I note that the Bundesbank during 1951-98 managed to meet the ECB's definition of price stability in only one third of the years. This shows that the target was too ambitious and explains why there has always been a strong majority on the SC for a symmetric target around 2pc. Indeed, the only reason the Governing Council had for selecting "below 2pc" in contrast to "around 2pc" was the particularly low inflation rate during 1998-99, resulting from weak energy prices at the time - the officials felt it would send the wrong signal if they adopted a definition which accepted higher inflation than the current rate.
The experience of the first (almost) ten years of EMU suggests that the ECB's definition of price stability -- an inflation rate of less than 2% -- is too ambitious. The definition dates back to a time when globalization, deregulation and strong productivity growth, along with two decades of restrictive monetary policies, weighed down on inflation. That was then. Today, emerging market economies -- through their very expansionary monetary policy stance and their hunger for food and energy -- have become a source of global inflation. Also, the productivity boom has ebbed and governments are looking at re-regulating certain sectors, such as the financial industry. Last but not least, the global monetary policy stance has been very expansionary for most of this decade. All of this suggests to me that the ECB and other central banks will have great difficulties meeting their inflation norms over the next several years. To be sure, in theory, the ECB could still achieve it current definition of price stability over the medium term. However, with the headwinds described above, this would require much higher interest rates and larger costs in terms of output than in the 1990s and early part of this decade. Against this backdrop, the ECB faces two equally unpleasant choices. First, maintain the current definition of price stability but (very likely) continue to miss this target in the next several years. Eventually, this would erode credibility and lead to a rise in inflation expectations. Second, acknowledge that the world has changed and raise the rate of inflation that is deemed compatible with (relative) price stability. In today's world of strong global inflation pressures and with more high-inflation countries expected to join the euro in the coming years, a rate of 2.5% would seem appropriate. Of course this would invite criticism that the ECB is changing the goalposts during the game. However, it is better to be open and transparent about the change than to keep missing unrealistic targets year after year.
It's the precision of the target which is disturbing. Increasingly, central banks in the developed world are having to cope with inflationary impulses, both good and bad, coming from elsewhere. A positive supply-side shock - stemming from access to cheap producers elsewhere in the world, let's say - can be absorbed through a reduction in the price level relative to the level of wages, profits and interest rates. This would count as "good deflation". Monetary resistance to this process would leave real interest rates too low, thereby heightening upside risks to asset prices. This seems to fit with the experience of the late-1990s at the time of the dot.com bubble. A negative supply-side shock - higher energy prices, for example - can be absorbed through a rise in the price level relative to the level of wages, profits and interest rates - not quite good inflation, but certainly appropriate inflation. It makes people worse off, reduces their spending, and helps them cope with what is, ultimately, a negative terms of trade shock. Raising interest rates in these circumstances might make matters worse. These relative price shocks are, in my view becoming bigger over time, largely because they stem from emerging market developments which are beyond the control of the ECB or, indeed, the Federal Reserve or Bank of England. They suggest that there should be greater flexibility in the interpretation of the target and over the time horizon. There is, however, an added complication. If the imported inflation/deflation is the result of a supply-side shock, the terms of trade approach is probably right. If, though, the imported price shock is the result of inappropriate monetary conditions elsewhere in the world, the inflationary process might more easily lift off. I'd argue that higher food and energy prices are, in part, a response to overly loose emerging market monetary conditions. Because emerging markets collectively are much bigger than they once were (on our calculations, in aggregate almost as big as the US), and because their inflation rates are racing away, the ECB is faced with some tricky choices. The Bundesbank is the 1970s chose to be a relative inflation outperformer in a world of high inflation (German inflation averaged around 5% per year). If we're facing an emerging market-led inflation shock, the ECB also has to choose whether to be a relative outperformer or, instead, to stick rigorously to the current inflation objective. If the latter, we shouldn't lose sight of the possible output losses. Where, for example, would German growth have been in the 1970s had the Bundesbank forced inflation down to less than 2%?
