New Keynesians, You Were Right All Along, ECB Economists Argue

  • Low price pressures in euro area due to cyclical factors
  • Monetary policy still works in anchoring price expectations


Photo Illustration: Tom Hall/Bloomberg, Photos: AP, Bloomberg

The feebleness of euro-area inflation since the financial crisis has puzzled the European Central Bank and the economists that staff it, threatening the credibility of the institution that guards the single currency.

Fear not, everything will be alright.

That’s the conclusion of an occasional paper published by the Frankfurt-based institution on Wednesday, which argues that the traditional models that provide insight into how prices and employment interact with each other still stand. It’s just that an extraordinary period of downward price pressures domestically and overseas since 2009 made it look like they’d broken down.

So even though inflation in the 19-nation currency bloc has undershot the official goal for almost four years, unconventional monetary policy prevented a worse slump and will continue to support expectations for future consumer-price growth, according to the paper edited by ECB economists Matteo Ciccarelli and Chiara Osbat.

“Unconventional monetary-policy measures are effective in mitigating the downside risks to price stability, curtailing risks of deanchoring, and expanding aggregate demand,” the authors write. “Public belief in the ECB’s commitment to keep the annual rate of inflation below but close to 2 percent has remained intact.”

The report effectively claims that the instruments of New Keynesian economics, which dominate in modern central banks, are still valid. That conclusion might justify the ECB’s stance of pumping as much money into the economy as it takes to reach its inflation goal, but it’s unlikely to be universally accepted in countries such as Germany where burdened savers are stepping up the political pressure.

ECB President Mario Draghi reaffirmed last week that officials intend to spend at least 2.28 trillion euros ($2.45 trillion) on bond purchases while keeping interest rates at or below zero and doling out free loans to banks.

The economists argue that part of a solution to the “missing” inflation puzzle, in terms of the weak upward movement in prices during the recovery, can be explained by global disinflationary shocks such as the slump in oil prices and greater sensitivity in domestic inflation to the hard-to-measure amount of slack in the economy.

“Adverse cyclical factors played a more crucial role in explaining the missing inflation” than so-called secular stagnation -- the idea, influential in recent years, that demographics and technology are helping to depress the natural rate of interest, according to the report.

With the U.K.’s plan for an industrial strategy after it leaves the European Union and new U.S. president Donald Trump pledging to accelerate growth in his nation, voices are emerging to suggest secular stagnation doesn’t carry as much weight as previously thought. Instead, the longstanding idea developed by A. W. Phillips that tighter labor markets lead to higher wages and inflation is back in fashion. The ECB says it was never really out.

Phillips Endorsement

“One of the main conclusions of this paper is that the Phillips curve remains a useful tool in understanding inflation dynamics in the most recent disinflation period,” the economists say.

What was needed was a bit of a monetary kick, and the fact that euro-area consumer prices are now rising, perhaps faster than expected, is proof that the ECB was able to provide it, according to the report. As investors, companies and households come to realize that, inflation is set to meet its goal in the medium term, which policy makers have indicated means around 2019.

“Agents may take time to learn about the effectiveness of the policy instruments,” the authors write. “The subsequent stabilization or reversion in 2015 signals the effectiveness of monetary policy to achieve its target within the monetary policy horizon.”

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