Should the ECB Reformulate its Inflation Objective?

Summary

The European Central Bank (ECB) is in the process of reviewing its monetary policy strategy. A majority of CfM-CEPR panel members support allowing inflation to exceed 2% following periods when inflation has been below target and making more explicit its secondary objective of supporting economic growth and full employment. Only a minority supports increasing the inflation target itself.

Background

The October 2020 CfM-CEPR survey asked members of its European panel to evaluate a variety of proposals for changes in the ECB’s strategy that have been in the policy discussion.

The European Central Bank’s Monetary Policy Strategy Review                                                        

The ECB is in the process of reviewing its monetary policy strategy. The review was due to for the end of 2020, but was postponed to mid-2021 because of the Covid-19 pandemic. The review will consider whether the ECB’s inflation aim should be reformulated and over which time horizon prices should be stabilized, among other questions.

Across the Atlantic, the Federal Reserve concluded its own strategic review in August.  One of the policy changes arising from the review was a commitment by the Fed to allow inflation to overshoot if inflation was persistently below its long-term target of 2 percent. As Fed Chairman Jay Powell stated in the Fed’s September 16 statement: “With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent.”

The Fed’s review also acknowledged that the Board may have overestimated the inflationary implications of the historically low unemployment rate at the end of the previous decade. Given the Fed’s dual mandate, this has been viewed by some as a de facto shift to a larger weight on unemployment in the Federal Reserve’s future policy decisions.

In contrast, the ECB’s mandate calls for price stability as its primary goal, with no specific labor market objective. In its previous review of 2003, the ECB interpreted its price stability goal as aiming for inflation “below, but close to, 2% over the medium term”. European inflation has met this target, averaging 1.7% since the euro was introduced. However, this average conflates the period before 2008, where inflation averaged around 2%, and the past decade, where inflation has averaged 1.3% and was in negative territory on several occasions.

In a recent speech discussing the pending strategic review, ECB President Christine Lagarde expressed support for moving to a more symmetrical target, with possible overshooting of the inflation target to compensate for past low inflation. As she puts it: “to underpin inflation expectations, we need to ensure that our aim is perceived to be symmetric by the public.” In support of this view, she argues that this policy “helps ensure that monetary policy is not forced too often towards the effective lower bound – the level of interest rates at which further cuts do not have the desired positive impact – when faced with shocks that push inflation too low.” This view is backed by Evans et al (2015) who argue that the asymmetry caused by the zero lower bound requires some policy accommodation following episodes of low interest rates (see also the arguments for symmetrical targets in Demertzis and Viegi, 2008 and 2010).

Banque de France President François Villeroy de Galhau has gone further and has argued that the existing framework already calls for a symmetric inflation target. In contrast, Deutsche Bundesbank President Jens Weidmann has rejected the notion that the existing target is symmetrical.

The panel was asked to express opinions on needed revisions to the ECB’s monetary policy framework.

Question 1: Which of the following best reflects your opinion on the following statement? “The ECB should explicitly state that it will allow inflation to temporarily exceed the 2% target following extended periods of low inflation.”

Thirty-six panelists responded to this question. The vast majority of panelists (75%) believe that the inflation target should be allowed to exceed its 2% target. This share increases further when weighting responses by panelists’ self-assessed confidence levels.

Panelists put forth a number of arguments in favor of allowing inflation to exceed its target following periods of below-target inflation. First, low real interest rates inevitably mean that the ECB will be hitting zero nominal interest rates more frequently. As Pietro Reichlin ( Università LUISS Guido Carli) put it: “ There is large consensus that structural problems (demographics, pace of innovation, excess savings) are behind a long term fall of real interest rates, so that the range of inflation rates compatible with the zero lower bound is shrinking.”  Second, in the current context, this policy would add credibility to monetary policy announcements calling for a prolonged period of low interest rates. Francesca Monti (King’s College London) writes that “the makeup strategy… would make the current low-for-longer policies more credible… and therefore more effective.” Third, this policy could avoid the scarring effects of recessions. Wendy Carlin (University College London) posits that “allowing inflation to rise above target is part of a strategy that (implicitly) targets the pre-recession output level, avoiding a permanent loss of output arising from scarring.”.

