Scott Sumner  

The ECB has an inflation target. How do the Germans propose they hit it?

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The Germans have traditionally argued that the ECB should focus like a laser on their inflation target, paying no attention to unemployment. Fair enough. But how are they supposed to do this?

The exact target is kind of vague, below 2% but close to 2%. It's a really bad idea to define the inflation target that way, which makes it seem obvious that it was a political compromise. Most pundits seem to assume the actual target is somewhere around 1.8%.

The ECB's tight money policy since 2007 has led to extremely slow NGDP growth, and just as in Japan the eurozone has fallen into a zero rate trap that looks semi-permanent. Also note that this is partly because of the German influence at the ECB. They favored higher interest rates in 2011, which is precisely the sort of policy that drove them deep into the zero rate territory. As a practical matter, the long run zero rate environment is a German policy.

(Ironically, they were concerned about their savers receiving low returns. Just one more reason to be skeptical that "self-interest" explains monetary policy screw-ups. Even most experts have no idea how monetary policy actually affects the economy.)

But this raises an interesting question, and one I have not seen discussed in the blogosphere. If the Germans insist on a policy that leads to ultra-slow NGDP growth, and the resulting zero interest rates, then the ECB cannot use a Taylor Principle-type approach to inflation targeting. The standard tool of almost all central banks. So what policy instrument do the Germans want the ECB to use, if not short-term interest rates? One obvious choice is negative rates on reserves, but I recall reading that the Germans are opposed. Another is QE, but I recall reading that the Germans are opposed. So over the next few decades when the eurozone is stuck at zero, what sort of policy tool do the Germans want the ECB to use in order to hit its 1.8% inflation target?

These things don't just happen by accident.

PS. Over the years some commenters have told me that they "don't favor using monetary policy." If the Germans take that approach they may be in for a nasty surprise. You may not care about monetary policy, but monetary policy most certainly does care about you.

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CATEGORIES: Monetary Policy

COMMENTS (20 to date)
TravisV writes:

Classic post by Ashok Rao: "The Europe Issue"

And here's a new one by Matt O'Brien:

"Why Europe is doomed, in 3 paragraphs"

Lorenzo from Oz writes:

The hope of the Euro was that it would be a Deutschmark for everyone (who joined).

The problem of the Euro is that it has indeed turned put to be a Deutschmark for everyone. And if the monetary that suits Germany does not suit you? Then just too bad, become like Germans.

In the 1930s, the policy of the Bank of France drove Europe towards fascism and war. Now it is Germany. Rinse and repeat ...

William writes:

You repeatedly say that low interest rates don't indicate easy money, but here you say that when the ECB raised rates in 2011, monetary policy got tighter. What role do interest rates have in determining how lose or tight monetary policy is?

Yancey Ward writes:


Low interest rates mean whatever one wants them to mean.

Kenneth Duda writes:

> What role do interest rates have in determining
> how lose or tight monetary policy is?

The stance of monetary policy (tight or loose) can be determined only by NGDP growth. If NGDP is growing faster than desired, then money is too loose. If NGDP is growing slower than desired, then money is too tight.

Interest rates arise from many factors, including growth expectations, inflation expectations, expectations about future rates, and supply/demand factors in the money market.

The CB can cause interest rates to rise in two ways:

1) tell the market that the CB is committed to tighter money. Prove it by selling short-term securities, taking liquidity out of the money market. Short-term supply/demand effects cause short-term rates to rise.

2) tell the market that the CB is committed to higher growth. Prove it by buying short-term securities, expanding the money supply. Higher growth changes market expectations, people expect higher inflation and thus higher nominal rates in the future, causing interest rates to rise.

As you can see, reasoning about tightness/looseness of monetary policy by looking at OMO's and interest rates is tricky business, because so much is transmitted through expectations channels, and expectations can be hard to see. We can see expectations in metrics like TIPS spreads, but we really need better visibility into NGDP level expectations, because that is the nominal indicator that best corresponds to a healthy employment/inflation trade-off. It's a travesty that we still do not have a good NGDP prediction market to allow us to assess in real time what the market expectations of future NGDP level are. Someone should really do something about that.


