>> GROUP: Shadow ECB Council / EZB-Schattenrat  Andrew Bosomworth

Andrew Bosomworth: The ECB’s definition of price stability of “below, but close to, 2% over the medium term” lends an asymmetric downward bias to inflation. This asymmetry was appropriate when the objective was to lower inflation toward target, but after years of low inflation, it is serving to entrench expectations below target.

The more important challenge for monetary policy nowadays is less the specification of the inflation target, but more the efficacy of policy at the zero lower bound. As the BOJ knows only too well, specifying a higher inflation target helps little when the how question – how to raise inflation to target? – remains unanswered.

For the eurozone, evidence suggests inflation expectations have already de-anchored from 2%. Inflation averaged just 0.9% since 2014 when the ECB lowered its key policy rate to zero. The ECB’s survey of professional forecasters’ long-term inflation projection has declined to 1.6% from 1.8% since then, while market-based expectations for inflation over the coming five to ten years are closer to 1% than 2%.

The conundrum facing central banks at the zero lower bound is that while monetary policy has proven highly effective at generating asset price inflation and stabilising financial conditions, it has proven elusive in generating and sustaining goods and services price inflation, even in the presence of full employment.

What should monetary policy do in this situation? The ECB could do four things:

First, it could re-specify the definition of price stability to better emphasize symmetry over time, for example by dropping “below” or adopting an average inflation target like the FED. While this symbolic step will neither harm inflation expectations nor help increase them, it will signal that future overshoots will be tolerated in the same way as undershoots are being tolerated today.

Second, it could support fiscal policy and financial conditions through continued purchases of government and private sector bonds. Specifically, it should merge the Asset Purchase Programme and Pandemic Emergency Purchase Programme into one, including the latter’s flexibility and making the new, combined programme open-ended and flexible in its deployment.

Third, it could restore the unsecured overnight interest rate to zero. The ECB hails negative interest rates a success. Research by "Acharya et. al." (http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/pdfs/ACEEInflation.pdf) suggest they are disinflationary and their detrimental effect on the intermediary role of the banking system is well documented. While rational expectations suggest real rates matter more, our observations suggest agents react differently to negative nominal rates than they do to real rates and in ways that increase both savings and risk-taking.

Fourth, it could formally acknowledge the subordination of monetary policy to fiscal policy. As part of the ongoing review of its’s monetary policy strategy, it should ask itself whether independence and the prohibition of monetary financing are still warranted in an environment in which the Phillips curve relationship no longer holds and interest rate policy is exhausted.
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