L. Bini Smaghi: Is the ECB at risk of becoming an underachiever?

Over the past eight years the European Central Bank has systematically failed to achieve its primary objective of price stability, defined as a rate of inflation “below but close to 2%”. This has raised several criticisms of the monetary policy implemented by the ECB. The new ECB President, Christine Lagarde, who took office on 1 November 2019, decided to launch a comprehensive review of the monetary strategy, to be conducted in the course of 2020.

One of the issues that is likely to be debated in this context is the definition of price stability that the ECB sets for itself. At the start of monetary union, in 1999, the ECB defined price stability as a rate of inflation “below 2%”. The issue was revisited in 2003, when the definition was clarified to be a rate of inflation “below but close to 2%”, to address potential deflationary risks.

The debate around the strategic review has already started. Some observers, including central bankers, proposed to keep the definition of price stability unchanged, at 2% or slightly below, but to allow for some flexibility by adopting a range, for instance 1-3%. A range would have the advantage of providing the central bank with more time to reach its target, thus avoiding the adoption of measures that could have undesired collateral effects. It would also allow for structural factors and unexpected shocks – such as globalization, demographics or technology - to be duly accounted for.

A change in the inflation target would, however, have important consequences for the accountability of the ECB. It could also affect its independence, given that any persistent and unexpected fluctuations of the inflation rate within the range would have distributional effects, in particular between creditors and debtors. It would also impact the functioning of financial markets by making the anchoring of inflation expectations – and thus the formation of asset prices – even more complex. Doubts would also be raised about the time-consistency of setting a target range if the central bank did not have the same incentive to tolerate inflation in the upper range compared to the lower one.

In any case, before even addressing the pros and cons of such a proposal and considering possible changes in the strategy, there is a need first to understand the reasons why the ECB was not able to reach the prevailing target. A preliminary question that needs to be answered is whether the measures adopted by the ECB over the recent years were consistent with the aim to achieve an inflation rate below but close to 2%. Indeed, any change in the strategy would require that the hypothesis according to which the ECB might not have done whatever was needed to achieve its price stability objective be first rejected.

The hypothesis is pertinent since the ECB performed worse than the other major central banks. The cumulated deviation from the 2% inflation target during the 2013-19 period amounted to 7 percentage points, against 2 for the Federal Reserve, the Bank of Canada and the Bank of England. Among the major central banks only the Bank of Japan performed slightly worse.

This note presents evidence suggesting that the hypothesis according to which the ECB might not have done whatever was needed to achieve its price stability objective cannot be easily rejected and needs to be considered carefully. The evidence is based on a relatively simple set of indicators. The intention is to stimulate a more thorough analysis of the policies that have been implemented in recent years. Counterfactual policy analysis is obviously very complex. However, it is interesting to note that while several authors – including those within the ECB - have concentrated their efforts on assessing what would have happened to growth and inflation had monetary policy been less expansionary, there is yet little work on the opposite scenario, i.e. of what would have happened if monetary policy had been more expansionary in a more timely way.

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