Europe Needs More Inflation

By its own reasoning, the European Central Bank has set its inflation target too low.

According to its own reasoning, the European Central Bank has set its inflation target too low.

Since 2003, the ECB has promised that inflation, as measured by the euro area's Harmonized Index of Consumer Prices, would average 2 percent or below over the medium term. But 2 percent is no longer enough.

The 2 percent target, the ECB says on its website, was chosen to "provide an adequate margin to avoid the risks of deflation" and to "provide a sufficient margin to address the implications of inflation differentials in the euro area. It avoids that individual countries in the euro area have to structurally live with too low inflation rates or even deflation." That reasoning made sense in 2003. The same logic today would recommend a much higher inflation target for the euro area, perhaps of 3 or even 4 percent per year.

The target was adopted under a false belief that all the euro nations would converge economically and grow together. And grow they did, for a while. From the introduction of the euro in 1999 until the recession, median growth in euro area gross domestic product was 3 percent a year. That's not bad for a mature economy. Growth was also relatively even across the euro area.

The recession changed that. Overall growth in the euro area slumped and hasn't recovered. Last quarter, the median change in GDP was a contraction of 0.8 percent year-on-year. The variance in growth rates, relative to average growth, has soared as well. Some euro nations, such as Germany, have fared quite well, and others have suffered shattering recessions. You see the same divergence in inflation. In three euro nations -- Greece, Portugal, and Ireland -- inflation is less than 1 percent, and all are facing severe recessions. The ECB's "adequate margin" is no longer adequate.

The ECB understood that some countries would have higher inflation, others lower. It didn't want to make inflation across the euro area as a whole so low that the countries with the lowest inflation would have falling prices, or so low that depressed countries would struggle to adjust real wages (bearing in mind that cutting wages in nominal terms is difficult). But that's exactly what has happened. Inflation, in general, doesn't produce lasting real growth. But when extraordinarily low inflation in a depressed economy inhibits the adjustment of prices and wages, it makes recovery much harder.

The ECB's Governing Council can adjust the inflation target. European Union treaties leave the definition of "price stability" up to the central bank. The council last altered the definition in May 2003, clarifying its inflation target as "below, but close to" 2 percent "over the medium term." Sadly, there's little chance the ECB will raise its inflation target now -- or even bend it to allow for temporarily higher inflation. Instead, it's needlessly holding back Europe's recovery.

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