September 22, 2016
It struck us yesterday as we read comments by Erkki Liikanen that we may soon have a big and angry debate among ECB policymakers about price level targeting, in particular because it came on the day that the Bank of Japan announced a policy to overshoot its 2% inflation target in the future on the grounds that they undershot the target for too long. This announcement is not exactly the same as the official adoption of a price level target, but it is a step in that direction. Under a price-level target you compensate target deviations in one direction with offsetting deviations in the other direction until the price index reaches the desired level. With an inflation target, you let bygones be bygones.
The promise to overshoot was one of two important decisions taken by the BoJ. The other is to impose a cap on the ten-year bond yield of zero per cent, which constitutes a form of monetary financing, as Ben Bernanke noted in his blog. The question the BoJ predictably had to confront is how it can credibly commit to a higher target than 2%, even temporarily, if it cannot even manage to hit the existing target. The BoJ said it took the new measures in order to raise inflation expectations, but if an increase in the target is not credible, it may not have that effect.
Liikanen, meanwhile, suggested in an interview with Bloomberg that the ECB might be going down the same route. As ever with newsagency interviews, we don't have the full transcript but his argument appears muddled, as though he is mixing the idea of a symmetric inflation target with the idea of a price-level target.
“You can never have average inflation close to 2% if you are never above two; it’s arithmetic...We must be consistent in both ways. My approach is symmetric in both directions.”
There is clearly symmetry in a price level target, while an inflation target is also symmetrical but in a different sense. You are indifferent about positive or negative deviations but, crucially, you do not compensate. Liikanen is stating clearly that the ECB would do precisely this. Mario Draghi himself also said in a couple of press conferences that he would allow inflation to exceed the target for a while, but he has not gone quite as far as Liikanen, who has effectively announced a change in the ECB's target (or he may be confused about this whole thing, or deliberately muddling things up).
While this appears to be a technical issue, we should note that it could easily give rise to big disagreements within the ECB's governing council. A policy of negative rates and QE at a time when inflation overshoots the target would trigger an extremely hostile reaction - not only from the Bundesbank. This could become a much bigger conflict than QE.
The Fed, meanwhile, appears a step closer to an interest rate increase as three out of ten voting members favour an increase right now, while the majority conceded that the case for a rate hike had strengthened.
We also have stories on Neelie Kroes and the latest Bahamas leak; on whether Deutsche bank needs a bailout; on BPI clearing the way for a takeover by Caixabank; on Portuguese plans to decentralise social policy; on the virtues of plastic money for Greek VAT revenues; on European Defence after Brexit; and on Sigmar Gabriel's pep talk ahead of his visit to Moscow.