The ECB is Talking Overshoot in a Low-Inflation World

As price pressures lag, at least one official may be ready to go above target

Germans Doubt the Euro
Photographer: Ralph Orlowski/Getty Images

Too much inflation, at least for a short time, could be a good thing for the European Central Bank.

An official account of the central bank's latest policy meeting on Jan. 21 showed that at least one policy maker said that it would be "logical" to overshoot the ECB's goal of keeping inflation at just under 2 percent "for a limited period," after almost three years of falling short of it.

The account didn't say whether this view was shared by any other Governing Council member, and it seems like a moot point with price pressures so muted. Even so, the mention of exceeding the ECB's inflation goal may signal the start of a debate among policy makers looking for ways to reinforce stimulus at a moment when expanding the current set of instruments — negative rates and asset purchases — risks yielding only diminishing returns.

As the chart below shows, the idea behind overshooting is that it would allow prices to recover, at least in part, the ground lost after years of sub-par inflation. It would also create room for policy makers to keep monetary policy easy even if inflation were to start picking up.

"Words matter as well as deeds,'' said Richard Barwell, senior economist at BNP Paribas Investment Partners in London. "If accompanied by decisive action, this is the answer to the ECB's problems. They have to commit to overdeliver.''

The idea of overshooting to make up for past periods of slow price growth evokes what economists term "price-level targeting," where central banks aim for a specific level of prices rather than a yearly inflation rate. ECB Vice President Vitor Constancio explicitly rejected the idea in a recent interview.

"I would never agree to price-level targeting. That is also not a consideration for us,'' he told Germany's Boersen Zeitung on Dec. 30.

Even so, other central banks have discussed the option. Chicago Fed President Charles Evans said in September there wouldn't be “any serious costs of modestly overshooting our inflation target — particularly considering how long inflation has been below our target.” A research paper from the San Francisco Fed earlier this week concluded that it might be "desirable to trade some future above-target inflation for a faster recovery in economic activity.''

Bank of England officials use the prediction of an overshoot to signal that policy might need to be tighter than the yield curve implies. Inflation is currently at 0.3 percent, and in the central bank's February Inflation Report policy makers predicted that price gains will exceed their 2 percent target after two years and then continue to rise. In reality, officials have looked through inflation as high as 5 percent in the past.

Whether ECB policy makers would show tolerance for any overshoot at all remains, for now, an open question.

 "Any hint that significant numbers of Council members would prefer to tighten policy at the first sign of inflation will undermine the policy,'' BNP's Barwell said.

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