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October 23, 2018

Europe in desperate demand for inflation

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Europe inflationEurope in desperate demand for inflation, as for years the ECO failed to reach its targets. The persistently low levels of inflation in the Eurozone have led some economists and central bankers to wonder whether the targets are real and their change to be considered. However, majority of economist opposes to this idea.

At the heart of the proposal for changing ECB targets is the idea that globalization and technological innovation have changed the very nature of inflation. Daniel Gross, director of the Center for European Policy Studies, says these forces are pushing production and distribution costs, leading to higher competition for all. The central bankers continue to fight 21st century inflation with the help of concepts and ideas from the 20th century.

Just before the Euro was created in 1999, the emerging ECB decided that its mission to maintain price stability means that inflation should be kept just under 2% “in the medium term”. A few years later, in 2003, the Governing Council of the ECB clarified that the target means that inflation, albeit lower, should be kept “close to” the 2% target.

The last time the ECB met this target was in 2012. However, it has failed in recent years. The Eurostat preliminary inflation estimate for December 2017 shows that prices rose by only 1.4% on an annual basis.

This is in line with the ECB’s own forecast, which predicts inflation to remain at 1.5% throughout 2017, with moderate energy prices and weak local wage increases. Looking ahead, the central bank is not at all close to achieving this mission. The inflation is expected to slow down this year to 1.4%, then to return to 1.5% in 2019 (1.5%) and accelerate to 1.7% in 2020. At that point, that will mean eight full years in which the ECB has failed in terms of inflation.

In theory, this should weaken the arguments of the ECB’s central bankers, who have long opposed Draggy’s loose monetary policy designed to accelerate both inflation and the Eurozone growth. Which does not mean they have stopped arguing. The allegations now are that loose monetary policy has to be stopped because the goal is unattainable.

Given the fact that the ECB, like other central banks, can not achieve its inflation target, some say that it must either abandon the goal altogether and stop worrying or officially declare that the goal is now, let’s say, 1.5% or even 1%. In 2015, the ex-governor of the German central bank Axel Weber even said that central banks should abandon a target for inflation as a whole, because in the modern world, the price index has become an imperfect way to measure the performance of the economy.

However, the arguments for lowering or eliminating the ECB’s inflation target, although interesting from an academic point of view, are opposed to strong political and financial realities.

The first is that, according to economists supporting the looser monetary policy, as the ECB wants to be assessed in the “medium term”, it should now aim for a higher target to offset weak inflation for years. In a widely discussed 2010 report, Olivier Blanchard, a former chief economist at the International Monetary Fund, suggests that western central banks – all aiming at less than 2% inflation – should raise the target to 4%. According to him, this will give central bankers more flexibility in their actions before they reach a “zero bottom line” in interest rates.

In the United States, the academic debate is clearly sharpening again after a group of influential economists advocating the Neo-Keynesian movement wrote a letter last June to Federal Reserve Officer Janet Yellen, defending the rise in the inflation target. “Economies are changing over time”, they wrote, noting that the current 2% did not allow the US central bank to aggressively promote growth.

Another powerful argument against the change of purpose is the question of trust in the central bank.

“We are building our policy on the inflation target. The financial markets are planning and waiting for it. Trillions of dollars are moving every year according to our decisions, and [in the background] some want to change our goals? I do not think that will happen”, said a representative of the ECB.

At least nothing is likely to happen, while central bankers around the world are still struggling with the consequences of the Great Recession and the sovereign debt crisis.

“I do not see the Western central banks diverging particularly on these issues, with some targeting inflation of 4% and others – of 1%”, adds the ECB representative. “There may be grounds on the way to think seriously about changes in the global economic slowness and adjust our definition of price stability to them, how and when to correct it, and according to what procedures. But the moment to do this is terrible now”, added he.

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