Maybe central banks will declare victory and go home

Politicians endowed central banks with supposed powers far beyond their grasp

PUBLISHED : Monday, 25 January, 2016, 8:40am
UPDATED : Monday, 25 January, 2016, 8:40am

Wars don’t always end with treaties; developments at the European Central Bank show how the war on low inflation may end when the loser declares victory and goes home.

ECB chief Mario Draghi on Thursday vowed a strong defence of the bank’s 2 per cent inflation target, a goal it and other central banks have been signally unable to meet.

Giving a nod to both dropping energy prices and to continued falls in market-based measures of inflation expectations, Draghi, speaking after the ECB left interest rates on hold, with one hand worked to downgrade expectations of inflation while with the other suggested strong action.

“So now these conditions have worsened and I think the credibility of the ECB would be harmed if we were not ready to review and possibly reconsider our monetary policy stance when we will have full information,” Draghi said in remarks indicating that further loosening is a very live possibility at the next ECB meeting in March.

Stressing there were “no limits” on the scope of ECB actions, if within its mandate, Draghi also called, yet again, for support from fiscal policy and structural reform.

What’s remarkable is not that Draghi is talking about further measures – after all he and his predecessors have been doing this for years, all the while watching inflation fluctuate below the 2 per cent target. Euro zone inflation now stands at 0.2 per cent and, given energy prices, will soon fall into negative territory.

We think at some point, there will be a need for the ECB, or politicians (!), to consider what the appropriate target for ECB should be if the target keeps getting missed
Anatoli Annenkov, Societe Generale

What’s remarkable is that Draghi is doubling down on meeting his 2 per cent goal, later, against a backdrop of credible criticism of the underlying idea and mechanism of inflation targets.

Otmar Issing, the former chief economist of the ECB, argued for pushing back the amount of time it allows itself for meeting the 2 per cent goal.

“There is a lot to be said for pushing back that time horizon a fair bit,” Issing told the financial daily Boersen-Zeitung in an interview published on Thursday.

Issing is quite right that failure to deliver undermines credibility, but so can changing the benchmarks.

Former Bank of England head Mervyn King and economist Marvin Goodfriend in a review of Swedish monetary policy released on Tuesday made a similar point, only more strongly.

“Where, in the opinion of the executive board, it is appropriate to deviate for a while from targeting inflation some two years ahead, the Riksbank shall explain its reasons and defend them” to parliament, the commissioned report said.

King and Goodfriend also argued not only for using an inflation measure that overlooks mortgage costs but also for a review of the inflation target every decade.

The report also recommended revisiting the inflation target every 10 years.

To be sure, the Riksbank famously tightened too quickly after the financial crisis and then eased too slowly but the fact remains that having failed to meet its mandate for an extended time we are now discussing, at least in part, measurement issues.

While acknowledging that it will take longer to get to 2 per cent, or declaring oneself willing to tolerate higher inflation down the road to get there, may be reasonable given the evidence, it does not inspire confidence.

The risk of more shock and awe from central banks is that strong moves increasingly get lower responses from financial markets. But there is a similar risk embedded in acknowledging changing inflation dynamics by changing targets: it feels out of control.

“We think at some point, there will be a need for the ECB, or politicians (!), to consider what the appropriate target for ECB should be if the target keeps getting missed,” economist Anatoli Annenkov of Societe Generale wrote in a note to clients.

“We expect this discussion to continue in the coming years and we see reasons why the ECB should task its committees with the question, seeing that it was 13 years ago since the ‘aim’ was formulated.”

These are, of course, ultimately political discussions and they are very difficult ones for central bankers to have openly without inviting threats to their independence, their credibility, or both.

The underlying reality is that most of the players in this game, politicians not least, endowed central banks with supposed powers that were actually far beyond their grasp. While this is easier to see in a small economy like Sweden, one need only turn to Japan to get another excellent example of the limits of monetary policy.

Draghi is exactly right that more of the heavy lifting should be done by politicians via structural reform and fiscal policy.

Yet, sensible as it may be, if financial markets ever come to believe that central banks are acknowledging the limits of their power, they will react violently.

Declaring victory and going home changes the meaning of both “victory” and “home”.