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Christine Lagarde Can't Avoid a Quagmire at the ECB

Christine Lagarde Can't Avoid a Quagmire at the ECB

(Bloomberg Opinion) -- In her first month as president of the European Central Bank, Christine Lagarde has spoken remarkably little about monetary policy. However, she’s made clear that she wants to launch a review of the ECB’s strategy to ensure it is fit for the times we live in.

It’s an exercise that’s well worth doing. The last rethink of the ECB’s monetary policy strategy occurred more than 15 years ago. The euro-area economy has changed a great deal since then. But a review will not brush away the differences within the governing council. The divergences in opinion aren’t simple disagreements over degree or amplitude. Rather they strike to the heart of the fundamental frictions on what a central bank should or should not do. Once the discussion is started, it will lead to bitter discord.

A case in point is the recent very public squabbling over the ambitious package of measures the ECB passed in September under Lagarde’s predecessor, Mario Draghi. Several members of the governing council opposed including a new program of net asset purchases to attempt to lift the inflation rate back to the ECB’s target of “below, but close to” 2%. They argued that the economic conditions didn’t warrant a new round of quantitative easing. Some, especially in Germany and the Netherlands, believe that since there is little the ECB can do to lift inflation, it would be better to stay cautious so as to avoid stoking dangerous financial bubbles.

Lagarde has tried to mend these divisions by spending her first weeks in office talking to the critics of the ECB strategy — and listening. An in-depth review can be seen as the next step in this complex healing process. Indeed, Jens Weidmann, Bundesbank president and one of the fiercest critics of the ECB’s current policy, has endorsed the idea of a strategic rethink saying he “fully” agrees with Lagarde.

But it would be wrong to imagine that carrying out a methodical examination of the ECB’s approach can be a nice and easy solution to the impasse the ECB is in. In practice, it will be a very complex discussion given the economic landscape facing them today.

When the ECB launched its last overhaul in the early 2000s, the ECB had to prove it could put a ceiling to inflation. Now, it’s struggling to lift inflation back to its target, as the price level grows only by around 1% a year. So the question has become whether the ECB should passively accept this as the new status quo, or set itself a more ambitious target in order to prove to investors that it is serious about fighting off the risk of deflation.

A straight-forward solution would be to lift the target to a simple 2%, full stop. That would be easier to communicate than the existing, more convoluted objective, and it would bring the ECB in line with other major central banks. Most importantly, it would be in line with the ECB’s current approach of refusing to surrender to a mediocre inflation rate. But it would not appease everyone in the council. Klaas Knot, the governor of the Dutch central bank, recently floated the idea of having a band around the current target, or alternatively, lengthening the horizon to bring inflation back to target. Both ideas suggest that the ECB should not act so aggressively when inflation is well below 2%. The Bundesbank is also likely to advocate a more conservative approach.

Lagarde could soon find herself choosing between trying to keep everyone on board, or acting decisively to strengthen the credibility and effectiveness of the ECB. In his eight years as president, Draghi prioritized action to unanimity, most notably when he said he would do “whatever it takes” to save the euro. Such assertiveness won him plaudits, but also contributed to the divisions Lagarde is now grappling with.

A policy review is a smart way to try to broker a truce between the different factions in the governing council. But a peace it is not. The battle over the future of monetary policy in the euro region has only just began.

To contact the editor responsible for this story: Melissa Pozsgay at mpozsgay@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or 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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