by Edwin M. Truman, Peterson Institute for International Economics
Op-ed in the Financial Times
December 17, 2002
© Financial Times
Wim Duisenberg, president of the European Central Bank, announced this month that the ECB would conduct a serious analysis of its two-pillar monetary policy strategy over the next half-year or so—but without any presumption of change or need for change. Although the ECB does not lack advice, it needs all the help it can get. Three proposals for change deserve serious consideration.
First, the ECB should formally adopt inflation-targeting as its framework for conducting monetary policy. At present, it is in the worst of all worlds. The ECB denies that it is an inflation-targeting central bank but one set of critics thinks it is fixated on keeping inflation below a hard ceiling of 2 per cent and pays scant attention to a soft floor at zero. Another, more sympathetic, set of critics argues that the bank is more flexible but that its monetary framework lacks transparency. As a first step, the bank would reap tremendous benefits if it formally adopted an inflation target, whatever that target might be. It would retain its treaty-enshrined focus on price stability and could maintain in the background its two analytical pillars: the growth of M3 and the thorough evaluation of other economic and financial indicators in terms of risks to price stability. In the process, the bank would score a public relations coup by setting a good example for the other Group of Three central banks, the Bank of Japan and the Federal Reserve. Inflation-targeting by the ECB would also be more compatible with the monetary frameworks of Sweden and the UK within the European Union and Hungary, Poland and the Czech Republic, soon to join it.
Second, the ECB should consider at least 2 per cent as the midpoint of its inflation target. In doing so, the ECB would acknowledge that its de facto inflation band over its first five years has been 1 to 3 per cent. Better yet, in the light of the eurozone's adjustment problems, would be to choose a midpoint of 2 1/2 per cent plus or minus 1 per cent. One of the eurozone's economic difficulties is that the only means of macroeconomic adjustment is through differential inflation rates; labour mobility is low and exchange rate flexibility has been discarded. Thus, changes in relative national price levels, via inflation, are the only mechanism to bring about changes in competitiveness among the constituent economies—for example, to improve the competitiveness of the German economy, which remains saddled with the continuing burden of adjustment to German monetary union. Inflation rates in the eurozone have become—and will remain—more variable. If eurozone inflation on average is successfully held below 2 per cent, the risk of deflation increases for some countries, exacerbating fiscal pressures.
Third, most challenging but most important, the ECB should consider three aspects of potential behaviour modification. Monetary authorities round the world have succeeded over the past decade in reducing inflation to low levels; as a result, the risk of deflation has increased. Central banks today have greater confidence in their technical capacity to lower inflation from 4 per cent to 2 per cent than to raise inflation from minus 1 to plus 1 per cent. Therefore, in this new, low-inflation environment, it is incumbent upon central banks to be more active than in the past in the face of economic weakness.
When the economy is operating below capacity, estimated at 2 1/2 per cent for the eurozone, as it has been on average for the past decade, getting behind the curve intensifies the negative economic consequences. Maximum sustainable growth is the underlying rationale for a central bank's pursuit of price stability. By its actions, the ECB has demonstrated that it believes that its policy in the short run can affect the level of economic activity. The ECB should modify its rhetoric as well as its actions to focus more openly on maximum sustainable growth for the eurozone.
A third aspect of potential ECB behaviour modification is its role in European policymaking. The bank should ask not what other European policymakers can do to bring about better economic conditions in the eurozone but what the ECB can do—and the ECB can do more. It should avoid Japanese-style finger-pointing among the various parties responsible for economic policies. This is not to say that the bank should fail to participate in European debates on fiscal and structural policy and their contributions to longer-term growth. But as long as the ECB is not doing all that it can to promote such growth, it should be judicious in its criticism of others.
The ECB has done an admirable job during the first 4 1/2 years of its existence. It has successfully established an EU payments system, achieved an impressive degree of consensus in framing a coherent monetary policy for the eurozone as a whole, weathered a period of excessive euro weakness and ably managed the complex task of introducing the physical euro. Now the ECB should build on that record and undertake a mid-course correction of its monetary strategy; and reshape the framework and orientation of its policy in the direction of formal inflation-targeting and achieving maximum sustainable economic growth.