Why the ECB is still opaque

By: Juergen von Hagen, University of Bonn

Yesterday’s rate increase by the ECB was, of course, expected. The more interesting question is, was it justified? On the one hand, interest rates are still low in the euro area. With real rates around or slightly below two percent both short and long term, monetary policy does not seem to stand in the way of a continued economic expansion. On the other hand, the outlook for actual inflation rates, according to the ECB’s own explanations and estimates, is for low and declining rates over the next two years. From that perspective, yesterday’s move towards more monetary restriction would push inflation rates away from the ECB’s own target of just below two percent.

 

There may be a good reason for this. Perhaps, after an extended period of violating its target on the upper side, the ECB now wants to make good for its past mistakes by pushing inflation below the target for a while, so that, over the medium term, inflation will average at two percent or slightly below. Doing so would assure that there is no base drift in the price level over the long term and create added security for private individuals that rely on long term price stability. If this is what the central bank wants to do, the problem is that it does not explain its intentions well, and, therefore, does not fully produce the intended benefits.

 

Instead, the ECB’s own reasoning stresses the existence of upside risks to the inflation forecast and the Bank seems to argue that these risks emerge primarily from a continued, excessive monetary expansion. But this is not convincing for two reasons. First, upside risk does not call for action now. It calls for readiness to act quickly if and when the risk becomes more substantial in the future.

 

Second, money growth has been “excessive” in almost all years since the creation of the euro, if one takes the ECB’s reference value for monetary growth seriously. From that perspective, there is nothing new and no upside risk to be perceived. Of course, eight years of “excessive” monetary expansion in that sense with relatively low inflation only tells us that we should not take the ECB’s reference value seriously. But then the ECB should tell us what it is that creates an upside risk for inflation at the monetary front. Short of that, its policy remains pretty opaque and will fail to yield the full benefits of price stability.

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