Perhaps central banks around the world have been suffering a strong case of anchoring: during the late 90s and early 2000s central banks saw inflation hovering around 1-2 percent and thought that 2 percent inflation was thus achievable and the "right" definition of price stability. However, the world was being hit by two tremendous positive supply shocks, the doubling of the labor force and the IT revolution, that contributed to the very low level of inflation. My suspicion is that central banks are slowly realizing that they were too optimistic - not just about the level, but also about the stability of inflation. "Close but below" implies a degree of stability that is probably difficult to achieve in normal times). With now the global economy suffering a clear negative supply shock in the form of commodity inflation, central banks are facing a very difficult dilemma:recognize that they were too optimistic and thus use some escape clause to adapt their frameworks to the new realities; or stick to their frameworks and adopt policy stances accordingly. It seems that central banks are treading a middle road for now, but I am afraid that at some point difficult decisions will have to be made. Price stability is a state of affairs where inflation does not affect the decisions of economic agents. The escape clause for the ECB is the definition of the medium term. 2 years is an arbitrary term, and the central bank can decide to use a shorter or longer period. So the ECB can decide that the inflation objective will be hit in 3 years, rather than 2, and that is perfectly compatible with its mandate. With one caveat: this longer period would affect expectations. So back to the usual statement: for as long as inflation expectations remain well anchored, the central bank can choose when to hit the target. This will probably require a period of undershooting the target later on to compensate and stabilize expectations. So far the ECB has been successful in anchoring expectations, so it can continue with its current strategy.
Since 1999, euro area headline inflation has averaged 2.1% a little above the ECB’s comfort zone of below to but close 2%. This average will likely move up slightly by the end of 2009, based on current inflation forecasts for this year and next, to 2.15%. Underlying measures of inflation have averaged significantly less with ex food, energy, alcohol and tobacco inflation averaging 1.6% since EMU started and ex energy and unprocessed food inflation averaging 1.75%. Total economy unit labour cost growth has averaged as little as 1.4% over that period. So the ECB has done remarkably well since its inception given the adverse shocks that have hit euro area inflation. However, that job is becoming increasingly difficult as global imbalances in the demand and supply of commodities keep euro area imported inflation and thus euro area headline inflation on the high side. There are thus risks that the ECB could be seen as not “being able” to achieve its objective as the main source of the price increases is out of its control and pressures from that side show no signs of abating. So does this rise in global commodity prices - equivalent to a negative supply side shock for the euro area - require a change in the ECB’s definition of price stability? The answer is no in the short term as the drivers behind these price movements are still far from well understood and as a revision to the definition in the current inflationary environment would ensure maximum loss of credibility. But it does require a different policy response than that to a demand shock, dependent on how protracted the supply shock and thus how large the impact on prices and output will be. In my view, the ultimate output loss will be large enough to warrant an ease in the policy rate. The definition of price stability might still need revising in the future should the commodity supply shock turn out to be permanent and/or in the context of monetary union enlargement.
If the objective of monetary policy is to keep the exchange value of money stable, it is questionable as to whether a consumer price index is the appropriate target variable. For instance, consumer price indices do not take into account price developments in asset markets. However, “asset price inflation”, which (and unfortunately so) has become a characteristic feature of “consumer price index targeting”, erodes the value of money just as “normal” consumer price inflation does. Under today’s government controlled paper money the best policy a central bank can follow seems to be one in which it expands the money supply at an ex ante pre-determined constant rate. This should keep (asset price) inflation at bay and, by no means less important, prevent monetary-induced boom-and-bust cycles.
In terms of the current monetary policy, it seems that the ECB’s stance is still overly expansionary. Without higher interest rates (consumer price) inflation is most likely drifting further up. The costs of acting too late, which may even require a kind of “stabilisation recession” at some point, might be pretty high. So better let’s act now than later.
When the ECB translated its mandatory goal of price stability into an operational objective it seemed possible, albeit ambitious, to keep inflation below 2%. Towards the end of the 1990s the world economy benefited from strong dis-inflationary pressures. Integration of key emerging market economies depressed goods prices and the use of new information and communication technologies kept service price inflation in check. Commodities were seen to play a minor role in the new “weightless economy”, and hence prices were subdued. In this environment it was appropriate for a new central bank to aim for an ambitious target for inflation in order to build credibility as an inflation fighter. Ten years on, the global dis-inflationary forces of the late 1990s have vanished and the persistent domestic structural inflationary forces—caused by insufficient competition in goods, services and labour markets—have become much more visible. In my view, these structural inflationary pressures cannot be reduced by monetary policy alone. What is needed is more competition, which can only be achieved by de-regulation and further trade liberalisation in goods and services markets. In labour markets, wage indexation schemes ought to be dismantled and government interference through minimum wages or other mandatory wage setting needs to be reduced. How should the ECB react to the change in the environment? A mechanical enforcement of the inflation target established in easier times would create considerable economic damage and probably eventually undermine popular support for the ECB. Simply dumping the inflation target, on the other hand, could weaken the ECB’s credibility. To solve this dilemma I suggest that the ECB borrow a leaf from the Bank of England and take up the art of letter writing. When inflation exceeds 2% on average in a year, the Council should send a public letter to the Eurogroup of Finance Ministers, explaining the reasons of the overshoot, the action monetary policy is taking to meet the target, and the contribution required from economic policy to bring inflation down again. By engaging in a comprehensive public discussion, possibly over several years to come, the sources of the inflationary pressures would become clearer to all parties involved. In the event, “price stability “ could be defined on the basis of a public discourse and not, as done in the past, fairly arbitrarily by ECB economists.
