The ECB has once again failed to take action to boost the European economy, either by cutting rates (from their already very low level of 0.25%) or, more effectively, by adopting one or more direct measures to inject liquidity into the economy. This is despite the fact that inflation, at 0.8%, is well below target of close to but below 2%. And it is despite the fact that the Central Bank itself does not see inflation returning to target across its whole forecasting horizon. It is now predicting a rate of 1.7% to be reached by the very end of 2016! HICP inflation fell below 2% in January 2013. In other words, if the ECB is right, by the end of 2016 inflation will have been consistently below 2% for four whole years.
How this can be squared with the ECB’s mandate is a complete mystery to me. Its primary responsibility, to keep inflation close to the target ‘in the medium run’, clearly requires it in my view to take expansionary measures. The current silence of those who questioned the legality of the central bank’s OMT programme before the German Constiutional Court is truly deafening.
I have heard a number of commentators pose the rhetorical question, whether the ECB would not be raising rates if inflation were as far above its target as it is now below. In the jargon: does the ECB have an asymmetric reaction function? Three remarks.
The first is that, while this is a good question, it stacks the cards rather in favour of the ECB, in the sense that most serious economists (and organisations like the IMF) are agreed that deflation (falling prices) is much more worrying than somewhat above-target inflation. All the more so when there is a lot of debt around that economic agents are trying to pay down. But let the cards be so stacked! What, second, does past evidence suggest that the ECB actually does when inflation is above 3%?
(The 3% figure is arrived at thus: the implict 1.9% target means that current inflation is around 1.1 percentage points below target. 1.9 + 1.1% = 3%)
The chart (from the ECB statistical warehouse) shows HICP inflation since the start of the euro.
The first obvious point is that, over the 15 year history of EMU, headline inflation, as measured by the HICP, has very rarely been above 3%. Twice it very briefly spiked above that level: in May 2001 and late 2011. Given the ‘medium-run’ nature of the target – on which more in a minute – these blips can be ignored. Which leaves only the end phase of the pre-crisis boom: from November 2007 to October 2008 inflation was above 3% and touched 4%, only to plunge in the crisis. Overall, in a tightening cycle that had begun at the end of 2005 (see here), the Bank raised base rates nine times. The last two of these occurred in June 2007 and July 2008. Given the well-known long and variable lags of monetary policy, this is a clear sign that the Bank was very concerned to reduce inflation below 3%. So much so that it raised rates despite the Bear Stearns debacle and just a couple of months before Lehman Bros bit the dust.
The picture, third, is even clearer if we look not at headline inflation but rather at a measure of core inflation: the HICP excluding energy and unprocessed food, again published by the ECB. (Why would that be justified? The ECB is supposed to achieve its target, defined in terms of headline inflation, in the medium term. In the short term the inflation numbers are blown around by volatile prices, the most important of which are energy and food. I would argue that core inflation is in fact a much better guide to underlying inflationary pressure, on which a central bank should rightly focus, and indeed the US Federal Reserve favours a similar measure.)
In fact the picture is nothing less than dramatic. If we now ask what the ECB does when core inflation is above 3%, we have to answer: we do not know because the Bank has never allowed it to go that high! Not even close. The peaks were 2.7% in March 2002 and 2.6% in August 2008. We see clearly that the price run-up in 2008 – to which the ECB reacted by hiking rates – was to a considerable extent a reflection of rising energy and food prices.
(Error corrected in this paragraph) The core inflation chart provides clear evidence of monetary policy asymmetry. Of the 181 months of data since the start of monetary union, core inflation was
above below 1.9% in 105. It was below above it in just 59 months (and equal in the rest). More worryingly still, never was core inflation permitted to go as high above target as it has now (and in warly 2010) beeen allowed to descend below. This is despite the fact that the dangers of under- versus overshooting are widely recognised to call, if anything, for asymmetry in the other direction: more robust action against inflation that is too low than too high. Meanwhile the US Fed continues to pump, despite tapering, tens of billions of dollars into bond markets every month, with core inflation rather steady at aound 1.6% and unemployment down to below 7% and falling (EA: 12% and “stable”). You might want to look back to the end of 2010 at this point, but if you are European you can be foregiven for prefering not to be reminded.
The ECB is asymmetric and that is a core problem of the euro area. It is an area in which we need urgent “structural reform”.