The ECB: Is it a hopeless case?
By Scott Sumner
Remember the joke about the motorist who gets lost, and then asks for directions to Podunk? The farmer replies, “If I was headed to Podunk, I wouldn’t start from here.” Yes, and if I was targeting inflation at 1.9%, I would not start from a position of negative 5-year inflation expectations in the eurozone’s most prosperous country. But first let’s review how they got so far off course.
Market monetarists claim that the ECB should target NGDP, not inflation. Had they done so, they could have responded much more vigorously to the eurozone depression. Recall that eurozone interest rates have been above zero for at least 80% of the past 6 years. But the ECB insists on targeting inflation. So then what do they do?
Then they should stop using interest rates as the policy instrument, and adjust the monetary base as needed to keep 5 year inflation forecasts on target. But the ECB insists on adjusting interest rates, despite the potential zero bound problems. So what do they do at the zero bound?
At the zero bound they should shift over the level targeting of prices. That way as prices fall further and further below target, expected inflation rises and real interest rates fall. That makes it easier to get back on target via forward guidance on interest rates (or QE for that matter.) But the ECB insists on targeting the rate of inflation, not the price level. So then what do they do?
Here’s the ECB’s basic problem. They don’t seem to understand what it means for a central bank to “target inflation.” They seem to think that some sort of magical process will make inflation return to 1.9%, even if they are not using any sort of policy instrument to make it happen. This view seems especially strong in Germany. Recall that interest rates cannot be lowered, and the Germans oppose QE. That means the Germans oppose having the ECB actually do anything to make 1.9% inflation happen, despite the fact that the Germans are often viewed as being more obsessive about inflation targeting than the others. Weird.
Many central bankers seem to think that monetary policy is something to be “used” or “not used” to fix problems. That’s not at all what inflation (or NGDP) targeting means. The right metaphor is steering a ship. There should be no debate between the pilot and co-pilot about whether to use the steering wheel to steer the ship. But there is a debate among central bankers about whether to “use” monetary policy.
Now for the bad news. At first glance the negative 5-year inflation expectations in Germany might look like a problem that the ECB is well suited to fix. And in a technical sense they could do so, quite easily in fact. Indeed one important theme of market monetarism is that market signals should be used to steer monetary policy. But the whole point of this approach is to prevent sharp deviations from occurring in the first place. The negative inflation expectations in Europe already account for the ECB’s likely response to those negative expectations. Read that again and think about what that means. The markets don’t just believe that policy will fail under current instrument settings, but also that it will fail under the likely instrument setting adjustments by the ECB. Those 5-year deflation expectations in Germany already account for the QE that the market expects the ECB to do in 2015.
(As an analogy, God’s knowledge that you are about to exercise your free will in such a way as to end up suffering eternal damnation is really bad news even if you think you have free will. And yes, I did just compare the markets to God. Call it the super-strong EMH.)
There are steps the ECB could have taken in 2011, like cutting their interest rate target instead of raising it, which will no longer work today. And there are things that would have worked in 2013, like QE, that will not work today, at the quantities being contemplated.
Now for the really bad news. During the 1930s, the worst outcomes did not occur when no devaluation was expected. Nor did the worst outcomes occur when devaluations occurred. The worst outcomes occurred when devaluation was feared, but did not occur. Perhaps when one country left the gold standard, and others were seen as likely to leave, but struggled to stay on the standard. Now consider the recent news out of Greece.
Polls suggest the winner would be Syriza, a populist party led by Alexis Tsipras. Although Tsipras professes that he does not want to leave the euro, he is making promises to voters on public spending and taxes that may make it hard for Greece to stay. Hence the markets’ sudden pessimism.
And now for the really, really bad news. There’s a rumor that Draghi might resign. Good luck to the new President. It’s like the car has gone over the cliff and the driver yanks off the steering wheel, and gives it to the person beside him; “here, you drive.”
Have a nice day.