The European Central Bank’s “asymmetric” inflation target is shackling its ability to react to crises and deflationary risks.
The Swedish central bank just lowered interest rates to zero because of deflation risks. This action comes after ignoring repeated warnings from Lars Svensson who had joined the bank in 2007 and later resigned because of disagreements with monetary policy decisions. What is interesting is the parallel between Riksbank’s decisions and those of the European Central Bank (ECB). In both cases, these central banks went through a period of optimism that made them raise interest rates to deal with inflationary pressures. In the case of Sweden, interest rates were raised from almost zero to 2 percent in 2012. In the case of the ECB interest rates were raised from 1 percent to 1.5 percent during 2011.
In addition, both significantly reduced their balance sheets after a big expansion following the 2008 crisis. During 2010, the balance sheet of the Riksbank was reduced by more than 50 percent. In the case of the ECB it was later in 2013 when the balance sheet shrank by about 1 trillion euros. Their policies stand in contrast with those of the U.S. Federal Reserve and the Bank of England where interest rates have yet to go up after the initial actions taken during the crisis. The reduction of their balance sheets is also still pending.
The consequences of the policies of the ECB and Riksbank are clear: a continuous fall in their inflation rates that has raised the risk of either a deflationary period or a period of too-low inflation. What is more surprising about their policy actions is their low speed of reaction as the data was clearly signalling that their monetary policy stance was too tight for months or years. In both cases their decisions to bring down their interest rate or take further action has happened in very small steps. And every time a step is announced the reaction has always been asking what will be next. So the announcement of the Riksbank has now been met with questions about when they will have to start their own version of quantitative easing (QE). The same goes for the ECB where their latest announcement has led to expectations of more aggressive actions in the future.
What we have learned from these two examples is that central banks are much less accountable than we thought when it comes to inflation targets. And they make use of the lack of clarity on the exact definition of their targets to produce a policy that is clearly asymmetric in nature. Taking some time to go from 0 percent inflation to 2 percent inflation is acceptable but if inflation were 4 percent, I am sure that their actions would be much more desperate. In the case of the ECB their argument is that the inflation target is defined as an asymmetric target ("close to but below 2 percent"). But this asymmetry, which was never an issue before the current crisis, has very clear consequences on the ability of central banks to react to deep crises with deflationary risks.
What we have learned during the current crisis is that an asymmetric 2 percent inflation target is too low. Raising the target might be the right thing to do but at the very least, the asymmetry implied by the ECB mandate should be reversed. Inflation should be close to but above 2 percent and this should lead to a very strong reaction when inflation is persistently below the 2 percent target.