Christine Lagarde must resist pressure on the ECB’s inflation target
Unhappy colleagues know that the best chance they will ever have to influence the new boss is right at the start. I am not surprised, therefore, to read that national central bankers in the eurozone see a unique opportunity to influence Christine Lagarde.
Her predecessor as president of the European Central Bank, Mario Draghi, resisted doing what she has promised to do: undertake a full review of the ECB’s monetary strategy. He had other priorities. There is, of course, a strong case for such a review. But beware of the traps.
What speaks in favour is that the ECB persistently failed to meet its inflation target of close to, but below 2 per cent. The inherent asymmetry of the target is one of the reasons why the central bank prematurely raised interest rates in 2008 and 2011, decisions that contributed to the eurozone crisis later.
The reason Mr Draghi avoided that review was in order not to have the discussion we are having now: whether the ECB should lower the target inflation rate to the actual rate, moving the goalposts to where the ball is.
The debate on inflation targets in the eurozone has a long history. Before the introduction of the euro, the governors of the ECB were divided between two different strategies, one focused mostly on monetary analysis and another based on model-based economic analysis. They agreed on a fudge: to have two pillars, a monetary and an economic one, and an inflation target that meant different things to different people.
Mr Draghi interpreted it as a symmetrical target — where deviation on the downside and the upside are equally undesirable. German central bankers never really accepted that inflation could ever be too low as long as it is firmly positive. But they reluctantly supported this compromise, not expecting that we would ever reach the point where the agreed fudge would become a problem.
A near-decade of financial and economic crises has thrown the eurozone economy so far off course that the relationship between output, interest rates and prices has broken down. We do not know whether this is permanent or temporary. The very concept of inflation targeting depends on a stable relationship between those variables.
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Before the 1990s direct inflation targeting was unknown. Central banks used different targets in those days — fixed exchange rates, monetary targets or even pure discretion. The global adoption of inflation targeting was the result of a shift in economic thinking in the 1980s that produced the current economic framework. If that framework is broken, so is the notion of an inflation target. So instead of meddling with the numbers, the ECB should reflect upon whether it has a deep understanding of the inflation process.
The current discussion is not driven by any such considerations, but by vested interests. The business model of German and French savings banks and insurance companies makes them critically dependent on positive nominal interest rates. The fight about inflation targets is in part about the future of national financial systems.
Ms Lagarde should resist this pressure and focus her strategic review on the shifting underlying dynamics. The ECB has been too optimistic in its forecasts for inflation and growth. There is a case for a rethink, but not for a return to the 1990s. And certainly not a return to discretionary policies or, worse, a situation where central bankers act as lobbyists for their domestic banking and insurance companies.
I think the most promising course is one for which Ms Lagarde is uniquely qualified: to get eurozone governments to understand the interaction between fiscal and monetary policy. Mr Draghi’s most important legacy is not the famous decision to do “whatever it takes”, but his farewell statement in which he spoke truth to power. He argued that the eurozone needs a central fiscal capacity large enough to act as a macroeconomic stabiliser. This is taboo in several European capitals, including Berlin and The Hague. I suspect that one reason the Germans are making a halfhearted attempt to compromise on deposit insurance is to get that discussion off their backs.
The banking union will make the eurozone more resistant to banking crises, but not to the deep industrial and technology shocks it currently faces. In the end, stability will require the full toolkit of a deeply integrated fiscal union, with a finance minister and a mutualised safe asset.
I realise that Ms Lagarde cannot just make this happen. But she should continue Mr Draghi’s campaign for governance reform — and resist quick fixes to the inflation target.