ECB Goes Its Own Way in Mission to Revive Inflation

The European Central Bank’s quest for faster inflation is taking shape as it enters the next phase of its Federal Reserve-style strategic overhaul.

One thing looks clear already — like their U.S. peers, policy makers are willing to temporarily tolerate price growth faster than their goal after periods of weakness. Yet they have no intention of simply copying the Fed, which concluded its own review this summer by agreeing to target an average rate of inflation.

ECB Goes Its Own Way in Mission to Revive Inflation

The ECB takes the crusade to revive faith in its inflation-fighting credentials to members of the public on Wednesday. They’ll get to share their views with President Christine Lagarde, who vowed at the start of her term just under a year ago to make the central bank better understood, and chief economist Philip Lane.

The event is likely to reinforce what many policy makers have argued ever since the review kicked off at the start of the year: That the ECB needs a goal for inflation which is easier to explain than the current “below, but close to, 2%” — and a strategy to meet it.

This formulation was appropriate at a time when the ECB was seeking to establish credibility and too-high inflation was its main worry. But in the current environment of lower inflation, the concerns we face are different and this needs to be reflected in our inflation aim.”
— Lagarde, Sept. 30

Euro-area consumer-price growth averaged 2.2% between the ECB’s establishment in 1999 and the financial crisis in 2008. It’s been at roughly half that level since then though, despite massive monetary stimulus, and is currently below zero.

That leaves the ECB with fewer tools — interest rates are already at a record-low minus 0.5% — and raises the risk that new shocks will spur a dangerous deflationary spiral of falling prices and wages.

Consensus is building that the new strategy should aim for “inflation around 2%” and respond both when it is too high and too low. To give policy makers flexibility, it should focus on the medium term.

ECB Goes Its Own Way in Mission to Revive Inflation

The key is to control inflation expectations. Using the ECB’s preferred measure, they dropped to a record low in March when the pandemic forced most euro-area nations into lockdown.

We are all convinced that a credible inflation objective makes stabilizing inflation easier because the objective anchors inflation expectations. Let us convince our fellow citizens of our determination, in plain language.
— Francois Villeroy de Galhau, Sept. 25

One way policy makers believe they can raise expectations is to make clear that the ECB will allow faster inflation in the future. An approach that views 2% as a medium-term target rather than a ceiling can achieve that, because inflation above 2% wouldn’t automatically trigger tighter policy.

A more symmetric nature makes clear that the degree of acceptance for inflation deviations above the target will be the same as when such deviations are below.
— Pablo Hernandez de Cos, Oct. 1

That’s not the same as the Fed’s new policy of average inflation targeting, which explicitly links future overshoots to past undershoots. The Fed strategy also raises the question of the time frame over which that average is calculated.

ECB officials aren’t convinced it’s the way to go in the euro zone.

The concept places very high demands on households, enterprises and market players [...] I am committed to ensuring that we formulate our goal in an understandable and realistic manner.
— Jens Weidmann, Oct. 7

Ultimately, the ECB’s change to its inflation goal, while potentially significant, may look relatively minor.

For Lane, the current strategy of committing to keep interest rates low and stimulus flowing until the inflation goal is convincingly in sight already, known as forward guidance, is capable of doing much of the work of supporting expectations.

There’s a lot of similarity between our current forward guidance and that family of policies which all say: we’re not going to have knee-jerk policy tightening, we’re going to make sure that inflation is in the neighborhood of where we want it to be before we tighten.
— Lane, Oct. 11

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