The 2 Percent Doctrine

Is the European Central Bank finally going to act? Despite 12 straight months of inflation readings below the supposed target for the Eurozone, the folks in Frankfurt haven’t changed interest rates since November or brought in any new measures to juice the world’s second-biggest economy. But this week, a member of the European Central Bank’s (ECB) governing council hinted that it might finally emulate the Federal Reserve’s tireless and unconventional fight against deflation. Here are some possible reasons why the ECB has been sitting on its hands — and may continue to do so at next week’s policy meeting.

1. Doing nothing has been fine.

Earlier this month, the media trumpeted a middling forecast for Eurozone growth as enough reason for Mario Draghi, the ECB president, to leave interest rates alone. This may come as little comfort to millions of jobless Europeans; indeed, the Eurozone’s unemployment rate in January was the same as a year before. But the ECB’s mandate is to maintain price stability over the medium term, not to ensure full employment.

Moreover, neither price stability nor the medium term has an explicit definition for the ECB. Its target for inflation is “below, but close to” 2 percent, and it doesn’t give any specifics about time frame. (Economists often think about the medium term as anywhere from three to five years, which doesn’t help too much.) So it’s anyone’s guess how quickly Draghi feels the inflation rate should return to its target, or where that target really is. For him, everything may well be going to plan.

2. It’s the Germans, stupid.

In January, Germany’s Sabine Lautenschläger replaced compatriot Jörg Asmussen on the ECB’s executive board after he decided to get back into politics in Berlin. Though Asmussen routinely insisted the ECB’s inflation target was a symmetrical one — that is, inflation below target was just as bad as inflation above — he reportedly argued against a suggestion by Draghi to push interest rates to zero. Lautenschläger may be even more hawkish, judging by a nomination hearing where she sounded skeptical of long periods of low interest rates and asset purchases by central banks.

By contrast, Asmussen had strongly backed Draghi’s controversial strategy of buying government bonds to improve liquidity, so his recent stiffening on monetary policy was somewhat unexpected. It may have had something to do with the difference between inflation back home in Germany and in the Eurozone as a whole. Though German price increases lagged behind for much of the past four years, since May they have been higher than inflation in the monetary union:

Source: Eurostat data via the Federal Reserve Bank of St. Louis.

In fact, the data since May show inflation of 0.8 percent in Germany and deflation of 0.5 percent in the Eurozone, despite the German contribution. Asmussen’s welcome in Berlin might not have been quite so warm if he had stoked fears of higher inflation just months before. But it is more than a little interesting that it was his countryman Jens Weidmann, the president of the Bundesbank, that dropped the hints about more radical moves by the ECB this week, especially given how the two men had tussled over such policies just this past summer. 

3. Hey, the ECB is pretty good at its job.

If the ECB’s job is to head off bouts of high inflation and deflation before they happen, it may be doing extraordinarily well by at least one measure: expectations. If the central bank truly can control the inflation rate in the Eurozone, then it has managed to outfox its constituents with remarkable regularity.

Economists have long supposed that people avoid making the same mistakes repeatedly when trying to forecast the future. In other words, their expectations for things like inflation should be decent predictors of the future, and never be systematically too high or too low. And yet that is exactly what seems to be happening in the Eurozone of late. 

Each month, the European Commission surveys people in the Eurozone about inflation in the coming year. They can respond that inflation will be higher, lower, or the same. The commission discards the “same” votes and takes the difference between “higher” and “lower” as an indicator of where prices are going. But what actually happens to prices?

For the past five years, the difference between inflation in the year after the survey (as measured by the European Commission’s harmonized index) and inflation in the year before has been almost the opposite of what people expected. Forecasts for faster increases in prices were followed by slower ones, and vice versa:

Source: Eurostat data via the Federal Reserve Bank of St. Louis and European Commission data via OECD.

So are people in the Eurozone just lousy at predicting inflation? Or is the ECB like an expert chef, turning down the heat precisely when inflation is expected to rise and fanning the flames when it looks like falling? If it’s the latter, then the people in these surveys must consistently be surprised by the ECB’s actions and influence. 

4. Who cares? The ECB can’t affect anything, anyway.

Perhaps the ECB doesn’t exert quite so much control over inflation. It may indeed be harsh to blame a few technocrats in Frankfurt for the lack of movement in prices across the continent; slack demand for goods and services in the Eurozone probably has a lot to do with poor national policies, widespread long-term unemployment, and an overall lack of confidence in the durability of the economic recovery. Expanding credit further can’t solve all of these problems, as at least one pundit has remarked, and may even create other ones. The question is whether, on balance, it can help. 

The ECB may have a symmetrical inflation target, but the costs of erring on either side are not necessarily equal. William Dudley, the president of the Federal Reserve Bank of New York, has frequently pointed out that the economic costs of deflation are likely to be much greater and harder to contain than the costs of a credit glut. Moreover, when the real return to investing falls — as it did in the United States after the Great Recession, and likely did in the Eurozone as well — then monetary policy that seems loose may in fact be far too tight.

Dudley came to his conclusions after studying Japan’s deflation and asking why historically low interest rates in the United States had been puzzlingly ineffective at reviving demand. He came away a strong advocate of the Fed’s program of enormous interventions in the nation’s credit markets, which Japan has since adopted as well. His counterparts in Frankfurt still have time to learn the same lessons.