenance, for instance), including them could also strengthen the link between wages and measured consumer prices.

During the transition period, the current HICP will remain the reference index for the definition of price stability by the Eurosystem. While for now it is too early to provide a precise timetable and while during the transition period the main reference index for monetary policy will remain the current HICP, the quarterly OOH price index will be an important complementary indicator.

Accounting for the impact of climate change

Climate change has far-reaching implications for the structure and cyclical behaviour of the euro area economy as well as its financial system. It may complicate the conduct of monetary policy. Extreme weather events, for example, increase the uncertainty around forecasts of future developments in the economy. Policies designed to encourage greener activities may disrupt some industries and regions while providing boost to others. Climate-related factors and policies aiming to mitigate climate-related risks may affect prices and inflation. Furthermore, risks created by climate change could influence the stability of the financial and banking systems. Last but not least, climate change affects the value and the risk profile of assets held on the Eurosystem’s balance sheet.

Addressing climate change is one of the EU’s policy priorities. While the primary responsibility lies with governments, the Eurosystem - without prejudice to the price stability objective - shall support the general economic policies in the EU with a view to contributing to the achievement of the objectives of the Union as laid down in Article 3 of the Treaty on EU.

Within its mandate, the Governing Council is committed to ensuring that the Eurosystem fully takes into account the implications of climate change and the carbon transition for monetary policy and central banking.

The Governing Council agreed on an ambitious climate-related action plan outlining the following key areas of ongoing and planned actions by the Eurosystem to systematically reflect climate change considerations in its monetary policy operations.   

First, the Eurosystem will expand its macroeconomic modelling capacity to assess the implications of climate change and related policies for the economy, the financial system and monetary policy transmission. In addition, the Eurosystem will develop statistical indicators to improve the understanding of the macroeconomic impact of climate change.

Second, the Governing Council will take into account climate change considerations in the design of its monetary policy operational framework in the areas of disclosure, risk assessment, collateral framework and corporate sector asset purchases. The implementation of the action plan will be in line with progress on EU policies and initiatives in the field of environmental sustainability disclosure and reporting.[15]

The outcomes of the review in relation to a) the medium-term orientation of monetary policy, b) the monetary policy instruments, c) the new integrated analytical framework, d) the enhanced regular proportionality assessment and e) communication will be the subject of a forthcoming blog article.

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[1] The first part of this series covered the motivation behind the 2020/21 strategy review as well as the inflation target as a key outcome of the review. I would like to thank P. Lünnemann and L. Wintr for their support in preparing this article.

[2] HICP data are disseminated monthly, around the middle of the month that follows the reference month. Moreover, Eurostat usually disseminates early estimates, called 'HICP flash estimates', of the euro area overall inflation rate and selected components on the last working day of the reference month or shortly thereafter.

[3] For an in-depth discussion of the concept, the objectives and the limitations of consumer price indices, please refer to “Essai d’Économie Politique – Division du travail, Spécialisation, Échanges, Marchés, État, Droit et Monnaie“ (Annex “Prolégomènes aux indices des prix à la consommation").

[4] Article 2(20) of Regulation No 2016/792.

[5] Hence, in principle, own production and barter do not qualify as transactions for inclusion in the HICP, nor do imputed transactions (i.e. when prices are not observed).

[6] Including payments for the use of the land on which the property stands; the dwelling occupied; fixtures and fittings for heating, plumbing, lighting, etc.; and, in the case of a furnished dwelling, furniture.

[7] The HICP does not cover the cost of major maintenance and repair, such as replastering walls or repairing roofs.

[8] https://www.ecb.europa.eu/home/search/review/html/ecb.strategyreview_monpol_strategy_overview.en.html

[9] On-going costs associated with living in such homes as well as costs associated with the transfer of ownership (e.g. legal fees and taxes), however, are included in the HICP under the net acquisition approach.

[10] The OOHPI released by Eurostat covers expenditures related to both the acquisition of dwellings (incl. new, existing and self-build dwellings), costs related to the acquisition of dwelling (e.g. property transfer tax, stamp duty, commissions, notary fees), major renovations, major repairs, maintenance of the dwelling, dwelling insurance and other costs related to home ownership.

[11] See, for instance, ILO, IMF, OECD, Eurostat, United Nations, World Bank (2004), “Consumer Price Index Manual: Theory and Practice“.

[12] See, for instance, Eurostat Technical manual on Owner-Occupied Housing and House Price Indices, Section 7.

[13] The price of land is included in the price index for new dwellings, while it is excluded from the index for self-built houses. Weights of the OOHPI price subcomponents exclude land.

[14] The full set of HICPs is published each month, typically between 15 and 18 days after the end of the reference month. The euro area HICP flash estimate is already published on the last working day of the reference month or shortly after that. The OOHPIs published by Eurostat, by contrast, are released on a quarterly basis and approximately one quarter after the reference period.

[15] Moreover, the Eurosystem also pursues its climate-related activities in the context of international fora such as the Network of Central Banks and Supervisors for Greening the Financial System (NGFS). Launched in December 2021, the NGFS is a group of central banks and supervisors willing, on a voluntary basis, to share best practices and contribute to the development of environmental and climate risk management in the financial sector and to mobilise mainstream finance to support the transition toward a sustainable economy. All 19 Eurosystem national central banks and the ECB are members of the NGFS and the Banque centrale du Luxembourg joined the NGFS as a member in 2018.

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