Christine Lagarde Gets a Heavy Pointer on Her ECB Review
(Bloomberg Opinion) -- The European Central Bank will spend much of this year reflecting on how to revamp its objectives and instruments to make them fit for an era of stubbornly low inflation. An ECB staff document published in December offers it much-needed guidance on the best way forward.
The mammoth 336-page document looks back at the central bank’s first 20 years of monetary policy. The authors — who include Massimo Rostagno, the respected head of the ECB’s monetary policy department — have been careful not to try to determine the outcome of Christine Lagarde’s separate policy review. The bank’s new president doesn’t want the review to be shaped by the ECB alone, preferring that it “turn each and every stone” and be open to the view of all national central banks, as well as academics and civil society. She also wants to look at broader questions, such as the role the ECB can play in fighting climate change.
Nevertheless, Lagarde and her colleagues would be wise to read the staff paper closely. Among all the carefully worded language, one can clearly see the contours of a monetary framework that would work for the ECB’s third decade. These include changing the inflation target to 2%, and maintaining all of the instruments — asset purchases, long-term loans to the banking system and negative interest rates — that the central bank used throughout the presidency of Lagarde’s predecessor, Mario Draghi.
The argument for a symmetric inflation target is rooted in the power of expectations. The ECB at the moment aims to reach an inflation rate “close to but below 2%.” This means that, as price pressures start climbing toward 2%, investors and consumers expect the ECB to react aggressively, tightening monetary policy to push inflation back. The authors believe this served the ECB well during its first decade, when it had to establish its reputation and fight off inflationary forces.
However, the objective has been less useful in today’s era of persistently low inflation. It may even be counterproductive. Consumers and investors don’t expect the central bank to act so decisively to counter deflation.
A straightforward 2% target would bring the ECB in line with many other central banks in the world, including the Bank of England, the U.S. Federal Reserve and the Bank of Japan. It would be simple to explain and to use as a benchmark of the central bank’s performance. Most important, it would make it clear that the ECB is as serious about inflation undershooting its target as it is about overshooting. That’s because, say, 1.8% and 2.2% would be both seen as an equal deviation from the target, whereas at the moment the former would be seen as acceptable.
What about alternatives? One possibility is to construct a corridor of acceptable inflation rates. Yet this would bring us closer to the early days of the ECB, when its objective was to keep inflation “below 2%.” A corridor — especially a wide one — would be confusing and might be counterproductive when fighting disinflationary forces: For example, some would argue that the central bank should cut back on stimulus or even raise interest rates as soon as inflation hits the bottom of the range.
The ECB staff notes that such “inflationary” biases in the target may have contributed to one of the ECB’s worst policy mistakes: the decision to raise rates twice in 2011, when the euro zone economy was slowing at the start of the sovereign debt crisis. All in all, a straight 2% target would be better than the status quo, and particularly helpful when inflation expectations start climbing — as they’re doing tentatively now.
The other important question looked at by the ECB staffers is the effectiveness of those asset purchase, cheap bank loan and negative rate instruments deployed by the central bank. The working paper believes all three have been effective, with asset purchases contributing 60% of the impact of the expansionary package and negative rates and long-term loans contributing 20% each.
This analysis is useful, showing that the central bank is more effective when it deploys its instruments as a package. For example, the long-term loans to banks at very low rates makes the central bank’s promise that it won’t raise rates for a prolonged period more credible. The ECB can pull more lightly on each policy lever if it pulls them at the same time.
It’s clear the ECB shouldn’t discard any of these measures. Negative rates infuriate bankers and some politicians because they’re seen as hitting bank profits and savers. But there’s little evidence that they’ve done more harm than good, nor that they’d be damaging even if they were pushed a bit further.
Lagarde’s policy review won’t not be plain sailing. The Bundesbank and other central banks from the north of the euro zone will probably oppose raising the inflation target to 2%. The criticisms against negative rates and asset purchases will reemerge. The central bank may get lost in endless debates over where it is overstepping its mandate when it comes to dealing with climate change
In difficult times, a ship’s captain needs the North Star to show the way. Lagarde is fortunate that her staff has just offered her something similar.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Ferdinando Giugliano writes columns on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.
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