If it is true that Mario Draghi saved the eurozone, then it must also be true that the eurozone will depend on future presidents of the European Central Bank doing the right thing at the right time. The eurozone member states have added a few policy gadgets since the crisis. But the ECB remains critical for the eurozone’s cohesion, if not survival.
Christine Lagarde, Mr Draghi’s successor, last week launched a strategy review. Over the course of this year, the ECB will put its entire monetary policy strategy on the table, and, unfortunately, a lot more than this.
I personally fail to get excited about whether votes in the ECB’s governing council should be published, or who writes the president’s introductory notes. I see no evidence that a stronger role taken by national central banks would lead to better policy. There is also too much talk about communication. When the Germans do not like the policy, it is not because the ECB has failed to explain it to them.
The ECB should instead focus on what matters: the policy target and the instruments to deliver it.
Under European law, the ECB’s primary target is to deliver price stability. The lack of precision was deliberate. It was supposed to give central bankers room for interpretation and manoeuvre — room the ECB chose not to use. In late 1998, the ECB adopted its first inflation targeting regime. Four years later, it modified it to an annual inflation rate of close to, but below, 2 per cent.
The concept of inflation targeting was relatively new at the time. It was based on an analytical framework that became popular in macroeconomics in the 1980s. It assumed that people act rationally and that financial markets are well behaved. I suspect most readers have formed their own views on those premises. But you may be surprised to hear that policies based on these assumptions are still in place. Inflation targeting is one of them.
The ECB’s research staff have recently published a fascinating 300-page working paper that has a direct bearing on this discussion. Its goal has been to shed some light on the successes and failures of the ECB’s policies over the last 20 years. The paper tries to establish how the ECB’s policies affected the economy. The surprise result was that the effect on inflation was smaller than previously thought, but the impact on economic growth larger.
This finding suggests that a policy based only on inflation targeting is not very effective at a time like this. My own preferred target would be based on nominal gross domestic product — economic activity measured in actual euro prices. You can think of it as a metric of both economic activity and inflation folded into one.
I know there are problems with the availability of nominal GDP data. But if these can be solved, the framework could give the ECB more flexibility. It would not be a policy of flying by the seat of your pants, or pure discretion as economists call it. It is less rigid than direct inflation targeting, but still a formal framework to hold on to.
This, in many respects, is a good time to ditch the inflation target. For a start, neither employers nor employees believe in it any more. Nobody uses the 2 per cent target in wage rounds.
Inflation targeting would constrain the ECB’s policy choices in potentially catastrophic ways — for example, if inflation were to rise, yet the economy remains weak. An inflation-targeting Ms Lagarde would then come under pressure to end quantitative easing and raise interest rates prematurely. Inflation targeting worked well for Mr Draghi in part because he was lucky. Without a sudden collapse of inflation, there would have been no QE.
A more flexible policy target would also address the concern that the central bank may be running out of firepower. The ECB’s research shows the policy affects growth. The bank could, if it wanted to, stimulate green investment, which is on the agenda of the review. Probably the least controversial decision would be to buy green bonds from the European Investment Bank. The ECB could also buy qualifying green private-sector bonds, or give incentives to banks to lend to green projects. This is just the easy stuff. But they could do a lot more if they want to.
I would urge the ECB to do some deep thinking on this issue. The last policy review took place in 2003. The choice it makes next will determine policy for a long time. If it gets this one wrong, no communication strategy will help.