Opponents of this proposal pointed its lack of clarity, credibility, and implementability. Regarding clarity and credibility, Robert Kollmann  (Université Libre de Bruxelles) asserts that “to keep her credibility, the ECB needs clear and verifiable objectives. The freedom to [allow] ‘inflation to temporarily exceed the 2% target following extended periods of low inflation’ seems too vague: What is the meaning of ‘temporary’? By how much would inflation be allowed to overshoot?” On implementability, Martin Ellison (University of Oxford) expresses his doubts: “Average inflation has been well below 2% over the last decade, despite the best attempts of the ECB to follow unconventional policies. From that base, it’s difficult to believe that a promise to support higher inflation after a period of low inflation will have much bite.”  Michael McMahon (University of Oxford) further points out that nothing prevents the ECB from doing so under its current stated objective: “[the ECB] is already able to do this and has had periods of its history when inflation was above target. The bigger issue is that the target is not 2% but rather the target it close to but below, with plenty of ambiguity about exactly what that is. So 1.8% is likely above its target, or, more precisely, above the definition of price stability to fulfil its price stability objective.” Kate Barker (Universities Superannuation Scheme) adds that “this change seems to me to fail two tests. It might prove hard to achieve (failing credibility) and in the long run poses the challenge of what to do following high inflation as a result of a fall in the exchange rate”.

Martin Ellison, Michael Wickens (Cardiff Business School & University of York) and Simon Wren-Lewis (University of Oxford) compared this policy proposal to price level targeting, but differed on whether this was desirable or not. Martin Ellison refers to this policy as a “poor man’s price level target”.

A higher inflation target?

A related question is whether a 2% inflation target is appropriate when the (real) natural rate of interest is low and potentially negative. Revising the inflation target doesn’t appear to be part of the ECB’s strategic review and the Federal Reserve Chairman has rejected this possibility in the US. Nevertheless, several academic economists have suggested that a higher inflation target (e.g. 4%) is more appropriate in light of low equilibrium real rates (see for example Blanchard et al 2010 and Andrade et al 2019). In this regard, the second question asks:

Question 2: Would you support increasing the ECB’s inflation target to a higher rate of inflation than the current 2% target?

Thirty-six panel members responded to this question. A slight majority (50% or 56% when weighting by confidence levels) opposed increasing the inflation target, but a substantial minority (33%) supported a higher target.

The minority supporting a higher inflation target argue that low real interest rates require higher inflation to avoid negative nominal interest rates. John Hassler (Institute for International Economic Studies, Stockholm University) comments that “an inflation target as low as 2 percent therefore implies that actual central bank policy rates often will have to be negative and occasionally at their lower bands. A higher inflation target would ease these problems.” Wendy Carlin asserts that “the arguments for raising the inflation target are quite compelling given the forces keeping the long run equilibrium real rate of interest low. But it would need to be a coordinated move by central banks to a higher target to avoid, for example, (if the ECB were to do this alone) the trend nominal depreciation of the euro (in equilibrium), which might be difficult for a wider public to understand.”

Supporters also argue that drastic moves are required to raise inflation expectations. Martin Ellison, together with Kevin O’Rourke and Sang Seok Lee, put forth the following argument in their research on “The Ends of 30 Big Depressions”: “Abandoning the gold standard was instrumental in ending the Great Depression in many countries. The turnaround in inflation expectations (and subsequent economic recovery) only started when many countries left the gold standard. Something equally dramatic may be needed to get inflation expectations up. Changing the inflation target could be a big enough policy change to make it work.”. Francesca Monti summarizes that “while the costs of inflation are still very debated (e.g. see Nakamura et. al QJE 2018), the advantages of a higher inflation target in a world of lower interest rates are more clear, specifically the ability to operate with conventional policy tools when faced with a downturn.”

However, the majority view was that this move isn’t credible and would only be successful if inflation expectations become far less anchored. Michael McMahon mentioned he is “[worried] that announcing an increase when inflation is currently persistently low will not be credible and the move will simply increase the extent of the inflation shortfall”. Ricardo Reis (London School of Economics) adds that “the benefits seem to be outweighed by the large costs of communicating this change to a public for whom, at the individual level, this has negligible welfare impact”. Jagjit Chadha (National Institute of Economic and Social Research) opines that this move “will unhinge inflationary pressures without any great gain”.