As for the ECB's rate policy: I find this month’s interest decision especially difficult. Headline inflation is unacceptably high and uncertainty about future financial and economic developments abounds. It is very tempting to remain on the sidelines and to “wait and see”. Yet, I continue to see substantial downside risks to financial stability and growth, and I fear that precious time will be lost if we do not act.
Since euro area inflation has been above the ECB's objective for 8 consecutive years, either the ECB's policy has been too loose or the objective too ambitious. I think that most analysts do not think that the policy has been too loose. One strong piece of evidence is that inflation has not kept rising from year to year, which would have been an indication that inflation expectations were getting higher. The ECB's objective is therefore probably too ambitious. There can be very good reasons for a central bank not to react mechanically to inflation being higher than its objective. And the ECB has been right to implement its policy in a flexible manner. Throughout the period, the ECB has pointed to 'special', 'short-term' factors that have pushed inflation above 2% (or 1.8-1.9% depending on how one wants to translate the ECB's objective into one single quantitative target). But it is now between a rock and a hard place. It risks loosing credibility by again blaming 'too high' inflation on some kind of special factor - typically oil and food. But it also risks loosing credibility by changing its objective at a time when inflation is so high. I think that a review of the objective is warranted. After all, no one, not even the ECB, knew how the economies of the euro area would develop once joined by a common currency. One would hope that we have learned about the structural features of the euro area as a whole and that one can, with the benefit of the experience of these past years, devise a more appropriate policy. But I think that it would be very difficult for the ECB to carry out this review in the present circumstances. We need to hope that inflation will come down and that the ECB can take this opportunity to review its objective. This is not without risk as the longer the ECB waits the more it risks loosing credibility as inflation keeps coming in well above 2%.
Is the ECB's target too ambitious? The task of the ECB is to pursue price stability, not moderate inflation. Hence its target seems appropriate. Is this too ambitious in a heterogeneous monetary area? It all depends on the nature of the prevailing shocks. If, as at present, a strong negative supply shock arrives it becomes of course more difficult to maintain price stability. Moreover, the ECB has in reality been rather flexible and looked forward, rather than backwards. The ECB should aim at getting inflation back to close to 2 % by next year. But should inflation in 2009 be still higher it will probably again look forward and try for the following year.
With regard to the ECB's monetary policy options: As the acute financial crisis seems to be nearing its end, the ECB should refocus on its long term mission of safeguarding price stability. Inflation is proving consistently higher than predicted and the widely held expectation that it would fall quickly with a sharp slowing of economic activity had to be revised as new data points to growth continuing, albeit at a much lower pace. It is still likely that the eurozone will experience a protracted slowdown as house prices in a number of countries (Spain, France and Italy) fall further. This process will take time, probably years, but this is unlikely on its own to guarantee price stability. Continuing vigilance is thus necessary.
The ECB has almost never achieved its stated objective of less than 2% inflation. Many good reasons have been given on an ad hoc basis. But shocks are in the nature of real life; they happened, they will happen again. If the ECB were like the Bank of England, “Letters” would have been sent aplenty to the European Chancellor. Fortunately for the Bank, and unfortunately for democratic accountability, there is no European Chancellor and the mandate is too weak to require explanations beyond the soothing statements of the ECB. The ECB has delivered what most mortals would qualify as price stability, but not its own characterization of price stability. Looking around the world, the ECB is almost unique – the Swiss National Bank is the other exception – in being committed to less than 2%. Other central banks typically aim at around 2%, sometimes more. (The Fed is another poor example but we all know about its dual mandate.) A reasonable conclusion is that the ECB has missed its objective not because it has conducted a bad policy, but because the objective is too strict. Some of us have written at length about this aspect, in fact since 1998, before the euro came into existence. The usual answer has been that the ECB must wear the Bundesbank’s mantle of credibility. This is quite disingenuous. One reason is that, in its fifty years of existence as a real central bank, the Bundesbank has rarely managed to keep inflation below 2%, especially over its last three decades. The other reason is that missing one’s own objective is not helpful in achieving credibility. The ECB is credible as an inflation-fighter, even though it hasn’t achieved what it set out to do. It should simply acknowledge that its objective is far too ambitious. “Not now!” has been its response. Too early, they said first. When we get below 2%, they said next. Certainly not now, they will say again, when inflation is close to 4%. Now, it seems, is never the time to acknowledge a mistake, even if it is inconsequential. I disagree. Now is always better than later.
