After more than a decade of spectacular shocks, failing monetary paradigms and broken down correlations, central bankers have reaffirmed their commitment to discretion rather than rules. If the Federal Reserve had said last year that it would target the three-year rolling average of core inflation and start tightening when that hit 2%, it would have foregone room for manoeuvre if the broader economic picture made that inappropriate. Basing its policy on explicit goals reduces the Fed’s chance of success. Central banks need flexibility and vague policy targets provide it.
There is little doubt that, hooked up to a lie detector, central bankers would admit they are operating in an unfamiliar landscape. Credibility gives them room for manoeuvre and rewards them with flexibility, both with their objectives and toolbox. Their ability to set the interest rate, print infinite amounts of money, buy whatever assets they like and adjust bank capital requirements endows them with might and, in a virtuous cycle, feeds their credibility.
The European Central Bank’s strategy review is the latest exercise in discretion and ambiguity. The ECB has dropped the deflationary bias of its first two decades of existence. Instead, it now officially targets 2% inflation over the medium term and tolerates overshoots. This is a bigger achievement than it may first appear, since two years ago Bundesbank President Jens Weidmann affirmed that the ECB’s inflation target was not symmetric. By targeting medium-term inflation without defining what the medium term is, the ECB has given itself a flexibility similar to that of the Fed, where average inflation targeting was introduced without providing the slightest detail about the timeframe over which the average would be calculated.
It is possible to argue that the ECB’s symmetric targeting gives it more flexibility than the Fed. After a period of below-target inflation, the Fed is now forced to generate above-target price increases, if it is to hit its target and maintain its highly prized credibility. The ECB can do so if it pleases, but it does not need to.
Vaguely defined policy goals reap their full potential when matched with decisive policy action. Such combination demonstrates that central banks can ‘do whatever it takes’. The statement can be seen as the ECB’s motto as article 123 of the Treaty on Functioning of the European Union provides enough ambiguity to allow the ECB to announce novel quantitative easing policies without violating foundational European law. On the fundamental question of its mandate, enough vagueness is built in for the ECB to have not only a dual mandate, but one that encompasses multiple goals and where full employment, social progress and environmental protection coexist with price stability.
The key article defining the ECB’s mandate states that: ‘Without prejudice to the objective of price stability, the European System of Central Banks shall support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union as laid down in article three of the Treaty on European Union.’ Article three, in turn, says that: ‘The Union shall establish an internal market. It shall work for the sustainable development of Europe based on balanced economic growth and price stability, a highly competitive social market economy, aiming at full employment and social progress, and a high level of protection and improvement of the quality of the environment. It shall promote scientific and technological advance.’
This is not to say that the ECB can easily switch between these areas of intervention. It all depends on the political backing it receives. That can shift the ECB’s mandate. The announced abandonment of market neutrality to incorporate climate change impact in the eligibility criteria to purchase corporate assets is a sign that things can move radically and quickly.
In the world of enhanced ambiguity, one group stands to face fresh challenges. Short-term focused investors are forced to obsess over central bankers’ every word in order to be on the right side of the trade and deliver the outperformance that asset owners demand. Ambiguity makes their job more difficult. But the task of central banks is to maintain price and financial stability, possibly also helping on some other vaguely defined objectives, not to provide investors with an early retirement and a Maserati.
Agnès Belaisch is Chief European Strategist and Matteo Cominetta is Economist and Director at Barings.