A Dual Mandate

In the same conference, Weidmann expressed a different view: “It is worth highlighting that we do not have a dual mandate like the Federal Reserve. That is one reason why the decisions the Fed takes with regard to its monetary policy strategy cannot simply be transferred to the euro area.”

The ECB’s official objective (outlined here) notes that “[to] maintain price stability is the primary objective of the Eurosystem”. It also states that "Without prejudice to the objective of price stability”, the Eurosystem shall also “support the general economic policies in the Union with a view to contributing to the achievement of the objectives of the Union”. These include inter alia "full employment" and "balanced economic growth".

Question 3: Which of the following best reflects your opinion on the following statement? “The ECB should explicitly recognize unemployment and/or economic growth as a secondary aim, secondary to its price stability mandate.”

Thirty-four panel members responded to this question. The majority of panelists (65%, or 69% when weighted for degree of confidence) agreed for a clearer objective with respect to the real economy (compared with 21% that disagreed).

Supporters of a dual mandate point to the potency of monetary policy as a countercyclical stabilization tool. Benjamin Moll (London School of Economics) points out that “monetary policy is a flexible policy tool with a potentially powerful effect on real outcomes like unemployment, GDP etc, so why not partially use it to this end?” Simon Wren-Lewis goes further and suggests making “economic growth the primary target, subject to achieving an inflation target within some time horizon”. Pietro Reichlin suggests that monetary policy needs to step in due to “limited fiscal space of some countries”. As articulated in Section 2.1 of his paper in the Vitor Constancio Festschrift, titled “The Future of Monetary Policy and Macroprudential Policy”, Lars Svensson (Stockholm School of Economics) makes a case for “price stability:” I would prefer to formulate the objective of ECB’s monetary policy as ‘price stability and full employment without prejudice to the price-stability objective,’ where ‘without prejudice...’ is clarified to mean that average inflation over a period such as 4-5 years shall be close to a symmetric inflation target of 2%.”

Opponents of a dual mandate (and even a few proponents) question whether this is feasible in light of diverging economic conditions across the Eurozone. Wendy Carlin notes that “with some countries booming and others stagnating, it is not clear how a true dual mandate could work in the eurozone”. Wouter Den Haan (London School of Economics) adds that “with a very heterogeneous currency zone, this would be very difficult and put quite a bit of pressure on the ECB”. Further, a number of panelists suggest that the ECB has sufficient flexibility in its current policy framework to address unemployment as a secondary objective. Michael McMahon notes that “the current mandate in the Treaty is sufficient to allow concern for issues of economic growth and unemployment to be important in the decision-making of the ECB”.

References

Andrade, Philippe, Jordi Galí, Hervé Le Bihan, and Julien Matheron “The optimal inflation target and the natural rate of interest”, Brookings Papers on Economic Activity, Fall 2019.

Blanchard, Olivier, “Rethinking Macro Policy,” VoxEU.org, 16 February.

Demertzis, Maria and Nicola Viegi, “Inflation Targets as Focal Points”, International Journal of Central Banking, Vol. 4 No. 1, March, 55-87, 2008

Demertzis, Maria and Nicola Viegi “Inflation Targeting: a Framework for Communication”, B.E. Journal of Macroeconomics (Topics), Vol. 9, 1, 2010.

Ellison, Martin, Sang Seok Lee and Kevin Hjortshøj O'Rourke, “The Ends of 30 Big Depressions”, NBER Working Papers, July 2020.

Evans, Charles, Jonas Fisher, Spencer Krane, and François Gourio “Risk management for monetary policy near the zero lower bound,” Brookings Papers on Economic Activity, Spring 2015.

Emi Nakamura, Jón Steinsson, Patrick Sun, and Daniel Villar “The Elusive Costs of Inflation: Price Dispersion during the U.S. Great Inflation” Quarterly Journal of Economics, 133(4), 1933-1980, November 2018.

Svensson, Lars, “The Future of Monetary Policy and Macroprudential Policy,”  The Future of Central Banking, Festschrift in honour of Vitor Constancio, European Central Bank, pp. 69-123, December 2018.