James Alexander/Jan 25, 2016
Of course we welcomed Mr Draghi’s willingness to ease monetary policy announced with at the January ECB meeting last week. And we recognised the positve impact on markets and therefore on NGDP expectations. But was this just a stopgap response to a poorer negative trend?
The fight over the direction of US monetary policy between the Fed and the markets will continue to dominate the news. The fight within the ECB will also continue, weakening the credibility of Mr Draghi’s easing bias and the current QE efforts. We think he should open a new front against the hawks by starting a discussion of the inflation target itself, the biggest barrier to optimal monetary policy in the Euro Area.
Wolfgang Munchau is right to despair after reading the minutes of the December 2015 ECB meeting.
The ECB has got itself into an extraordinarily difficult position. It has missed its policy target — a headline rate of inflation at “close to but below” two per cent — for four years. The target has lost credibility. Once people have lost confidence in an inflation target, it becomes very hard for the central bank to persuade them to trust the target again.
It was touching to hear Mr Draghi last Thursday talk about failing to reach a goal, then to try again and to fail again. I do not doubt his determination but the minutes of the December 3 meeting of the governing council tell us that not everybody supports the target in the same way. The minutes are anonymous. We know what has been said but not by whom.
What struck me in particular were two specific arguments used by some of the governors against a further increase in the size of asset purchases — part of the programme of quantitative easing aimed at revitalising the eurozone economy.
One said that he would not accept a further increase in QE unless the eurozone was once again in deflation. The implicit message of that statement is that this particular governor’s policy target must be zero per cent, not two per cent. He will only act once prices actually fall.
Another argument was that the positive effects of QE were diminishing over time while the negative side effects, like potential financial instability, were not. This argument is clever but also inconsistent with the policy goal. It is clever in the sense that it is self-fulfilling: if you choose not to increase the level of QE, then its effects diminish over time. And, of course, when the policy is not working, the adverse side effects may dominate.
However, what is infinitely more depressing in the minutes, and so sad too Munchau does not mention it, is the constant reference to the “close to, but below, 2%” inflation target. Expectations are almost everything in life, QE is fine but only as a tool to achieve a target. This inflation target undoes a huge part of the QE and general easing bias. Markets and economic actors know the ECB will tighten if inflation really does start to approach even 1.5% let alone 2%. Such tightening would then crush economic activity just as it did in in the Euro Area in 2008 and 2011.
European mainstream economists seem to think the ECB has a flexible target. But do these economists read the minutes of the policy-making body? It seems not.
Although we were encouraged by the near non-mention of the inflation ceiling target in the recent January ECB press conference, it’s dead hand still appeared, if very late in the statement, chilling all it touches.
Third quarter Euro Area economic growth was modestly encouraging. Signs are that 4Q will continue this trend, although monthly consumer inflation looks too weak for comfort. While many fret about headwinds from the China slowdown or US monetary tightening, the biggest headwind to Euro Area growth remains the inflation ceiling. Even if the Germans seem more inflation-phobic than ever, it would be nice to see some on the ECB open up a discussion about changing to a formally flexible inflation target, if not NGDP target like some Europeans have proposed.