What is inflation target
A higher inflation target for the ECB? –
The European Central Bank (ECB) is currently discussing its monetary policy strategy and in particular the specification of its inflation target. So far, the ECB has defined the implementation of the contractually stipulated target of price level stability as an inflation rate in the medium term of below, but close to, 2% per year. It is now being discussed whether to increase this target slightly to 2% and to aim for its achievement on average over several years (Lagarde, 2020). Both elements are quite surprising, since the realized inflation rate has tended to be lower in recent years and since a multi-year average further expands the scope of the ECB for a more expansive monetary policy. Why is the discussion still going in this direction and what are the pros and cons?
Review of strategy development
The development of the ECB's strategy is best understood by looking at its history. When the plan for a newly founded ECB was concretized in the 1990s, the role model of a successful central bank in Europe was certainly the Deutsche Bundesbank. This had an impressive history of price level stability in an inflationary international environment. In the 1970s, it was the first central bank to introduce monetary targets and to derive them from projections. Part of this justification of their policy was the assumption of an "unavoidable" increase in price levels at the time, which has been 2% per year since 1985.
This 2% was primarily a pragmatically chosen value, because in the 1970s and up to the early 1980s the inflation rates were also quite high in Germany, up to around 6% to 7% per year. Against this background, 2% was a very moderate value for an accepted inflation rate and should form an anchor for reducing and developing stable inflation expectations. In fact, the Bundesbank, especially its long-time chief economist and temporary President Helmut Schlesinger (1976), did not regard inflation rates well below 2% as absurd.
When designing the ECB strategy, it made sense to orientate oneself on the model of the Bundesbank, especially since Ottmar Issing, the former chief economist of the Bundesbank, an intimate connoisseur of the monetary concept, had switched to the position of the first chief economist. The original approach was formulated as a two-pillar strategy, with the first pillar following on from the tradition of the Bundesbank with the derivation of a monetary target, while the second pillar formulated a broad analysis of the price level environment. The target figure was a price level increase of less than 2% per year, as measured by the newly established Harmonized Index of Consumer Prices (HICP).
As a result of the strategy review after the first years of practice at the ECB, there were two changes. On the one hand, the two pillars have now been given a new ranking, with the “old” money supply target being formulated more softly and viewed as secondary. In contrast, the analysis of the price level environment was placed in the foreground. The second change was a slight refinement of the price level target to the current formulation. Basically, the ECB had thus made the transition from a money supply strategy (as the Bundesbank had formally practiced) to an inflation target.
Since its start as an institution responsible for monetary policy on January 1, 1999, the ECB has, by and large, achieved its goal of price level stability well. Inflation rates in the euro area have almost always moved in a range of around 1% to 3%, with a slightly downward trend (see Figure 1). In particular, the two major economic crises in 2008/2009 and 2020, the sovereign debt crisis in the middle of the last decade and oil price shocks are easy to recognize. An international comparison also shows how much inflation rates have changed since the 1970s. The central banks of other industrialized and emerging countries, such as the US Federal Reserve (Fed), “achieve” a level of price level stability that is comparable to that of the ECB.
Inflation in the euro area and in the USA and the price of oil
Sources: Eurostat (2020); OECD (2020); U.S. EIA (2020); own representation.
Is the risk of deflation a current problem?
Due to the recently often low inflation rates, there are discussions as to whether the ECB could miss its inflation target and instead threaten the euro area with deflation. This is one of the reasons for the extremely expansionary monetary policy of recent years. In fact, average inflation rates have remained in the 1% to 2% range, and only major crises and falling commodity prices have pushed inflation rates below this range. However, this may be partly due to the expansionary monetary policy. In addition, it is also stated that the structural changes in the context of globalization with the expansion of the workforce and the declining dynamics of aging societies have led to inflation rates remaining low all over the world (Summers, 2014; see also Figure 1) .
After all, if the risk of deflation is seen as a central problem, then an increase in the inflation target is a measure that is in line with the target. It is hoped that, with credible forward guidance, inflation expectations can be increased without monetary policy having to become active in the short term (in the USA, the increased inflation target has not yet been reflected in household inflation expectations, Coibion et al., 2020). In the medium term, however, the ECB is called upon to achieve its goal.