Kenneth Duda
Menlo Park, CA

Michael Byrnes writes:

William wrote:

"You repeatedly say that low interest rates don't indicate easy money, but here you say that when the ECB raised rates in 2011, monetary policy got tighter. What role do interest rates have in determining how lose or tight monetary policy is?"

If a central bank raises its policy rate, it is tightening money relative to what monetary policy otherwise would have been had it not raised its policy rate. This is what the ECB did in 2011.

That is a very different proposition from the idea that one can infer the stance of monetary policy from the policy rate. No one can credibly argue that monetary policy is looser today than it was in the 70s and early 80s (when inflation was routinely over 10% and the Fed funds rate seldom dipped below 5%). Even though the Fed funds rate was higher in the 70s, monetary policy was much looser (as evidence by the double digit inflation).

Scott Sumner writes:

William, Good question. I prefer to use NGDP growth as an indicator of easy or tight money. Another possibility is inflation. By either measure money has been tight in recent years. But some people ask for specific actions taken by central banks. In that case I point to 2011, which shows "contractionary intent" on the part of the ECB. I do that in case some people think the ECB was stuck at the zero bound, and this stuff just happened.

But you are quite right, higher interest rates are not a foolproof indicator of easy money, as we can see in hyperinflation episodes.

Also take a look at the very good comments by Kenneth and Michael.

Kenneth Duda writes:

Scott wrote:

> But you are quite right, higher interest rates
> are not a foolproof indicator of easy money,
> as we can see in hyperinflation episodes.

I'm pretty sure Scott meant "tight" where he wrote "easy".


Ken from Ohio writes:

The question posed is, in my opinion, the primary problem facing the Eurozone and the ECB.

What policy instrument is available to the ECB that satisfies the limitations of the ECB charter and is politically acceptable to the Germans?

I don't see a way out for the ECB-in other words, I don t see a suitable policy instrument that is available.

As I have said in previous comments along the way, the ECB seems stuck. It will be interesting to see how this is resolved.

TravisV writes:

"Draghi Sets Stimulus Pace as ECB Reveals Covered-Bond Buys"

Ken from Ohio writes:

Excellent article referenced by TravisV

It's hot off the press - and illustrates the constraints imposed on the ECB.

It will be very difficult (given the political and legal issues involved)for the ECB to expand its balance sheet....

Yancey Ward writes:

See, William? I was right.

Floccina writes:

If the ECB keeps preforming like this how long until even Paul Krugman starts to consider free banking?
Considering that voters can safely be rationally ignorant, a monetary system that relies on politics will not necessarily yield a good result even if that is what everyone wants and non the ignorant know how to get a good result.

ThomasH writes:

Maybe the Germans don't really want a 1.8% inflation target. Maybe all they want is less than 2% and that's what ECB has achieved. Question: why should the ECB accept one country's domination?

Ken from Ohio writes:

My proposed answer to ThomasH question.

The ECB is not specifically dominated by Germany. The ECB is dominated by the rules of its charter. And it's charter specifies a single mandate of price stability - defined as close to but below 2%. In addition, the ECB has specific policy instruments available to achieve that goal. These policy instruments ( for the most part ) are the MRO ( Main refinancing Operations) and LTRO (Long Term Refinancing Operation). These facilities are essentially collateralized "repo" loans of short (MRO) and long (LTRO) term.

These facilities have been exhausted in that they have reached the zero bound- 0.05% for MRO and 0.15% for LTRO.

And now the ECB is faced with the need to turn to unconventional policies (policies not specifically allowed in its charter) such as outright bond or ABS purchases to further expand its balance sheet in order to move towards its 2% goal.

Given that the ECB is a rules based system, it cannot deviate from its charter without broad based approval (silent acquiescence) from the Eurozone members.

Today the resistance comes from Germany. But in the future, depending upon the situation, the resistance may come from France, or Italy, or......Greece.

