Eyebrows may well have been raised at the European Central Bank (ECB) this morning after its chief economist said the organisation was in danger of losing credibility.
Peter Praet, who also sits on the ECB’s six-strong executive board with the Bank’s president, Mario Draghi, said that low inflation was bringing into question the ECB’s remit to promote low and stable inflation, and said that it must stand ready to take further action.
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Except, he is a central banker and top notch economist, so he didn’t quite put it that simply.
Here’s four of the most important passages from Praet’s speech, delivered to the Luiss School of European Political Economy in Rome this morning, and a breakdown of what he really meant.
In search of stability
Decades of experience have confirmed the importance of price stability for macroeconomic stability and sustained economic growth. That is true both when inflation is too high and when it is too low. The prolonged period of low inflation we are in today has increased the risks that inflation misses might become persistent, which would be deeply damaging for the economy.
Economists are pretty much united that when prices go up slowly, steadily and predictably, it is good for consumers, businesses and the wider economy.
If people know goods and services will be more expensive in the future, they are encouraged to spend money today. This boosts demand across the economy, creating growth. On the other hand, when people think prices will be cheaper in the future, they delay buying things, waiting for prices to come down. This results in people stashing cash - in savings accounts, piggy banks and under mattresses - which is bad news.
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If inflation hops up-and-down too violently it also creates problems for people locking themselves into long-term contracts or trying to plan for the future. Since inflation eats into the value of debt and savings, too high a rate sees savers witness the value of their assets dry up in real terms. Too low, and paying back debt, for individuals, companies and governments becomes an uphill struggle with growth flat-lining.
A credible approach?
Allowing inflation to re-anchor downwards comes with a high risk of credibility losses for the central bank, and especially when the expectation is not being met … Disavowing the inflation aim in current conditions might also be perceived especially negatively by the public, for instance as revealing expectations of “secular stagnation” and associated weak price pressures.
In a fragile post-crisis situation where monetary policy is sustaining the recovery, any perception that the central bank is adopting a greater tolerance towards a future regime of lower inflation can have very negative effects.
Central banks are the ones tasked with making sure inflation ticks along at a healthy pace. People - either implicitly or explicitly - place their faith in them to be a steady hand on the throttle of the economy. Once that trust is eroded, say, because the central bank looks helpless in the face of global developments and is failing to do the job it was created for, people may buy into the idea that the economy is doomed, the world is coming to an end and there is nothing anybody can do about it.
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Whether or not that is based on fundamentals matters little. Economies are built on confidence and expectations, so the fears become self-fulfilling, the central bank becomes even more helpless and every lurch deeper into negative interest rates, or every extra billion spent trying to kick-start growth becomes another signal that the economy is doomed and the world is coming to an end.
The prolonged period of low inflation we are in today has increased the risks that inflation misses might become persistent, which would be deeply damaging for the economy. This is why we have reacted so forcefully to secure our objective – and will continue to do so in the future if necessary.
This is Praet’s big finale. When Draghi announced the latest dip into negative interest rates in March he said he didn’t think they could go any lower, and plenty of people have said they think he might be running out of options.
He wants the ECB to be ready to react to whatever the future holds. He doesn’t believe they should rule out further monetary policy and thinks central banks needs to own the idea that they having ultimate control over the markets and economies and, in Draghi’s words, are willing to do “whatever it takes”.
Cry for help
To be sure, the crisis has proven that ensuring price stability is not sufficient for sustainable growth. It is only an enabling condition and other policies must also play their part. Still, the need for a superior policy mix is no excuse for central banks to be passive when their mandates are under threat. The ECB has demonstrated through its actions that it does not wait for others to move first.
Praet may think the ECB has options at its disposal, but he knows that no central bank can act alone and is calling on national governments to start doing some of the legwork. This echoes Mario Draghi’s line that individual countries need to reform their own economies and make sure policies help to bring down stubborn rates of unemployment and instil consumer confidence.
Since the crisis, Spain, France and Italy have all flirted with labour market reforms - with varying degrees of political commitment and success. The ECB wants to make it clear that politicians cannot lean on innovative central bank policies to try and generate demand - which will raise inflation - across the Eurozone.