The author is head of Western European economics at JPMorgan
Over the past decade, inflation outcomes in the eurozone have consistently underlined the European Central Bank’s goal.
In other words, output and employment were lower than they should have been in order to deliver the ECB’s self-defined measure of price stability. These losses are significant in themselves, even if they do not continue in the future.
But it also leaves a legacy of larger budget deficits, higher debt shares and lower inflation expectations than would have been the case if the price stability target had been reached. This legacy makes future production losses relative to the potential of the economy more likely.
During almost all of this period of inflation, the ECB instituted monetary policy, while its own forecasts showed that inflation would not reach its target during the normal two to three year horizon. One would have expected the recent ECB strategic overview to discuss why this has happened and how policy should develop in response to it. There are few signs that it did so.
In defense, the ECB can claim to have innovated in the design and scope of its low-inflation policy responses. In the wake of the global financial crisis, it had to deal with fiscal policy that was turning too early. The ECB also had to play a role in mediating a response to a sovereign funding crisis that politicians are slowly solving.
The ECB lent to banks on a large scale, set negative interest rates and bought trillions of assets. It immediately responded to the pandemic. Not only does the policy work, but so does the ECB promises to continue that action into the future. And the ECB argues that it further has room to harness these tools and others as needed.
But if the ECB has the policy instruments to return inflation to its target, why not use it? It can be argued that its impact has become uncertain as policy has become increasingly unconventional. The policy changes needed to bring inflation (or at least the ECB’s forecast for it) back on target will also increase the uncertainty of the forecast.
For example, the possibility of financial instability may increase as asset purchases stretch. Alternatively, the ECB may be concerned that perverse or destabilizing incentives for fiscal policy makers may emerge with ever-increasing purchases of government debt.
Although such arguments can be legitimately argued, it is the ECB’s argument to make them if it is the explanation for its tolerance of low inflation. By making these arguments, the ECB will emphasize the role that other policies and policymakers can play in the mix.
For example, if financial fear is the fear, the ECB should make it clear that macro-prudential and other far-reaching regulations will become more important. If there are fiscal incentives, the ECB should emphasize this.
Instead of participating in these debates, the ECB has chosen to obscure what its policy seeks to achieve. The interim objective of maintaining ‘favorable financing conditions’ was recently introduced. But (by design) no significant, quantitative definition of purpose was provided. There is also no systematic explanation of why that interim objective is the right way to deliver price stability.
The strategy review made it clear that the ECB gives equal weight to deviations from inflation above and below a target of 2 per cent. It also introduced the idea of greater tolerance for inflation overruns after a period in which policies were constrained by the effective limits on how low interest rates could be reduced.
But the impact these ideas may have on building the credibility of the inflation target is being undermined by the ECB’s failure to explain why the outlook for inflationary undercurrents is now being tolerated in the forecast.
One only has to look at the recent experience of the Bank of Japan to see that large-scale and sustained monetary policy action, not to mention a tolerance (albeit unwelcome) for inflation exceeding, is not sufficient conditions to does not occur.
The US Federal Reserve has moved its regime to ensure that its more limited downward inflation will compensate over time. ECB President Christine Lagarde suggested that the strategy review provided a “European” implementation of the same idea. But there is a big difference between saying that inflation will be actively sought above the target and simply accepting it as a risk after a period of underperformance. The difference is now reflected in the behavior of wage and price determinants.
Greg Fuzesi at JPMorgan contributed to this article