An inflation target of below two percent does seem too ambitious. In the absence of any shock from international conditions (commodity or gloabal competition conditions), two percent inflation is probably close to the equilibrium level in mature industrialised countries. This means that:
- as the monetary union is set for integrating a increasing number of partners, with the new one having generally structurally higher inflation due to their lower level of productivity, targeting two percent inflation on average means lower than two percent for the most developped countries of the union. This is below what the economic analysis suggests to be the level of inflation in healthy industrialised countries. The one sized fit all monetary policy being by nature more accommodative for the less developed economies with higher inflation than it is for the others, the only way to achieve the overall target is to dampen inflation forces below what they should be in a normal situation in the most developed countries of the union.
- as international conditions on commodity markets and global competition are by nature exogeneous, any external inflationary shock would need domestic conditions to compensate for them. This is struturally very negative as once again it imposes abnormal contraints on domestic conditions to offset external price pressures. In the current context it would require domestic prices to offset sharply rising commodity prices which is simply unachievable except in a case of a hard recession. Whatever the timetable the ECB has in mind to return to below two percent, this policy would be very costly: It might even be unachievable, if the world inflation standard moves higher than it has been in the past, which seems highly likely.
As regards the monetary policy recommendation: economic conditions in the emu area are deteriorating rapidly, while we are just at the very beginning of the slowdown process. Sure inflation is a problem, this is however just hurting further domestic demand which is already under the strain of tight lending conditions and the housing market slowdown. This seems to call for policy easing.
There are certainly a growing number of signs that economic growth in the euro area will slow down in the second quarter of 2008 after a surprisingly strong first quarter. However, despite this likely weakening I expect economic growth in the average of 2008 to be close to its long term trend. So for the time being no urgency measures are necessary to stimulate the economy in the average of the euro area via monetary policy; for this purpose fiscal measures in some member countries appear to be more appropriate. On the other hand inflation expectations are still high and only slowly begin to soften somewhat. In this environment it makes sense to wait with any cut in interest rates some more months. A new situation would arise if economic growth in the euro area in the second half of the year would not - as expected – show signs of a moderate strengthening.
The very recent data on inflation in Germany suggests that, most likely, a cooling of the macroeconomic outlook is finally containing the pressure on prices experienced in the euro area in the last few months, arguably helped by the strong euro exchange rate. Synthetic indicators of the cycle, such as the €-coin remain broadly stable in April, at the level reached in February and March, which were however reached after a prolonged decline. We are quite used by now to conflicting news, and this month is no exception (e.g. surveys record more pessimism, industrial production still shows positive dynamics, financial markets remain volatile). However, as new pieces of information could relax concerns about inflation, the current monetary stance still appears appropriate.
GDP growth probably continued at a moderately sub-trend pace in 1Q, and is likely to slow further in the current quarter. Consumption remains very sluggish, implying together with housing weakness, that domestic demand continues to moderate. Emerging market demand remains dynamic but overall export orders are correcting downwards, reflecting a severe downturn in the U.S. and the U.K. Despite attempts by the ECB to counter tensions, money market rates have rebounded again; at the same time, corporate bond yields remain elevated and the euro is stronger than three months ago, all that implying another tightening of monetary conditions. I now expect GDP growth to average 1.4% this year and no higher than that in 2009, implying two years of clearly sub-par expansion. Early indications suggest that the surprising jump of inflation in March was corrected in April, tenatively confirming the expectation that the inflation spike since last September would soon be over. The real uncertainty at the moment hovers around the pace of the correction downwards, given the difficulty in predicting food and energy prices. Energy prices rose again in April, even measured in euros. However, “hot” food prices (milk, cereals) are cooling down appreciably at the wholesale level, confirming tentative indications at the time of last month’s meeting, and the appreciation of the euro is lowering import prices of manufactures. Inflation expectations remain reasonably contained, and the recent wage agreements point to an area-wide acceleration of negotiated wages this year to about 2.75% (compared with about 2.25% in recent years). The probability of a below-2% inflation rate in 2009 remains high, especially as the opening output gap will start to help soon. There is no new bank lending survey for the euro area but the ones released in other countries in recent weeks (U.K., Norway) and anecdotal evidence suggests that the tightening of standards since late last year probably is intensifying. Lending to households was almost flat in the four months to March. The still strong bank lending to non-financial corporations probably masks a much weaker performance of total financing, because of the virtual freeze of debt and equity issuance. All in all, the current level of short-term rates (above 4.80%) are equivalent, under normal circumstances, to policy rates of 4.50%, which appear to high for an expected nominal GDP growth of less than 4% this year and next.