The ECB Must Show Leadership to Fight Threat of Deflation

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As the recent experience in the US and Japan has shown (and the FT’s James Mackintosh” explains), quantitative easing may produce its strongest effects on financial markets before the policy is implemented. In other words, it is the expectation that the central bank will embark on massive asset purchase that matters most, more than the purchase itself. And the more markets are convinced that the policy will be successful, the less the central bank may need to actually intervene.

When it comes to the eurozone, markets continue to have doubts about whether the European Central Bank will ultimately be willing to purchase government bonds. Indeed, such a policy decision seems to raise legal and institutional issues that make it “the instrument of last resort”. The ECB has clarified that the purchase of government bonds in the secondary market is not prohibited by its statutes, and can be used if the purchase of private assets is insufficient to boost the size of the balance sheet back to 2012 levels.

Another reason for the uncertainty is that while incoming data and projections suggest the ECB is at risk of not achieving its primary objective of price stability, the concept seems to be the subject of interpretation. Like most other central banks in advanced economies, with the exception of the US Federal Reserve which has a dual mandate, the ECB’s primary objective is price stability. But unlike most of its peers, the ECB gets to define what it means. And differently from most other central banks, the ECB has adopted an asymmetric definition, ie, “below but close to 2 per cent over the medium term”.

At the start of European monetary union the definition of price stability was simply “below 2 per cent”. The main reason might have been that the ECB was a newly created institution which had to build its reputation as an inflation fighter. Indicating a precise target might have led inflation expectations to remain excessively high for too long.

The definition was reviewed in 2003. The words “but close to” were then added to the “below 2 per cent”. The intention was to make it clear “that not only inflation above 2 per cent but also deflation (ie, price level declines) is inconsistent with price stability”. This seemed appropriate at that time as inflation was temporarily falling. But the fears of deflation or low inflation subsided, while inflation expectations remained well anchored.

What the 2003 change does not clarify is whether a positive but low level of price increase is consistent or not with price stability. Is 0.5 per cent inflation consistent with price stability? Probably not. What about 1.5 per cent?

The issue is relevant for several reasons. First, protracted low inflation may be as disruptive as deflation, especially in the aftermath of a global financial crisis, where public and private agents need to deleverage. It may progressively unsettle inflation expectations, leading to excessively high real interest rates, which produces recessionary effects.

Second, protracted low inflation in the eurozone makes it more difficult to adjust internal imbalances, both for the surplus and deficit countries, and may trap the eurozone in a low-growth equilibrium.

Third, the argument that the ECB needs to keep inflation lower than needed to strengthen its credibility is no longer valid. The average inflation over the first 16 years of monetary union is well below 2 per cent, and projected to remain lower. The ECB does not need any more to prove its anti-inflation credentials. Critics who have accused the ECB of having been too expansionary or taken too many risks have been proved systematically wrong. They should recognise it.

Finally, low inflation produces an undesired narcotic effect on people, as they believe this increases their purchasing power. Convincing them this is not consistent with price stability is much more difficult. It requires explaining that low inflation is the result of excess savings and leads over time to low growth and higher unemployment. People may need to see these effects before accepting that monetary policy has to become more expansionary, which implies acting too late.

These arguments suggest it may be time for the ECB to further clarify its strategy by giving a more precise definition of price stability, either in a symmetric way, for instance 2 per cent, or with a range, for instance 1.5-2.5 per cent. The reference to the medium term should remain. It is needed to explain that monetary policy operates with long and variable lags.

A further refinement of the concept of price stability would help eurozone citizens and financial market participants to better understand the ECB’s policy intentions, and thus strengthen its accountability. It would also reinforce the credibility and effectiveness of its actions. This possibly means that the ECB’s overall purchase of government bonds would be lower than otherwise be the case.

When change is needed, it is better to initiate it, and show leadership, than having to adapt.

Last updated on 12/02/2014