ECB policy makers wary of following Fed route

FRANKFURT — There is reluctance among European Central Bank (ECB) policy makers to follow the US Federal Reserve’s move to target an average inflation rate, fearing this could tie their hands, sources involved in a revamp of ECB policy told Reuters.

The four central bank sources, including members of both the hawkish and dovish wings of the ECB’s policy making governing council, also expressed doubts about whether orthodox inflation theory still applied in economies where prices have long stagnated despite interest rates close to or below zero.

After missing its goal of keeping inflation “below but close to 2%” for a decade, the ECB is reviewing its strategy in the wake of a similar review by the Fed and just as a pandemic-induced recession is pushing euro zone inflation into negative territory.

The euro zone’s central bank has been expected to follow the Fed, which said in August it would aim for 2% average inflation over an unspecified period, so that periods when prices grow too slowly need to be compensated by times of faster increases — and vice versa.

But the policy makers who spoke to Reuters feared that going down this route risked encouraging financial markets to jump to the wrong conclusions about future policy decisions based simply on where the average happened to be at a given point in time.

Instead, they wanted to retain the flexibility to judge each situation on its own merits, for instance by playing down the significance of temporary changes in inflation due to swings in the price of oil.

“We want flexibility so an average target would not really give us a benefit,” one of the sources said.

An ECB spokesman declined to comment.

With euro zone inflation averaging 1.3% over the past decade and currently negative, they also feared they would be setting the bar too high by explicitly committing to overshooting 2% for long enough to make up for the time spent below target.

“You don’t want to create expectations you can’t fulfill,” another source said.

Furthermore, some of the sources noted that the Fed had  a hard time communicating its new strategy and members of its Federal Open Market Committee were split over how to apply it, leaving some investors and the broader public confused.

Most of the ECB policy makers who spoke to Reuters were leaning towards a more general definition, whereby the inflation target is set at 2% over an unspecified medium term.

That would remove the “below, but close to” formulation that has caused ECB-watchers to believe that the bank would prefer to see inflation lower than 2% rather than above that level.

This should be coupled with a renewed commitment to “symmetry,” meaning that any undershoot would be taken as seriously as an overshoot, the sources said.

In their view, this would continue to show commitment to the inflation goal while giving rate-setters greater discretion to react to each situation as they see fit, the sources said.

The sources were giving their own opinion and the ECB’s Governing Council has yet to discuss this matter formally, meaning any consensus is still a long way off. A fifth source was more open to the Fed’s approach, saying it was an option.

The ECB hopes to publish the first conclusions by the end of the year but some involved in the review question whether it will be ready by then.

So far, rate-setters have tackled preliminary questions, such as what role fiscal policy has in helping the ECB achieve its own goals and to what extent globalization, increased digitization and ageing populations impacted price behavior.

One such issue is whether such trends were undermining the validity of the so-called Phillips curve, a widely used theory developed in the late 1950s which states that there is an inverse relationship between inflation and unemployment.

Policy makers acknowledged in their discussions so far that price growth was linked more tenuously to changes in the unemployment rate than in the past as a result of factors beyond central bankers’ control, such as cheaper products sourced from around the world as a result of global supply chains.

There was a general agreement that the EU’s newfound willingness to spend, as shown by the €750-billion Next Generation fund, was helping the ECB, compared with during the 2010-12 sovereign debt crisis when public purse strings were tightened. — Reuters