MUNICH – The upcoming change of leadership at the European Central Bank represents an opportunity – if not an obligation – to review the Bank’s policy framework. The ECB can take credit for major achievements during Mario Draghi’s presidency – most importantly, stabilizing the eurozone during the 2007-08 global financial crisis and ending speculation about the possible breakup of the single currency during the sovereign-debt crisis in 2012. But the ECB’s strategy of steering consumer-price inflation has been much less successful.
The ECB’s policies regarding inflation have had some powerful side effects – including increased risk-taking, skewed capital allocation, rising inequality, and growing pension gaps. Yet annual inflation has undershot the bank’s objective of “close to, but below 2%” for over a decade, and has averaged only 1.2% since the financial crisis. To bolster its credibility on inflation in today’s uncertain policymaking environment, the ECB should adjust its rules and adopt a more flexible approach.
The impact of monetary policy on economic activity and inflation has been hotly debated ever since John Maynard Keynes published The General Theory of Employment, Interest and Money in 1936. Although there have always been cracks in the transmission of such policies to the real economy and prices, the financial crisis and its aftermath exposed major ruptures.
Even the ECB’s drastic interest-rate cuts and practically unlimited long-term refinancing operations failed to trigger additional lending for years following the crisis. Banks, companies, and households were in deleveraging mode, repairing their balance sheets and rebuilding savings. As a result, eurozone inflation fell toward zero in 2014 and 2015.
The ECB responded with even more monetary stimulus, and introduced large-scale asset-purchase programs. These measures further depressed eurozone government bond yields and boosted asset prices. But despite the ensuing wealth effects, people did not spend more, owing to persistent policy uncertainties and a realization that near-zero interest rates required them to save more for retirement.
Of course, we cannot know with any certainty how the economy would have performed had ECB policies been less accommodative. But even if we assume that monetary policy did manage to increase capacity utilization and reduce unemployment, the expected higher inflation did not materialize.
The traditional inverse relationship between unemployment and inflation, as posited by the Phillips curve, seems to have broken down or at least become much weaker. Moreover, persistently low inflation – or “lowflation” – is not unique to the eurozone and likely reflects broader economic trends, such as changing wage and price dynamics, owing to the globalization of labor and product markets. Hundreds of millions of Asian and Eastern European workers have joined the global labor force in recent decades, while advances in digital technology and artificial intelligence continue to disrupt existing business models. Economists do not yet fully understand how such trends affect wages and prices, and the ECB’s policy framework should reflect these increased uncertainties.
Early adopters of inflation targets, notably the Bank of New Zealand and the Bank of Canada, have set a range of 1-3% for medium-term inflation. Such an approach seems to make sense for the ECB as well in today’s climate. The Bank could combine a medium-term inflation target with a broader definition that might include core consumer prices (excluding energy), along with its preferred measures of inflationary expectations. ECB policymakers would thus have more flexibility to accept above- or below-target inflation, should conditions warrant (for example, in the event of commodity-price shocks).
Greater flexibility would also help the ECB to accommodate policy trade-offs between inflation and financial stability. Central banks should attempt to smooth the financial cycle by leaning against the wind during booms and loosening policy in periods of volatility and fear. History has repeatedly shown that debt-fueled financial bubbles result in economic and social misery once they burst. While taking away the metaphorical punch bowl while the party is in progress is never popular, there is plenty of evidence that, by preventing nasty debt hangovers, smoothing the financial cycle is conducive to long-term growth. The “Greenspan doctrine” of mopping up after a bubble has burst has fallen out of favor since the global financial crisis eliminated millions of jobs and wiped out billions in savings.
For now, the ECB faces a manageable build-up of financial risks in the eurozone. True, investors’ search for yield is compressing risk premia for corporate bonds, loans, and, to some extent, equities. Real-estate prices have increased significantly, too. But greater risk-taking has not yet been accompanied by a large increase in private debt. Moreover, prices of financial assets have repeatedly been hit by political uncertainties related to trade wars or the risk of a hard Brexit.
Although these developments suggest that the ECB does not urgently need to tighten monetary policy, the bank should be wary of loosening it further in an attempt to raise inflation, which currently stands at 1.7 %. Measures to accelerate credit expansion – via negative interest rates or targeted refinancing operations, for example – would almost certainly lead to new financial-market bubbles in the future. The ECB should thus consider adopting a two-pronged strategy focusing on consumer prices and systematically smoothing financial cycles.
A central bank that consistently misses its inflation target over a long period risks losing credibility, and may feel compelled to adopt aggressive policies and “do whatever it takes” to regain market confidence. To reduce the need for drastic measures, the ECB’s next president should push to replace the bank’s relatively narrow inflation objective with a broader target range.
Michael Heise is Chief Economist of Allianz SE.