Breakingviews - ECB has chance to avoid Fed’s strategy revamp flaw

European Central Bank President Christine Lagarde looks on during a debate on the 2018 annual report of the ECB, at the European Parliament in Strasbourg, France, February 11, 2020.

LONDON (Reuters Breakingviews) - European Central Bank boss Christine Lagarde can learn from her peers’ mistakes. She’s partway through a strategy review, including basics such as what its inflation target should be and which price measure to track. Federal Reserve Chair Jerome Powell, who came up with a new mission statement after conducting a similar exercise, offers a useful lesson on one pitfall to avoid.

Powell said in August the Fed will aim to ensure inflation averages 2% over time and target full employment more aggressively. This means the U.S. central bank will allow annual changes in prices to overshoot the target level for a while if they have undershot previously. That means monetary policy will be more accommodative than under the old regime of simply targeting 2%.

The ECB, which has missed a similar inflation target by a wider margin, could do something different. One alternative, targeting a higher rate of inflation such as 3%, was proposed at the ECB’s virtual annual forum on central banking, which convened monetary policymakers, academics, and financiers this week.

Aiming for even higher inflation when the ECB’s efforts thus far have failed may appear odd. The theory behind the proposal is that the inflation-adjusted interest rate which may prevail when the economy is humming has declined over time because of structural factors like ageing populations. A 2% inflation objective was appropriate when this so-called natural real interest rate was higher. But not anymore if central bankers are to avoid policy rates hitting zero or lower more frequently.

Some euro zone central bankers will dislike a much higher inflation target. Others may worry that the ECB’s credibility will suffer if it tries to jump a higher bar than it’s already failing to clear. Fed-style average inflation targeting bridges some of the gap. One flaw with the approach is that it hasn’t specified the period over which inflation is being averaged. A different monetary policy may be warranted depending on whether, for instance, a three-year or eight-year average is used.

Ambiguity about how much extra inflation the Fed will tolerate and for how long gives the central bank more latitude for interpretation but also means there’s more uncertainty for the public and investors. Even if long-term inflation expectations remain anchored, shorter-term views on what will happen to prices could become more volatile. Asset prices may become jumpier if investors aren’t sure how American rate-setters will react to overshooting inflation.

If Lagarde does decide to take a leaf out of Powell’s book, at least she can improve on his idea by being more precise.


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