Fed’s new inflation strategy is not a good guide for the ECB
The review of the ECB’s policy strategy has been delayed by the outbreak of the Covid-19 pandemic. Preliminary conclusions are not expected before the second half of 2021. Nevertheless, it seems already clear that the Fed’s recent adoption of a framework of average inflation targeting is not a suitable guide for the ECB. There are conceptual objections to this approach, and it risks destabilising inflation expectations in the short to medium term. Moreover, there is so far little empirical evidence that this policy strategy is more effective than classical inflation targeting. A related issue is credibility: if all major central banks have been unable to reach their inflation targets in the past decade, why should markets believe that monetary policy may succeed in even engineering an overshooting, without having to rely heavily on a excessive fiscal stimulus? For these reasons, the ECB should stick to its current framework of classical inflation targeting. Moreover, the ECB should consider returning to its initial policy objective at the start of the EMU. That objective defined price stability as inflation below 2%, without the reference to ‘close to 2%’ added in the 2003 policy review. This would acknowledge the structurally lower global inflation rate. It would also eliminate the need for extreme unconventional monetary policy in pursuit of an unattainable inflation objective that has become a goal in itself.
In August 2020, the US Federal Reserve concluded its monetary policy review, moving, among other decisions, from classical inflation targeting to an average inflation objective. However, this new policy approach has flaws. Average inflation targeting is equivalent to implicit price level targeting. While there is a theoretical case for targeting a moderately positive inflation rate in a world with nominal price rigidities (facilitating changes of relative prices and thus supporting the efficient allocation of resources), there is no such theoretical case for directly targeting the price level itself. The reason is the backward looking nature of an average inflation target, as opposed to the forward looking nature of a classical inflation target. If the argument in favour of a moderate inflation rate is that it ‘greases’ the functioning of the economy, past inflation rates should not matter.
This ‘make-up’ feature of average inflation targeting sooner or later leads to a policy dilemma. If too low inflation is caused by economic slack, it is not controversial that the central bank allows this slack to be fully eliminated before tightening, even if that comes at the cost of temporarily higher inflation. On the contrary, the central bank will probably not follow the same reasoning if temporarily higher inflation occurs in combination with strong growth and low unemployment. When such a temporary positive demand shock is fading out, it is not credible that the central bank will deliberately further slow down growth and raise unemployment only to reach its backward looking average inflation target. Hence the credibility of the whole policy framework is questionable.
Furthermore, despite the proponents’ argument that average inflation targeting stabilises long term inflation expectations, there is a risk that it actually destabilises them in the short to medium term. It will take some time before the market learns how far the central bank looks into the past to ‘calculate’ the relevant average inflation rate, and hence the desired future inflation rate for the future. Related to this, actual short term inflation volatility is likely to increase, leading to a higher inflation risk premium required by bond markets.
Finally, as the Japanese experience shows, there is little empirical evidence that average inflation targeting is more effective than classical inflation targeting. To fight low inflation, the Bank of Japan has pledged to expand its monetary base until inflation persistently overshoots its target rate of 2%. So far, however, this has not delivered the hoped-for inflation boost. This raises a crucial credibility issue: if all major central banks have consistently undershot their inflation targets in the past decade, why should markets now believe their announcement that they are able to engineer a persistent overshooting, without having to rely heavily on an excessive fiscal stimulus?
What lessons for the ECB?
For all these reasons, the ECB should resist the temptation to conform to the Fed’s example when concluding its own review in 2021 and stick to its current classical inflation targeting. At the start of the EMU, the ECB’s original definition of price stability was an inflation rate of “below 2%”. The main purpose was to reassure financial markets that the ECB would follow the footsteps of the Bundesbank. The idea that too low inflation may become problematic was initially of no concern. Only in 2003 was this definition ‘clarified’ by including “close to 2%” to avoid the perception that even 0% or outright deflation would in principle be acceptable.
Despite all the ECB’s policy efforts so far, inflation in the euro area has been systematically below the policy objective in the past decade. Given this apparent inability to raise inflation in a relevant time horizon, any updated ECB strategy should acknowledge this New Normal. This does not require explicitly reducing the inflation target itself. The easiest way to achieve this would be for the ECB to return to its original definition of price stability, with an added zero lower bound for inflation.
As such, a lower inflation rate would not be harmful. After all, the commonly used inflation target of 2% is a somewhat arbitrary balancing of the various theoretical arguments for what the optimal inflation rate should be. Put simply, in an ideal and frictionless economy, the long-run inflation rate would not matter for the real economy (the so-called ‘neutrality of money’). In the real world, however, nominal (downward) price rigidities and lower bound constraints for central banks do exist, making the case for some positive inflation to facilitate adjustments of relative real prices. However, if this inflation rate becomes too high, it distorts the price signals necessary for an efficient resource allocation. An inflation target of 2% is therefore considered to be a reasonable, but ultimately arbitrary, compromise of this trade-off.
A return to its original policy objective is unlikely to affect the ECB’s credibility. Markets are already familiar with the objective and are also aware that moderate inflation is a global phenomenon, largely beyond the ECB’s control. This is consistent with the observation that inflation expectations of financial markets are already in line with the ECB’s original definition of price stability (see Figure 1).
Reverting to the ECB’s original inflation objective would have a clear advantage. If we look beyond the Covid-19-related short term inflation volatility, the actual inflation rate would lie comfortably within the new target zone. Hence the need for highly unconventional monetary policy measures would immediately disappear. Hence policy measures, that are justified only by the fact that inflation remains below its current target, can be reversed.
In times of a pandemic, there may be good reasons for a central bank to run large-scale asset purchase programmes to support the economy. Trying to reach an inflation target that has become a goal in itself is not one of them.