The monetary watchdogs in Frankfurt turn their attention to Luxembourg once a month, when European Union statisticians release the inflation rate for the euro zone. This publication is very important for the European Central Bank because, like many other central banks, it bases its monetary policy on inflation forecasts. If the monthly inflation rate is low — as has often been the case in recent years — and the ECB threatens to fall short of its inflation target of just under 2 percent in two to three years, then the central bank continues to step on the gas. If, on the other hand, an upward trend is in the cards, it might gradually abandon its extremely relaxed monetary policy.
This inflation targeting strategy obliges central banks to maintain price stability, enables citizens and companies to expect low inflation and thus stabilizes inflation and the economy. So much for the prevailing view. But the global triumph of inflation management masks the enormous risks inherent in this monetary policy strategy, as it is based on two faulty assumptions, which together increase the risk of new bubbles forming in the financial and housing markets, ultimately leading to greater instability.
First, the ECB cannot begin to target inflation for a period of two to three years. Milton Friedman, the founder of monetarism, was right when he famously said that “inflation is always and everywhere a monetary phenomenon” and as such is significantly determined by the central bank. But this only applies in the long term, perhaps for a period of five to 10 years. For the period of two to three years that the ECB is targeting, inflation appears to be less a monetary than an increasingly global phenomenon, beyond the influence of individual central banks.
The ECB’s credibility does not depend on the attainment of short-term, narrowly defined inflation targets.
Global factors exert a growing influence on national inflation, whereas domestic factors such as national unemployment rates become less important. In the context of global value chains, more and more companies are distributing production steps among various countries. If labor in a company’s home country becomes scarce and expensive, it shifts to other, cheaper locations. As long as globalization continues, it can push inflation below the ECB’s target of just under 2 percent for many years without the ECB being able to prevent it.
Second, the inflation management policy overlooks the fact that dangerous bubbles in financial and housing markets can arise even when consumer prices are hardly increasing at all. In the United States, for example, a stock-market bubble arose in the 1990s, followed by a real estate bubble, even though inflation was low. It is no coincidence that bubbles develop despite low inflation rates. After all, asset prices benefit from technical innovations like the internet or from better overall conditions, such as those resulting from globalization. At the same time, these factors reduce production costs and thus inflation. And once inflation is low, higher key interest rates become less likely, boosting asset prices even further.
The tendency of globalization to reduce inflation and the coexistence of low inflation and bubbles are a toxic mix for the inflation targeting strategy. The ECB justifies its very relaxed monetary policy with inflation forecasts of less than 2 percent, setting the stage for new exaggerations in bonds, equities and real estate. To prevent this in future, the ECB should modernize its inflation management strategy.
First, it should base its monetary policy on long-term rather than short-term inflation forecasts. This will enable it to look past periods when inflation is depressed by globalization, for example. The ECB should not continue to fight against inflation, which is inevitably low in the medium term, thereby risking a new bubble.
Second, it should also focus its monetary policy on the longer term by being more mindful of the financial cycle, for instance, to real estate prices along with corporate and household debt. The ECB could incorporate these early-warning indicators against new bubbles into the monetary pillar of its strategy, which has wrongly been marginalized since the retirement of former ECB chief economist Otmar Issing.
The ECB’s credibility does not depend on the attainment of short-term, narrowly defined inflation targets. Instead, the goal must be to stabilize the economy in a comprehensive sense. To this end, the ECB should adapt its monetary policy strategy to globalized inflation and the increased risk of asset price bubbles – even if this is not an approach favored by the finance ministers of southern European countries, which benefit from the current relaxed monetary policy.
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