A possibly bigger problem than the average inflation rate is the heterogeneity in the euro area. The inflation rates in the participating countries can be very different. Not only did inflation rates decline over time, but also differences within the euro area. Nevertheless, there are still some significant differences, such as 2019 (see Figure 2). It cannot therefore be ruled out that individual, especially smaller, national economies will go through phases with negative inflation rates and, at the same time, positive average inflation in the euro area.
Inflation rates in numerous member states of the euro area 2019
Note: Country code according to ISO-3166 Alpha-2. Order of countries according to gross domestic product.
Source: OECD (2020); own representation.
Are temporarily negative inflation rates a greater danger than temporarily positive ones? In general, central banks emphasize the dangers that temporarily negative inflation rates will lead to expectations of permanently falling prices, with corresponding negative consequences for the demand for goods and thus economic development (European Central Bank 2011). The central variable are therefore the inflation expectations. In the euro area, however, these are quite stable. Private households, companies and experts seem to understand that falling inflation rates, including negative ones, are due to exogenous shocks, and they expect the ECB to stick to its original inflation target. In particular, the inflation expectations for the 5-year period are very persistent compared to the current inflation rates. This means that they are firmly anchored in line with the ECB's inflation target and are well below the zero limit (see Figure 3). However, the shorter-term expectations in particular react slightly to the current inflation trend (Möhrle and Wollmershäuser, 2020), so that the divergence to an increased inflation target increases.
Euro Area Inflation: Actual and Expected
Sources: ECB (2020); Eurostat (2020); own representation.
Consequences of unconventional monetary policy
In its pronouncements, the ECB has always emphasized the risk of possible deflation in order to justify its expansionary monetary policy. Since the short-term interest rates were already close to zero as a result of the global economic and financial crisis in 2008/2009 and the subsequent sovereign debt and banking crisis in the euro area, the ECB followed the example of the Fed and has since used newer instruments of the so-called "unconventional" Monetary policy. Essentially, it is about buying securities in order to increase the central bank money supply and to keep long-term interest rates low. A - not undesirable - side aspect of this policy is to generate considerable demand, especially for government bonds from member states.
In most empirical studies on this topic, the unconventional monetary policies of various central banks lead to falling interest rates and usually to an expanding real economy (Bernoth et al., 2015). The debate is less about the fact of an effect and more about the benefit-cost ratio. The ECB argues that the growth impact can be achieved in goods and services without inflation, so its main objective is not jeopardized. Critics, on the other hand, point to an inflationary effect on asset prices.
It is difficult to negate the latter, because it follows logically from the expansionary monetary policy. In current valuation models for asset prices, the risk-free interest rate is used as a discount factor, and if this is close to zero, then the consideration of long periods of future income of an asset consequently leads to valuations of almost any level. This is compatible with the empirical illustration in Figure 4, in which for the years after the great economic crisis the total assets of the ECB (as a proxy for its unconventional monetary policy), the nominal gross domestic product of the euro area and the Euro Stoxx 600 as a measure of the development of the stock markets be compared in the euro area (Deutsche Bundesbank, 2019, on residential real estate).
ECB total assets, gross domestic product and European share index Euro Stoxx 600
Sources: ECB (2020); Eurostat (2020); Thomson Reuters Datastream (2020); own representation.
Increased, multi-year inflation target?
Against this background, it is astonishing that - based on the Fed's approach - there is discussion of slightly increasing the inflation target and stretching it out over the years. One could actually expect that a futile attempt to achieve the inflation target - despite extremely expansionary policy - would give reason to possibly adjust the target downwards, because monetary policy is obviously finding it difficult to implement higher inflation rates. There are good reasons, precisely because of globalization, why inflation is so low. And if inflation is actually contained by high and cheap labor potential, then this does not lead to deflation, but rather describes an equilibrium.
Formulating a multi-year inflation target would also have far-reaching political consequences. The ECB is already aligning its monetary policy to the medium term, thus taking into account the fact that the transmission delays are not only long, but also vary in time and size (European Central Bank, 2011; Gischer et al., 2020). It does not try to immediately and completely neutralize a deflationary shock in the goods market, but rather tolerates deviations and is aiming for an inflation rate of just under 2% again in the medium term. Under a regime of multi-year inflation targets, as announced by the Fed in the summer and also brought into play by President Lagarde for the ECB, the ECB would react to a (temporary) decline in the inflation rate below the target value with a monetary policy that would increase the inflation rate in the future for raises the same period of time above the target value accordingly. Monetary policy is therefore no longer only future-oriented, but also reacts to developments in the past. Former ECB Vice President Christian Noyer considers this to be an “extremely risky” strategy (Handelsblatt 2020). For example, after falling below the inflation target by one percentage point for ten years, the ECB would have to achieve a value of 3% for a decade in order to achieve the average of 2%. Obviously, this would come at a huge cost to the economy. A more volatile development of the inflation rate would then have to be expected.