Welcome to the world of rules based Monetary Policy

Scott Sumner writes:

Kenneth, Yes, that was a typo.

Ken, actually they do have all the tools they need, even now. But I'm actually more interested in your perception. Let's say they do not. In that case the tools need to be added. So where are the German proposals to give the ECB more tools, so that it could hit the target? Shouldn't the Germans be almost panic-stricken that the ECB lacks the tools (supposedly) to hit the inflation target, given that the Germans think hitting the inflation target is the most important thing in the universe?

BTW, You left out by far their most powerful tool, level targeting of prices.

Floccina, You asked:

"If the ECB keeps preforming like this how long until even Paul Krugman starts to consider free banking?"

A long time.

Thomas, Read the article in the Economist "You Kant Do That", it suggests you are wrong. The Germans believe in rules more than anyone else, and hence it's extremely important that they target inflation. What's to stop eurozone prices from falling at 10% per year, as American prices did in the early 1930s? That would be a disaster for anyone who believed in strict inflation targeting (as do the Germans.)

Ken from Ohio writes:

I am interested to know what conventional policy instrument that the ECB currently has to approach 2%. As I said - MRO and LTRO seem exhausted.

So what specifically can the ECB do?

Purchase of sovereign debt and ABS are not conventional policy tools. And seem to be opposed.

NGDP targeting is not in the ECB's playbook in that the charter explicitly adopts a money neutrality position.

Also, I don't get the impression that Germany is panic stricken (maybe it is - but I don't see it.) I get the impression that Germany is generally satisfied with the status quo - or at least worried that unconventional policy interventions could make thing worse.

Scott Sumner writes:

Ken, You are still missing my point. I'm asking why the Germans are not panic stricken. I can think of several reasons, but none are justifiable reasons. The fact that Germany is doing well should be of no consequence, the ECB is not supposed to do the right policy for Germany, it's supposed to do the right policy for the eurozone.

BTW, one policy the ECB has not tried is level targeting of prices.

In any case, I find the arguments that a central bank cannot do X to be silly. Government can do whatever they like. Where there's a will there's a way. Rules can be changed. The real issue is what is the ECB trying to do? I thought price stability was the policy. I thought the Germans were supposed to have agreed to that policy target. So how do the Germans propose they hit it?

Rien Huizer writes:

Savings rates do matter politically in Germany. And German politicians -in as far as they still like the EUR, which was basically a French idea and the price for French consent to German unification- consider an inflation target as a "maximum". No one would like to be responsible for policies aimed at increasing inflation..

Maybe next year, when they effects of several shocks (eg the Russia boycott Germany deeply disagreed with but could not avoid) start to show real effects that cannot be compensated by trade etc, there will be some policy discussion. But it is unlikely they would look towards monetary policy.

Ken fromOhio writes:

The unfortunate reality (or fortunate depending on your perspective) is that the ECB is constrained by rules. This is unlike the American Fed that can do just about anything it wants - by citing Sec 13 of the federal reserve act (Unusual and exigent....) And the ECB's constraints are enforced by the various political factions within the Eurozone - Germany in this case.

And so in this case, Government (ECB) cannot do whatever it wants.

It so does not seem to be a question of what the ECB is willing to do, it is a question of what can it do.

A few quotes from the Article "You Kant Do That"
Economist Sept 2014

Hans Werner-Sinn: "The ECB has cut rates too much, and it is not authorized to buy bonds as this is a fiscal and not a monetary measure.

Horst Seehofer: "It is our job to criticize thes policies"

"Germans side with Immanuel Kant, believing that nothing works except through the rule of law, and are horrified when the ECB strays from its narrow mandate"

"Outside Germany the purchase of sovereign debt is considered an effective step....inside Germany it is considered illegal."

"Buying ASBs is another step in the wrong direction...Breaking rules destroys trust"--Ralph Brinkhaus.

And so...the ECB is constrained by rules, and those rules are being enforced.

The rules could be changed of course. but that won't happen at any time in the near future.

For now, my perspective is ...Welcome to the world of rules based monetary policy. Sometime rules are inconvenient.

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