A Little Inflation Is Just What Europe Needsby
The European Central Bank has faced criticism lately for failing to give a clearer blueprint of future monetary policy in its new “forward guidance.” The critics are missing the point.
In a statement this month, the bank’s governing council promised to keep interest rates at current or lower levels for “an extended period of time.” That sounds vague, if you are looking for details on policy-making plans. Yet the ECB was doing something quite different: It was telling the world that it won’t mindlessly follow the U.S. Federal Reserve if the Fed removes monetary accommodation.
This was, in effect, a European declaration of monetary policy independence, and the governing council’s 23 members were unanimous in delivering it. The ECB, however, needs to do more and act to raise the euro area’s inflation rate to meet the bank’s target.
Europe doesn’t appear to have an inflation problem, but it does: The rate at which prices are increasing in the 17 economies of the euro area is too low. Core inflation excluding energy, food, tobacco and alcohol, has been stuck at 1.2 percent for months, and a recent uptick in the headline rate the ECB uses for targeting should fool no one. These increases in the Harmonized Index of Consumer Prices were almost entirely due to rising energy prices. Inflation will probably remain well below the bank’s target rate of just less than 2 percent for some time to come, on current policies.
This is damaging, because below-target inflation causes perverse income transfers from the periphery of the euro area to its core. The currency zone’s rate of inflation fell by almost a third -- from 2.4 percent in June 2012 to 1.6 percent in June 2013 -- helping creditors such as Germany at the expense of debtors such as Italy and Spain. This is because the lower the rate of euro-area inflation, the higher the real burden of interest payments that debtor countries have to pay. By the same token, the real benefit to creditor countries rises.
Even Germans suffer from an unduly low inflation rate, because it makes it less likely German loans to the troubled periphery economies will ever be paid back, without further aid. The left hand takes, and the right hand is pressed to give it back. In the meantime, this process fosters further mutual resentment and suspicion -- the last thing that Europe needs at the moment.
Moreover, a too-low inflation rate raises the real cost of capital to business, hindering investment and economic growth throughout the region. Germans must understand that inflation can be too low and that this comes at a cost to them. There are no winners here.
The ECB shouldn’t acquiesce in subtarget inflation. The bank has a mandate, and its credibility depends on adhering to it. It isn’t enough for Europe’s central bank to promise to keep its foot on the monetary accelerator for an extended period of time. The ECB must press down harder and pick up speed so that inflation rises -- not past the target, of course, but above where it is now.
Some on the ECB’s governing body worry about a slippery slope. They think that once the bank starts boosting inflation, it won’t be able to stop, because they see inflation as a drug -- the more you take, the harder it is kick the habit. This is tantamount to declaring that the euro area’s central bank lacks the means to fulfill its price stability mandate and so shouldn’t try. It simply isn’t the case.
Recently, the influential ECB executive board member Joerg Asmussen was quoted as saying, “while monetary policy would remain expansive as long as necessary, one can assume as soon as we see a sign of inflation, we will act against it.” This is the wrong message. How is Europe to escape its low inflation problem if the ECB seeks to nip in the bud any new developments that might increase the inflation rate? It is wrong -- and dangerous -- to encourage creditor countries such as Germany to think that the lower the inflation rate, the better it is for them.
Members of the ECB’s governing body may well be divided over whether to adopt even further monetary accommodation to boost current inflation to target levels. My response is, so what? Unanimity doesn’t guarantee good policy. The ECB scored its greatest triumph -- the Outright Monetary Transactions bond purchase program that cut borrowing costs for troubled euro-area economies last year -- despite fierce opposition from the German Bundesbank.
An overemphasis on unity can give a determined few effective veto power over what the majority wants. Just think, if ECB President Mario Draghi had insisted on unity before introducing the bond purchase program last year, there might not be a euro today and Europe’s economy would be in significantly worse shape than it is.
The first thing the ECB should do to fight anemic inflation is cut the bank’s main policy interest rate by 25 basis points, and perhaps go to negative deposit rates. At July’s meeting, the governing council said with one voice that further interest-rate cuts would be acceptable, if the economic data warrants them. An inflation rate stuck well below target is exactly the kind of data that makes the case for a further rate cut compelling.
(Melvyn Krauss is an emeritus economics professor at New York University and a senior fellow at the Hoover Institution at Stanford University.)
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