How to enhance ECB credibility
Saying goodbye to inflation target
by Bert Rürup in Düsseldorf
Wed 25 Oct 2017
Germany's economy is in the midst of a strong upswing, likely to intensify in the coming year. Many economists now think there is a danger of overheating, although none of the usual symptoms – like robust increases in wages and prices – are in evidence. In spite of full employment and a lack of skilled workers, wage increases remain modest in many parts of Germany.
The other euro economies have been revitalised, too. The European Central Bank sees this as a vindication of its loose monetary policy. Yet in reality the ECB must concede that it has failed in its central ambition of increasing inflation to 'below but close to 2%'. It even expects next year a further slowdown in consumer price increases to 1.5%.
The ECB's policy-making council meets on 26 October to decide the next phase of quantitative easing, which looks set to continue into 2018, albeit at a reduced rate of bond purchases. Today would be an appropriate time for the ECB council to accept it has no real control over inflation and give up its rigid target. One alternative would be to return to the German Bundesbank's former targeted annual increase of 'below 2%', which was the ECB's yardstick until 2003. Another possibility would be to follow the Swedish Riksbank and define a range of 1%-3%.
Neither option would bring the ECB any major reputational loss, as past transitions in the Bundesbank's own monetary targeting have demonstrated. On the contrary, a change in the inflation goal would enhance the ECB's credibility. The central bank could then focus on countering the threatened instability of the financial system caused by the drawn-out bond purchasing programme and negative interest rates. The euro area needs to extricate itself from this predicament as soon as possible.
In the debate on why inflation is so persistently low, the ECB should recognise one crucial factor. The main reason for low wage increases in many industrial states has been globalisation, which, in tandem with technical progress, has weakened workers' negotiating position.
If jobs can be moved abroad and domestic products replaced by cheap imports, this significantly reduces the threat potential of strike action by trade unions. The process of digitalisation, with machines taking over human activities, intensifies this trend. Of course, new jobs are still being created, but above all in the service and information technology sectors – both industries with traditionally low levels of union organisation. So there is no sign of a revival of trade union power.
Another factor is that a high salary is no longer the sole priority for many employees looking for their ideal employer. Modern offices, a good working climate and flexible working hours play an increasingly important role. Germany's most powerful trade union, IG Metall, is trying to assert its members' rights to shorter working hours. But none of these factors feature in wage and inflation statistics. Claudio Borio, chief economist of the Bank for International Settlements, is right to state that a fall in unemployment no longer has to mean a rise in inflation.
All this poses a serious problem for ECB President Mario Draghi. If he wants to control inflation, he needs more than just a target figure for the rate of price rises – he also needs valid inflation forecasts and reliable models of monetary transmission channels. But economic models can be tested and calibrated only on the basis of past data. The greater the symmetry between the past and the future, the better economists' forecasting models will work. On the other hand, if former economic circumstances lose some of their validity for defining today's realities, this devalues the central banks' principal operating instruments – and their own credibility.
All this explains why today, at least in Europe, the standard concept of monetary policy, direct control of inflation, faces similar problems to those which affected the control of money supply nearly 40 years ago, when the correlation between money supply and inflation crumbled.
Beyond the discussion about whether the ECB should reduce monthly bond purchases to €20bn or €30bn, Draghi and Peter Praet, the ECB's chief economist, would do Europe great service by stating how the world of inflation forecasting and control has changed. Rethinking the ECB's inflation target would be an important step towards strengthening the ECB and safeguarding the future of economic and monetary union.
Prof. Bert Rürup, a former Chairman of the German council of economic experts and Professor of Economics at the Darmstadt University of Technology, is President of the Handelsblatt Research Institute. This forms part of a series of articles on the European Central Bank's policies ahead of its 26 October meeting.
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