Lagarde cannot just imitate what the Fed does

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Can central banks still fulfill their task at all? Hardly, said one learned participant at the annual conference on the policy of the European Central Bank. The “sensitivity” of inflation to monetary policy is “limited,” said Claudio Borio, economist at the Bank for International Settlements, the think tank of central banks, at the symposium on Wednesday. The ECB and its Watchers.

That was a sobering message for the online meeting, at which ECB president Christine Lagarde and the heads of the German and French central banks spoke. Because controlling inflation is central to the mandate of central bankers. Their role is to monitor “price stability”, widely interpreted as 2 percent inflation. That 2 percent serves as a buffer against deflation, a dangerous negative price spiral. The ECB is targeting inflation of “below, but close to 2 percent”.

Certainly since the financial crisis, Borio said, central banks have “worked very hard” to bring inflation to target levels. “And they have failed.”

The problem that the ECB is struggling to get to grips with is called ultra-low inflation. Lagarde himself called the numbers. Inflation in the eurozone was on average 2.3 percent between 1999 (the start of the euro) and 2008 (the start of the credit crisis). After that at only 1.2 percent. This is despite “unconventional” monetary policy to raise inflation, including the ECB’s purchase of EUR 3,400 billion in government and corporate debt, with which the bank pumped money into the economy.

It is high time, says Lagarde, to thoroughly review the ECB’s entire strategy. Following the example of the US Federal Reserve, the ECB is conducting an evaluation. “No matter how beautiful your strategy is, every now and then you have to look at the results,” Lagarde quoted Winston Churchill. The last time this happened in 2003, when excess inflation was the main concern.

Lagarde will have a hard time adapting the strategy to the low inflation era, it became clear during the conference. And also to align the 25-member ECB board. Should the inflation target, conceived in 2003, be discarded? Should inflation be measured differently? Should it be less about inflation and more about the economy? These are all still open questions.

The economy, it was said at the conference, has fundamentally changed. Globalization and digitization are depressing prices, partly because competition has become fiercer. Even as wages started to rise just before the corona pandemic – something that normally leads to higher prices – inflation lagged, Lagarde noted.

The US Fed, often an example to the ECB, has now completed its evaluation and adjusted its strategy. From now on, the Fed will tolerate inflation above 2 percent “for some time” to make up for the years of low inflation. The idea behind this is to increase the expected inflation among the public. According to economic theory, which is otherwise controversial, this leads to actual inflation because people then start consuming in order to be ahead of price increases. The extra consumption should drive up prices.

Also read: The monetary jigsaw puzzle is getting trickier

The Fed will also be less likely to raise interest rates when the labor market is tight, because low unemployment does not, as in the past, quasi-automatically lead to higher wages and thus inflation. The Fed prefers to keep unemployment low.

Exceeding inflation target

Fed Chairman Jerome Powell calls the new strategy “targeting average inflation in a flexible way”. In practice, the bottom line is that the Fed’s ultra-low interest rate policy will continue for years to come.

Regardless of whether the new Fed strategy will work, the ECB cannot simply adopt it, said speakers at the conference. Unlike the ECB, the Fed has a dual mandate: price stability and maximum employment. On this basis, the Fed can give the fight against unemployment a more prominent role. The ECB mandate has only price stability as its main objective, and that is laid down in the EU treaty. Employment is a secondary goal.

Lagarde did not want to prejudge the conclusion of the evaluation – the entire board will decide on that – but she said she would “consider” whether, like the Fed, to allow the inflation target to be exceeded. She also seemed to argue for an inflation target of simply 2 percent: not ‘below, but close’.

But no matter how much central banks tinker with their goals, the unanswered question is whether the instruments – negative interest rates, massive debt buybacks – still work. This week, a study by the American economist think tank NBER found that central bankers often positively estimate the effect of their purchasing policies on inflation, but that academics often perceive little or no effect.

To make things even more complicated, according to some economists, the era of ultra-low inflation is already coming to an end, partly because worldwide, even in China, the labor force will shrink. This will lead to upward pressure on wages and – logically – to inflation. Whether it is true? Nobody knows. But in that case, central banks would be lagging behind in their evaluations and new strategies.





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