By Reza Moghadam, chief economic advisor at Morgan Stanley International
High Noon at the ECB Corral
European policymakers, often paralyzed by divisions, finished 2020 on a high note. They finalized the €750 billion European recovery fund, agreed to ambitious climate goals (a focus of fiscal spending), and announced new measures to ensure easy financing conditions in the coming year. Together with a reliable vaccine pipeline and distribution system, all this adds up to a much stronger outlook for 2021.
Will a robust recovery spell the end of ECB stimulus, which, except for a brief interlude, has been in place since 2015? Only one inconvenient fact stands in the way: the ECB’s chronic inability to deliver on its “below, but close to, 2%” inflation target.
Unlike in the US, inflation has been closer to 1% than 2% for most of the last eight years, and markets expect that to remain the case for the next decade (Exhibit 1 and Exhibit 2).
A sinking inflation anchor poses a serious problem for any central bank: lower bond yields can’t help if expected inflation falls at the same time, leaving expected real rates unchanged. With its effectiveness compromised, the ECB could soon find itself bracketed with the Bank of Japan as an institution perpetually at war with the risk of deflation.
But an influential minority in the ECB’s Governing Council, brushing aside such arguments, is looking to pare the inflation target, declare victory, and bring stimulus to an early close. The problem with too low an inflation target, aside from raising real debt burdens, is that it doesn’t leave much room for price and wage adjustment between euro area members with starkly different needs and vulnerabilities. And as the Fed moves in the opposite direction, it risks casting the ECB as a congenitally hawkish central bank. This could strengthen the euro, push down prices, and dismay key exporters like Germany – which would give pause even to hawks.
My sense is that the doves will prevail, especially given the risk of long-term economic scarring from the pandemic. The compromise might simply be to eliminate the ambiguous “below, but close to” clause attached to the current target. Less likely, the ECB could follow the Fed’s lead in adopting an average inflation target – which, by stoking expectations of above 2% inflation in coming years, would more effectively counter current pessimism on inflation.
Regarding the toolbox, rather than tweaks to its well-worn asset purchase and bank credit programmes, the ECB should look for something bolder to lift sagging inflation expectations. The most potent instrument may be coordination with fiscal policy. The taboo against coordination made sense in a high-growth world, where the perception of collusion risked high inflation. But in a world of secular stagnation, sustained public investment will be key to lifting aggregate demand and inflation. The ECB must be clear that it will pull in the same direction as fiscal policy even after the pandemic.
These two critical issues – the inflation target and policy instruments – are to be taken up in the ECB’s upcoming strategy review. Despite its jargonistic ring, the review in mid-2021 will be high noon for the ECB, its most consequential policy pronouncement for perhaps years to come.