The ECB is not doing its Job – Even on its own Definition

The mandate of the European Central Bank has been a source of controversy since before the start of monetary union in 1999. A battle raged between those who wanted to focus exclusively on ‘price stability’ and those arguing for a broader mandate, taking in growth and employment on a formally equal footing, as is the case with the US Federal Reserve.

The outcome of the battle is well-known: victory for the inflation hawks. Germany was only willing to accept monetary union, and the demise of the D-mark, if the ECB was a European replica of the Bundesbank. So it happened: the ECB was given a primary mandate to ensure price stability, subject to which it was to contribute to the other Treaty-defined goals of the European Union: among a long list of other things this includes employment.

While the treaty wording closely paralleled that of the Bundesbank law, the ECB was left to define ‘price stability’ as it saw fit. Initially its definition was annual price increases (as measured by the so-called Harmonised Index of Consumer Prices – HICP) ‘below 2%’, a target achievable over an unspecified ‘medium term’. In 2003 this was tweaked to ‘below but close to 2%’, to avoid giving the impression that the lower inflation was the better, and possibly even that deflation – persistently falling prices – was welcome.

The crisis has seen a renewal of calls for a change in the mandate. A higher inflation target has been suggested (here). Calls for including employment and growth objectives have re-emerged (here) and there is widespread agreement that central banks need to pay more attention to asset-price bubbles and financial stability. These are important debates but they must not obscure an important fact: the ECB is currently failing to fulfill its mandate – even on its own narrow definition.

Let’s look at the numbers. Start with the annual inflation rate for the euro area which comes out every month and is the figure usually reported in the media. In June it was (provisionally) 1.4%. That’s below 2%. But is it ‘close’? Well reasonable people might disagree on that. The thing to do is look behind the headline number and at the context.

The annual inflation rate measures the change in prices between, in this case, June this year and June last. As long as inflation is fluctuating gradually, it’s a pretty good guide, as it has the advantage of smoothing out short-run blips in the month-on-month data, enabling us to focus on the bigger picture. This is not true of the US, where inflation has been falling steadily, so the annual-change figure clearly becomes a ‘lagging indicator’ and can be misleading. But in the euro area headline inflation picked up during the winter, having been negative before that (see chart). More on the EU-US difference in a minute.

Next, the price index (HICP) contains elements that fluctuate wildly and should not be targeted by a sensible central bank. If you compare HICP with an index excluding energy prices and seasonal food (‘core inflation’, the preferred measure in the US, but not, alas, in Europe) you get the picture in the chart.

While the big swings in HICP since the start of 2008 are impressive, the key point is that core inflation has been falling almost monotonically month for month since the crisis broke in the late summer of 2008. Core inflation has been at or below 1% – i.e. only half the target rate – since October 2009, that is eight consecutive months. Thus the underlying rate of inflation is substantially and lastingly below ‘below but close to’ 2%. On this basis the ECB is missing its target ‘from below’ and policy should be more expansionary.

Now, monetary policy operates with time lags and it is right and proper for central banks to look at inflation prospects when setting policy. A possible defence against criticism of policy inaction at the present juncture is that, as the economy recovers, inflation is expected to rise. But how plausible is this argument?

The recovery is extremely sluggish and highly uncertain. Consumption is constrained by stagnant employment and sluggish wage growth, as firms seek to rebuild profit margins and unemployment remains high. An investment pick-up is highly unlikely given capacity utilisation rates some ten percentage points below long-term averages – there is just too much existing spare capacity. The very limited growth of achieved in the first two quarters of the year was on the back of government stimulus measures and net exports. The stimulus packages have been wound down and already reversed in a number of euro area countries.

From 2011 all the European countries will be engaging in budget consolidation, throttling demand. Continuation of rising net exports is questionable. The depreciation of the euro has come to an end – indeed the euro has appreciated by almost 10% against the US-dollar since the start of June: this will tend to reverse the pattern, mentioned earlier, that inflation has been falling more rapidly in the US than Europe, which was contingent on a sharp depreciation of the euro against the dollar. On top of this, there are worrying sign that growth in the USA and some Asian emerging markets, i.e. Europe’s export markets, is running out of steam.  Unsurprisingly in the light of all this, all the main leading indicators of economic activity have now already topped out – with growth sickly and unemployment at 10%!

In such an environment it is hard to see where any growth is to come from, much less a recovery strong enough (of the order of 0.5% a quarter) to close the output gap: yet this is a condition for the argument to hold that rising economic activity will push inflation upward.

The facts are inescapable. The ECB is not fulfilling its mandate, even on its own narrow definition. Inflation is too low. It is very likely to fall further, raising real interest rates and damaging the prospects of recovery. Very low inflation also makes it much harder to correct competitive imbalances within the euro area, because more countries have to go through actual deflation. And there is a significant risk of area-wide deflation resulting from even a small negative shock, which would be poison to attempts to reduce both government and private debt levels. In such conditions the ECB is obliged by the Treaty in its own restrictive interpretation to engage in expansionary policies.

There are a number of options. The official base rate could be cut, which would above all else send an important signal to the markets. There must be an immediate cessation of all measures to tighten liquidity provision – the recent ending of one-year liquidity helped push up the value of the euro – and renewed liquidity provision for six or even 12 months should be re-introduced. Given the fiscal crisis facing many euro area economies, a substantial program of long-term government bond purchases on the secondary market (quantitative easing) is an obvious way forward.