The European Central Bank’s new president, Christine Lagarde, has launched a strategic review of monetary policy. This is a welcome initiative.
However, some analysts and governing council members are calling for lowering the ECB’s ‘close to, but below 2%’ inflation target. They suggest reducing it, perhaps to 1%-2%, or making the target more flexible and achieving it over the longer term.
The ECB has long failed to meet its inflation target. These calls could simply be seen as recognising reality. The real objective is to push back against quantitative easing and negative interest rates.
Lowering the target or redefining it as a band of 1%-2% is ill-advised.
There is no perfect inflation number. But in seeking an inflation target that does not distort economic agents’ decisions, most advanced economy central banks have opted for around 2% per annum.
A lower target carries risks. Many studies have found that inflation measures are overstated, perhaps up to one percentage point, due to various biases. Indices fail to measure quality improvements. They only catch up with a lag to changing consumption habits – including goods substitution. An excessively low target could invite deflation.
Modest inflation can be helpful in boosting economic activity. Given downward wage rigidity, modest inflation allows for a degree of relative price adjustment. It erodes the real value of debt, whereas debt deflation aggravates defaults and contraction.
The call for reduced targets belies recent economic debates, urging higher targets. Higher nominal interest rates, associated with higher inflation, provide more scope to cut rates when economies are impacted by shocks and recession, without recourse to unconventional monetary policies. Former International Monetary Fund Chief Economist Olivier Blanchard, among others, at one point called for a 4% inflation target, much to the chagrin of the Deutsche Bundesbank. Discussions at the Federal Reserve and even the ECB about ‘symmetry’ in the target are often little more than code for allowing inflation targets to be surpassed.
Cutting the ECB inflation target would be deleterious for other reasons.
Germany’s relative cost competitiveness is substantially stronger than other euro area countries, especially key peripheral members. This advantage is reflected in Germany’s and northern Europe’s massive current account surplus, including with the euro area. While peripheral countries have adjusted current account deficits, they have done so largely through demand compression rather than relative price adjustment.
Hypothetically, if Germany held a 10% relative cost advantage versus a peripheral country, and rather than relying on demand compression, the advantage was eliminated over five years by adjusting costs, and the euro area as a whole met its inflation target, several situations could arise.
If Germany ran 2% inflation per annum, the peripheral country would run zero inflation for five years. If German inflation exceeded 2%, the periphery could have some inflation. Worse, if the euro area inflation target was cut to 1% and Germany ran corresponding inflation, the peripheral country would deflate by 1% per annum for the next five years.
Such deflationary forces might well be associated with even further reduced euro area growth. Ironically, then, these forces could bolster pressures for more highly accommodative euro area monetary policies. In this sense, the policy consequences of northern euro area member calls for lowering the inflation target could contradict the very reason they want a reduced target.
As part of its strategic review, the ECB should not cut its inflation target. That would only buttress the euro area’s current deflationary bias and intensify challenges that smaller member economies face.
Policy-makers must guard against secular stagnation, stall speed and ‘Japanification’.
Instead, the euro area should do its utmost to spur growth. The periphery must do far more to bolster its performance. Risk sharing can only move forward if there is risk reduction. Continued strong monetary accommodation is necessary. But national politicians and authorities, rather than focusing myopically on the entrails of ECB policy, should find ways to use fiscal space where feasible, as well as support the monetary union by creating a centralised fiscal capacity, re-examining the excessive complexity of fiscal rules, cleaning up decrepit national banking systems, and enhancing banking and capital markets union.
The ECB – as any central bank – should always consider how it can do better. The strategic review is welcome. But finger pointing and rows over monetary policy are in part a distraction. Then again, national politicians rarely like to look in the mirror.
Mark Sobel is US Chairman of OMFIF.