The U.S. Federal Reserve has adopted a new inflation target objective. We expect a similar change from the European Central Bank (ECB) when it concludes its Strategic Review in mid-2021. But the ECB will need to do much more than revising its inflation target if it wants to ensure speedy recovery and growth.
At the first-ever virtual Jackson Hole Conference, U.S. Federal Reserve Chairman Jerome Powell announced that the bank will move towards a policy of flexible average inflation targeting. This means the Fed will tolerate inflation above 2 percent for an extended period of time.
The new policy would allow inflation to overshoot the Fed’s target without adhering to a specific formula or time-frame. In layman’s terms, this allows the US economy to “spend and invest without worry that the Fed will curb it”, at least until the longer-term effects of the pandemic-induced recession are understood.
Powell’s announcement comes at a time when major central banks worldwide are experiencing the same challenges. These challenges include below-target inflation rates, slowing global growth and output, exploding balance sheets due to monetary expansion, and policy rates hovering around 0. Compounding this, we are approaching the frightening prospect of the zero-lower bound, at which point monetary policy is deemed powerless.
This is how we entered the Covid-19 pandemic. Since then, these trends have only increased.
Following the Fed policy announcement, the question is whether the ECB will follow suit. However, it is unlikely that the ECB will reveal its strategy before its monetary policy review concludes in mid-2021.
The ECB also faces an additional challenge. The eurozone is a special case as it functions as a central bank to 19 member states, and there are major differences between them. Not only has the euro area average inflation been below the ECB’s target since the financial crisis, but inflation rates have diverged significantly between member states since 2013.
Headline inflation in the Euro area.
(3-month moving average, percent)
The ‘northern’ countries have higher than average but still significantly below-target inflation, while ‘southern’ countries have been hovering below one percent for some time. The figures are even lower when it comes to core inflation (excluding volatile items such as food and energy).
Therefore, lowering the inflation target increases the risk of achieving positive average inflation while letting a few individual countries go into deflation. For that reason, if it was changed the ECB target should be higher, rather than lower.
Even though the ECB made its inflation target symmetric in their communication, “below, but close to, 2 percent” still signals that it will not allow room for overshoot for a period of time to bring average inflation closer to this target.
As the chart below demonstrates, even with this target and forward guidance, the ECB failed to meet its inflation expectations for the last six years. It shows the ECB staff projections for each quarter for core inflation, which have always been revised downwards. The exception to this pattern is for the last June 2020 forecast, where it is projected that core inflation will fall further until at least 2022, before rebounding to pre-pandemic levels. It is clear that inflation expectations have become dangerously de-anchored. It should also be noted that projections are for the euro area average, meaning that the ‘southern’ member states will stay in a debt-deflationary cycle for some time to come.
Euro area core inflation and projections.
Source: Eurostat(prc_hicp_manr) and quarterly ECB staff projections (https://www.ecb.europa.eu/pub/projections/html/index.en.html).
It has been two decades since the ECB set its numerical target. At the Jackson Hole conference of August 2020, Powell clearly departed from the Fed’s pre-financial crisis policy and revised it in response to the growing fear of deflation and secular stagnation. Will the ECB also face this reality?
The ECB’s monetary policy strategy should also consider different options, such as price-level targeting and nominal GDP targeting. Price level targeting implies that the central bank aims for a constant price level, while inflation targeting aims at a steady increase in the price level.
Price level targeting looks at the consumer price index. If the index is performing below a predetermined rate, it will introduce a policy to increase it and vice versa, allowing “more deviations” from the target. Inflation targeting, as practiced by the largest central banks around the world, seeks to fight the steady increase in inflation. As such, it does not allow for deviations and instead seeks to keep inflation steady and even slightly below its target.
Nominal GDP targeting on the other hand implies that, for instance, if the inflation rate increases above its target while growth and output is stagnating, then the central bank will not necessarily move towards curbing inflation. It will take both inflation and real GDP growth into account when setting monetary policy, which could potentially reduce the risk of recession.
It is true that historic examples of both price-level targeting and nominal GDP targeting are scarce. But in a world of persistent debt-deflation, these proposals have many merits and therefore need to be seriously researched, discussed, and considered.
The ECB needs to do more than just revise its inflation target
In the wider debate, whatever option is chosen, the ECB will not be able to credibly achieve its target, if it does not accompany it with other measures and broader policy tools. These measures should include revising how the Harmonized Index of Consumer Prices (HICP, i.e. the headline inflation) is calculated by better incorporating housing prices but also using effective demand stimulation policies such as helicopter money or “QE for the People”. The eurozone and its central bank need to consider all options on the table to escape the looming deflationary cycle and ensure a speedy recovery.
*The authors would like to thank Marie Storli for research assistance.