The European Central Bank last set its objective for inflation in 2003. In the intervening years, the order that defined that era — one of globalisation, steady growth and centrist politics — has been replaced by an environment that even before the pandemic was altogether more brittle and volatile. That shift thrust central banks into the spotlight, placing responsibility on monetary guardians to experiment with bold policies to soothe market jitters and secure a return to normality. Yet, for all their power, it is also an environment in which they have far less control. For years, policymakers have failed to return price growth to their objective — in the ECB’s case, of below but close to 2 per cent.
The current paradigm is no longer fit for purpose. On Wednesday, the ECB’s president Christine Lagarde gave the clearest sign yet that the bank will abandon it in favour of a new, more aggressive approach that policymakers hope will lift inflation to levels more consistent with a well-functioning economy. At the very least, the bank will make sure its objective is perceived as “more symmetric”, paving the way for policymakers to target inflation of 2 per cent, as opposed to just below.
In shifting the goalposts, the ECB is following the lead set by the US Federal Reserve, which has also engaged in a review aimed at enhancing credibility and improving policymakers’ fading public image. Indeed, Ms Lagarde cautiously opened up the possibility that the bank could ape the Fed by adopting average inflation targeting, under which policymakers play catch-up for years of lower inflation and allow the economy to run hot for a period. In the eurozone’s case that catch-up would be significant; the level of prices post-2008 is now more than 8 per cent lower than it ought to have been.
Ms Lagarde’s intent is welcome. The persistent undershooting of inflation has important ramifications. It not only undermines trust, but implies a significant wealth transfer from debtors to creditors — though these debtors have also benefited from ultra-low interest rates. While the shift might sound nuanced to non-specialists, a greater tolerance for higher inflation potentially paves the way for the bank to deploy far more aggressive tools to spur growth. The trouble is that few are sure what those tools might be.
During the years that have followed the great financial crisis of 2008, the ECB has bought trillions of euros’ worth of bonds. The eurozone’s monetary policymakers have also gone a step further than their counterparts in the US and UK and cut rates below zero. Neither policy has been deployed without considerable controversy, not least in the eurozone’s largest economy, Germany. Though bond buying has done a great deal to curb market turmoil and raise asset prices, the impact on the real economy has been less dramatic. It is also difficult to reconcile Ms Lagarde’s hints at a more dovish objective with less immediate policy action given that the bank’s latest projections suggest inflation will not even hit the existing goal.
Some will question whether monetary policy has reached its limits. Ms Lagarde fuelled that suggestion on Wednesday, saying that much of the lift will now have to come from fiscal spending. Luckily Europe’s leaders increasingly recognise that — including in Berlin, which since the pandemic has discovered Keynesianism and spent big. Yet central banks can — and should — do more. The Fed’s ability to hit its new target has already been questioned. In its shift to a new regime, the ECB must avoid the same trap and revamp not only its goal, but the tools to hit it.