Is the ECB playing catch up with the Fed?

Fed Chair Powell used his opening address at a virtual Jackson Hole event last month to announce an updated version of the Fed’s ‘Statement on Longer-Run Goals and Monetary Policy Strategy’. This came after an almost two-year strategy review, the conclusions of which were four-fold,

• An acknowledgment of lower neutral rates allowing other policy tools to be deployed as interest rates more regularly reach the effective lower bound
• Mitigating ‘shortfalls’ rather than ‘deviations’ of employment from its maximum
• To incorporate financial stability more explicitly into its decisions making
• Most importantly, particularly when it comes to implications for the ECB, the FOMC has moved to a 2% average inflation target over time, whereby persistent shortfalls will be offset by aiming “moderately above 2 percent for some time”

As a result of this latter change, our US economists point out that it will be easier now for the committee to react aggressively when inflation undershoots the 2% target, and more passively when inflation is above.

The question for European economy watchers is: what does all of this mean for the European Central Bank, which is itself in the early throes of a strategy review, expected to be wrapped up in the second half of next year? One specific issue for the strategy review is that of the inflation target itself. We consider the pros and cons of an average inflation target for the euro area, evaluate the likelihood of the ECB heading down the route, and consider how the Fed’s latest announcement might change the calculus for the ECB in favour of such a move.

How does the ECB set its target?

The ECB has more leeway to determine its precise inflation target than, say, the Bank of England (BoE), which only has “operational” independence. In contrast to the BoE, the ECB is tasked with a ‘primary objective’ to ‘maintain price stability’ in broad terms. To meet that objective, the ECB is free to adopt a specific strategy, and whilst it defines price stability as HCIP inflation running below 2%, it aims for inflation ‘below, but close to 2% over the medium term’, and to achieve its objective, a ‘two-pillar’ approach provides the framework for the central bank’s appropriate economic and monetary analysis.

The pros and cons of average inflation targeting in the euro area

The pros

1. Serial inflation misses – The last full year that the ECB exceeded its inflation target was 2012, as the ECB has missed its inflation target over the past decade, average inflation targeting may act as a solution for this.
2. Following the Fed – In using its own strategy review to change its target to an average inflation goal, the Fed’s decision provides some cover for the ECB to do the same. No longer would a switch by the ECB to average inflation targeting ‘stand out’ so much. Additionally, a similar move by the ECB would even out the playing field in the context of FX.
3. Average inflation targeting already has some ECB support – In his annual letter to French President Macron, Banque de France Governor and ECB Governing Council member Vileroy remarked somewhat guardingly, by saying that it was an “open question” as to whether insufficient inflation in the past should be offset by above-target inflation in the future.
4. Expectations – A move to average inflation targeting could support medium-term inflation expectations, avoid inflation expectations becoming dislodged. And thereby help the ECB hit its target in any given year.
5. Good for growth – An ECB paper published in the April this year concluded that following a large recession shock a central bank with an AIT objective keeps the policy rate low for longer than a central bank with a standard inflation targeting.

The cons

1. Uncertainty about any given year’s inflation aim – There is a risk of both difficult-to-correct over- and under-steering of inflation. Inflation could end up being more volatile under an average inflation targeting regime.
2. Implications for credibility – Lets say that the ECB decided to implement average inflation targeting right now. After missing its target for many years, if the central bank cannot achieve its standalone inflation target, what chance does it have of meeting a higher make-up goal? Thus, the ECB may be viewed as impotent.
3. Implication for policy – What more could the ECB do its price-level/average-inflation target required it to run the economy ‘hotter’? More asset purchases could be difficult in the light of potential ownership constraints and risks from Germany’s constitutional court.
4. Above-target inflation – The introduction of an average inflation targeting scheme would clearly be designed to allow the ECB to keep policy looser for longer. If for any unlikely reason inflation surprises on the upside, future make-up strategies could at some point require tighter, rather than loose, monetary policy.
5. Arbitrary make-up period – It is not clear how long the make-up period with an average inflation target framework would be, nor over what period deviations should be corrected. The selection of both parameters will be especially influential on monetary policy settings, and a failure to be precise could add perceived uncertainty about the central banks intentions.

Conclusions

Whichever way the ECB decide to adjust its target following the completion of its strategy review, we can expect it to provide space for the Governing Council to lean towards looser policy than otherwise in order to achieve higher inflation outcomes than weak current expectations suggest will be the case. While the Fed’s move to average inflation targeting will not go unnoticed in Europe, the EC may yet choose a more nuanced strategy to support expectations and lift measured inflation outturns.

Read the full report here.