As dedicated followers of fashion, European central bankers have also been following the intellectual trends set by others. When inflation targeting was in vogue in the 1990s, the European Central Bank adopted the new regime and became a paid-up subscriber to the economic theory that lay behind it. Inflation targeting turned out to be a stunning success, for about a decade. That ended at about the time a series of crises descended on Europe. The last time the core rate of inflation in the eurozone was above 2 per cent was in 2008.
The ECB’s persistent inability to reach the inflation target of close to, but below, 2 per cent has nothing to do with the level of the target or the inbuilt asymmetry. Inflation targeting is critically premised on the assumption that central bank policy targets have credibility with the general public. There was a time, many years ago, when trade unions and employers used the ECB’s target as a basis for their wage negotiations. Nobody does that now. The ECB has lost control of inflation. It is not its fault. But it is a reality.
The adoption of another type of target will not change anything. A debate is currently raging about an alternative concept: price level targeting. The difference is that this regime compensates for past deviations from the target, while inflation targeting lets bygones be bygones. The US Federal Reserve has just adopted what I would call flexible price level targeting, allowing for inflation to overshoot the target to compensate for below-target performance in the past but without committing itself to a formal future price level. US inflation may very well shoot above 2 per cent as the economy recovers, but there is no chance of that happening in Europe. In August, annual core inflation in the eurozone hit an all-time low of 0.4 per cent. The economic recovery has weakened after an initial post-lockdown surge.
The question European policymakers should ask themselves is: how did the eurozone manage to get stuck in a disinflationary trap? I think the following two factors play a role: a dearth of public investment and a chronic inability to deliver discretionary fiscal stimulus during a crisis.
A good example of a potentially botched stimulus is France’s €100bn plan of supply-side measures, which includes various categories of corporate tax cuts, most of which will not kick in until 2021. The European Commission and member states are very good at fooling gullible observers with large headline numbers. Germany was applauded for a €25bn package of credit support for small and medium-sized companies, yet only €700m has been taken up.
Also, between February and July government deposits in the eurozone banking system shot up by €339bn. This is money that had been reserved for stimulus but that governments are hoarding. It will be interesting to see how much of the recently agreed €312bn in EU fiscal stimulus will actually trickle through into the real economy. Generally, it is sound advice not to count on a fiscal stimulus coming through until you see independent evidence of how it is spent. Until then, headline numbers are best treated as a promise.
When economies are stuck in what is known as secular stagnation, they have bigger problems than an inflation target. I am not an adherent of modern monetary theory but the MMT folk have got one thing right: it is time to question the orthodoxies of present doctrine and its features, such as inflation targeting and the closely connected notion of central bank independence. Both rely crucially on the validity of an economic theory that has persistently failed to explain the essential features of economic life in the 21st century.
A further headache for European policymakers is the appreciating currency. The euro/dollar rate touched $1.20 at the beginning of this month. The euro’s nominal effective exchange rate — weighted according to trade flows — hit a five-year high last month.
This is an environment in which European policymakers and central bankers need to stay focused. It would be a dangerous detraction if they wasted the next 12 months with a discussion of price level targeting when there are more urgent issues to address, such as corporate solvency, productivity and an appreciating exchange rate.
The ECB needs to be brutally honest both with itself and with EU leaders about what it can and cannot achieve. It would be wrong to say that monetary policy is ineffective. But it would also be wrong to state the opposite: that a central bank can do, and achieve, whatever it takes.