Is the ECB secretly postponing its monetary value targets?

The fact is that there is no such thing as an optimal inflation rate and that the German hyperinflation of the early 1920s and the hyperinflation that was backed up until the currency reform in 1948 were just as unpleasant an economic problem as a real depression that has existed in modern world history, the end from the 1920s to the mid-1930s – also in Germany. Both dramatic undesirable developments are rare, but a central bank should always be careful to nip such critical developments in the bud.

But whether an inflation rate of two percent is “optimal” cannot be answered in general. However, it becomes problematic when uncertainties about future price developments hinder investment decisions. In addition, it must not be irrelevant for politics that inflation is accompanied by redistributive effects: to the detriment of wage and transfer recipients as well as savers and in favor of debtors.

Original definition of monetary stability changed

The fact is that in the two decades of its existence the ECB has changed its original definition of monetary stability several times, specifically raised it. These target adjustments can be seen as an indication that the perspective of the majority in the Governing Council and thus the interpretation of their mandate have changed over the past two decades.

At the time it was founded, the ECB was known as the “European Bundesbank”, so it made sense to adopt the “below two percent” inflation target of the German model. This target dates back to the 1970s and was primarily a pragmatic value at a time when inflation rates were quite high in Germany at six to seven percent.

The two percent were thus a signal that the Bundesbank’s monetary policy was aimed at significantly lower inflation rates. Inflation expectations should and have been depressed. Because the other major central banks acted similarly, inflation fell worldwide from the 1980s onwards.

What is disputed, however, is whether this “great moderation” is largely attributable to monetary policy or whether it was primarily external factors that caused the low inflation. After all, a new surge in globalization that began 30 years ago as a result of the integration of many countries of the former Eastern Bloc and of emerging China into world trade resulted in many products becoming cheaper.

And the credible threat of relocation of production facilities to low-wage countries broke the power of the unions in the established industrialized countries, so that price-driving wage increases remained the great exception.

Ultimately, digitization led to new products that were significantly cheaper than their analog counterparts. In addition, the Internet created unprecedented price transparency, which made price increases difficult. These were all developments that would have suggested lower inflation targets.

Increase to “near but below two percent” target

But it turned out differently. In 2003, under its first president Wim Duisenberg, the ECB believed it had to raise its target to “close to but below two percent”. This made it possible for Mario Draghi, the third ECB president, to fight against a specter of deflation, even though the moderate inflation rates were not a pathological development. For eight years in a row, the inflation rate in the euro area was below this inflation target, and the ECB took this as an opportunity to counter this “target failure” with previously unusual measures.

Against the background of the goal of “close to but below two percent”, this argumentation was possible, but not mandatory. At the end of the 19th century there were already two decades in which consumer prices fell in Germany, but the economy and real wages rose steadily.

The reason was a surge in modernization combined with strong productivity growth. At the time, both of these, in conjunction with the gold currency, caused the price level to fall, but production as well as real profits and wages increased – there was no trace of a depression.

After the end of the corona recession, it became apparent that inflation in the euro area would pick up significantly. The ECB should soon reach the inflation target it has set itself and could actually usher in a return to normal monetary policy.

Instead, the inflation target was de facto raised last summer. According to the Governing Council’s new opinion, price stability can best be guaranteed if an inflation target of two percent is aimed for in the medium term.

Incidentally, this aim should be interpreted symmetrically. If this target were not reached for several years, a similarly long overshoot would not be an undesirable development that would require countermeasures. However, there are doubts that the ECB will actively strive for an inflation rate below two percent again if it overshoots this target for a longer period of time.

Inflation determined by special factors

Sure, the current price hikes are still determined by special factors. The ECB is powerless against inflationary impulses that spill over into Europe through imports from the Far East. Wages in China have risen sharply, so that further price reductions, for example for everyday electronics, are no longer to be expected in the future.

And the ECB cannot do anything against Asia’s hunger for oil and raw materials, which is driving up prices, as well as against permanent price increases for semiconductors as a result of the current chip crisis. In addition, it is politically desirable – at least in Germany – that many products become noticeably more expensive in the fight against climate change.

Nonetheless, the ECB would have to pay close attention to self-reinforcing second-round effects – and there are certainly signs of this. In some EU countries, public sector salaries are linked to inflation, and across the euro area trade unions have good reasons to call for steep wage increases, referring to the rise in prices.

Even without collective wage-setting power, at least in those countries and sectors with an acute shortage of skilled workers, there are higher wage offers by employers. In addition, the politically intentional strong increase in the minimum wage in Germany is likely to lead to wage increases across the board in the entire lower wage segment in order to maintain the existing wage structure.

Another factor driving inflation is the fact that many rental contracts provide for an “inflation indexation” so that many existing tenants will soon have to expect noticeable rent increases. So there are actually good reasons for the ECB to be vigilant instead of lulling governments and financial markets into security from any rate hikes.

To make matters worse, the new inflation target is so vague that an easy monetary policy could be compatible with considerable actual inflation rates. Therefore, one cannot help but get the impression that the ECB has modified its inflation target primarily to signal to the heavily indebted euro countries that they will continue their very simple interest rate policy associated with buying bonds for the time being. This would have made the cohesion of the currency community the implicit overall objective of the ECB – “whatever it takes.”

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