Considering an increased multi-year inflation target therefore means nothing more than continuing the current monetary policy over the medium term. What is more, the inflation expectations and then the inflation rate are supposed to be brought to 2% by force, so to speak. You have to be very sure of your cause in order to increase the stake further, i.e. to expand a multiplied central bank balance sheet (and central bank money supply) again significantly.
The considerations made not only increase the costs of the previous policy in the sense of a prolonged phase of inflated asset prices, but they may also endanger the stability of the monetary system. Historically, it has always been easy to devalue. In the past, this typically involved inflationary financed national debt. Now, on the other hand, it looks like the threat of deflation should be counteracted. But the economic processes are not so different that one can be sure that current politics will not slide off. Not that the ECB is deliberately managing this, but isn't it risking its credibility?
On the one hand, from a monetary policy point of view, it is a risky strategy to try to raise inflation with a lot of money when you realize that this is hardly possible. It is not a new insight that inflation is not just a monetary phenomenon and in any case does not correlate one-to-one with the (central bank) money supply. But if this is true, then not only today, but also in the future, when the inflation rate - finally? - goes beyond the 2%. If monetary expansion is scaled back, will this automatically limit inflation? If the ECB loses confidence, it can also lose control of a restriction process and the adjustment costs can rise significantly.
On the other hand, it can happen that the policy of the ECB makes the one day imminent restriction impossible. This is difficult to imagine at the moment, but there may be scenarios in which the ECB can no longer act as autonomously as it seems natural today. Central bank independence is only one period in their history. The more the ECB embarks on a strategy that appears attractive today, but the costs of which may appear later, the more so.
The risks indicated would be more manageable if Europe were to face a dynamic economic future, as many countries experienced after 1945. Then the ECB could stop monetary expansion, the real economy would gradually fill the large monetary cloak, figuratively speaking, the states would outgrow their debts if successful, and the situation would be resolved without painful adjustment processes. But is that realistic? Doesn't Europe have fundamental structural problems, not least an aging population, which make low growth rates much more realistic?
Understanding of the role of the ECB
The current economic situation, triggered by the corona-related pandemic, is certainly an enormous challenge for economic policy. And monetary policy in Europe was certainly able to act quickly due to the unified decision and the waiver of direct parliamentary control. In the interplay of the policy areas, monetary policy has given the other policymakers room to maneuver without inflation becoming a problem. However, these are not good reasons why monetary policy is not only strengthening its currently extremely expansionary course with the new Pandemic Emergency Purchase Program (PEPP), but is also making its monetary policy goals more expansive.
Bernoth, K., P. König and C. Raab (2015), Large-Scale Asset Purchases by Central Banks II: Empirical Evidence, DIW Roundup, 61.
Coibion, O., Y. Gorodnichenko, E. S. Knotek II and R. Schoenle (2020), Average Inflation Targeting and Household Expectations, Federal Reserve Bank of Cleveland, Working paper, No. 20-26.
Deutsche Bundesbank (2010), Price level control as a monetary policy strategy, Monthly report January, 31-46.
Deutsche Bundesbank (2019), Financial stability report.
European Central Bank (2011), The monetary policy of the ECB.
Gischer, H., B. Herz and L. Menkhoff (2020), Money, credit and banks. An introduction, 4th ed., Springer.
Handelsblatt (2020), Lagarde opens the door to a more flexible inflation target, Handelsblatt, 30th of November.
Lagarde, C. (2020), The monetary policy strategy review: some preliminary considerations, speech at the "ECB and Its Watchers XXI" conference, 30th of November.
Möhrle, S. and T.Wollmershäuser (2020), On the threatened unanchoring of inflation expectations in the Eurozone and the scope of action of the ECB, ifo express service, 73(10), 30-32.
Schlesinger, H. (1976), Monetary Policy in the Reconstruction Phase (1950-1958), in Deutsche Bundesbank (Ed.), Currency and Economy in Germany 1876-1975.
Summers, L. H. (2014), U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound, Business economics, 49(2), 65-73.
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