Setting a higher target should move inflation expectations in the right direction and help the ECB reach that target.
At the latest monetary policy meeting of the European Central Bank (ECB), Mario Draghi was asked about the possibility of changing the ECB's inflation target. His response says a lot about the extremely asymmetric nature of monetary policy these days (at least from the ECB viewpoint).
Draghi admits that the ECB is having a very difficult time reaching its target and he is now hoping this will happen by 2018. He rules out lowering the inflation target (to within easier reach) as this would lower inflation expectations and increase real interest rates. So what about raising the inflation target to avoid falling into the zero lower bound again (and possibly to show a stronger commitment to higher inflation)? According to Draghi this would make no sense, if they cannot reach a two percent target why would they set a higher target that would be missed by an even larger margin?
This might be a realistic view on how asymmetric the effects of monetary policy are these days, but it also highlights the difficulties that central banks have communicating their targets and policies, and demonstrates how the confusion around this communication is making their actions less effective.
Here are some thoughts:
- Mario Draghi forgets that the ECB target is asymmetric in nature. The target is below (but close to) two percent. That's a signal that falling below the target is ok, while being above it is unacceptable. Maybe this asymmetry is partly to blame for the difficulty in reaching two percent.
- In his speech he clearly states that lowering inflation is always easy but raising inflation, because of the zero lower bound, is much harder. Despite his arguments this sounds to me like a very strong argument in favour of higher targets. The fact that he does not see it that way tells us that the ECB is really averse to higher inflation.
- The idea that the same asymmetry is present when it comes to inflation expectations might be realistic, but in my view it sounds too pessimistic. It might be true that raising inflation is hard but not impossible. Setting a higher target should move inflation expectations in the right direction and help reach that target. The fact that he does not see it that way is, once again, a reflection of the asymmetric view of the ECB about inflation.
So maybe the asymmetry that he sees is not completely independent of the asymmetric view that the ECB and its officials clearly express every time they talk about the subject.
These are interesting times for monetary policy and a reminder that we need to change the way we teach monetary policy to our students. Olivier Blanchard has some interesting suggestions on ways to modify the next edition of his textbook to include what we have witnessed and learned from the recent crisis. But I think that he might be falling short on the changes. What we need to include is an explanation of central bank policies and their outcomes.