President Joe Biden’s massive fiscal stimulus is being carefully watched around the world. But it is not the only economic experiment taking place in Washington that could inspire policy rethinking elsewhere. The Federal Reserve’s shift in regime last summer — to become more tolerant of inflation rising above its target — is now making its influence felt in the European Central Bank’s strategy review.
In an interview with the Financial Times, Olli Rehn, governor of the Bank of Finland, has broken cover to endorse a Fed-style reform of the ECB’s own policymaking.
Last year, the Fed chair Jay Powell announced two important shifts in the US central bank’s approach to setting monetary policy. It now looks at inflation as an average over time, rather than as a snapshot at a particular moment. In the current context, with inflation having fallen short of the 2 per cent target for most of the time since the global financial crisis, that would allow inflation to overshoot for some time to make up for lost ground.
The Fed also adopted an asymmetric view of employment, which would see a weak labour market as a problem in its own right but a strong one only as a concern if it really pushed inflation up.
Legally speaking, the ECB is free to shift policy along both dimensions. It can set its own definition of price stability, and its mandate requires it to take broader policy goals, including employment, into account so long as it does not destabilise prices. But would it be wise to follow the Fed?
The answer is that the considerations that led Powell and his colleagues to set a new course are if anything stronger in the eurozone. Consumer price growth in the single currency area has fallen further behind the central bank’s target than it has in the US. This has caused a correspondingly larger economic distortion, with real debt liabilities being greater than either lenders or borrowers anticipated when they trusted the ECB to keep inflation on track.
As Rehn highlights, the ECB’s current formulation of the inflation target — of “below, but close to” 2 per cent — suggest a downward bias. An explicitly symmetric target of an average over time would be clearer, and could well improve the anchoring of inflation expectations.
The monetary union’s member states are also unlikely to engage in fiscal stimulus anywhere near the size now undertaken in the US, even after the unprecedented adoption last year of a €750bn common recovery plan. That means the case for monetary tightening is much weaker in the eurozone than across the Atlantic.
Taking more explicit account of the employment situation when setting policy, as far as the mandate allows, would help the ECB signal that it intends to keep financing conditions favourable to the investments that both the public and the private sector are required to make for the economy to return to its full potential. The world is moving towards more a co-ordinated relationship between fiscal and monetary policy, and the central bank’s strategy should evolve so as to keep any such co-ordination safe and transparent.
There are good reasons, then, for the ECB to update its strategy along the same lines as the Fed. The bigger challenge is proving that it can achieve it. After years of failing to reach the less demanding current inflation target, some scepticism is warranted. The ECB is not out of ammunition — but its lack of alarm at previous shortfalls suggests an unwillingness to use its full power. The strategy review is an opportunity to clear away such doubts.