Peter Praet gave an important speech on disinflation risks and the ECB’s reaction function (see also his slides) but it is relatively confusing both on how the ECB sees inflation risks and how it can respond to them.
The first part of his speech discusses how the ECB’s price stability mandate has been refined over the years to provide a buffer away from zero on average.
What are the […] considerations that suggested clarifying a policy aim within the price stability interval? Two main considerations led to that decision.
The first was to make sure that the steady state inflation in the euro area as a whole would incorporate a sufficient buffer away from zero. […]
Given that the buffer argument is exactly Olivier Blanchard’s case for a higher inflation target and that the need for allowing inflation differentials within a currency union only reinforces that case, we would have liked to see Praet explain whether and why the current target (below 2% but close to 2%) is adequate.
Then he goes on to discuss intra euro area inflation divergence and recognizes that the ECB doesn’t only look at the average inflation but wants a sufficiently high level of inflation to allow for inflation differentials to help relative price adjustments. This is potentially very important but remains unclear. When does the ECB consider that one country’s inflation is being pushed excessively low? Does the ECB take issue with one country having a negative rate of inflation? That is the target in fact average inflation below 2% but close to 2% and the Minimum inflation in the euro area not too far from 0%?
The second motivation for the May 2003 communication was associated with intra-euro area inflation differential. […] A focal point for policy within the price stability range sufficiently away from zero allows the correction of cross-country relative prices to take place without forcing national inflation rates to excessively low or even negative levels.
The second part of the paper confirms that there is a worrying disinflation trend since early 2012 and discusses more clearly possible tools to stem deflationary risks.
Inflation has been on a downward trend since early 2012. Over the last four months, the trend has accelerated noticeably. […] The fact that [the various components of the inflation index] are all at their minima at the same time is something that we have not observed in recent times.
Peter Praet also makes a series of comments on current policy that we found confusing:
Although we had been surprised by a drop in inflation in October to 0.7%, that was not the reason we lowered the rate on the main refinancing operations on 7 November. The reason was that we were expecting inflation to remain weak […] for an extended period of time.
It’s hard to decode what Praet means. Does he suggest that the ECB thought that the subdued inflation outlook warranted more action, but waited until November to deliver a rate cut? Or that the surprise inflation drop occurred at the same time as the inflation outlook became weaker? Or that the ECB’s optimal plan does not react to unexpected shocks?
We believe our decision has rebalanced the risks to price stability. We think deflation […] has become even more unlikely after our decision.
We’ll write more on deflation risks later and the extent to which it warrants further unconventional monetary measures by the ECB. But it’s clear that the risks have not rebalanced with this rate cut and the ECB knows it well. But even putting this aside, it is somewhat confusing to rely uniquely on this metric to assess whether the size of the policy impulse was adequate. For example, it would appear appropriate to look at whether the combination of the unexpected inflation drop and the (also largely unexpected) monetary impulse have reduced or increased the gap between the interest rate and its natural value.
This speech important because Peter Praet explicitly recognizes that non-standard measures can also be used to fight “falling prices”, and not just to address financial fragmentation as in the Trichet doctrine. This is a pretty important departure from a doctrine point of view and may open the door to more agressive actions. Indeed the charts presented by Peter Praet highlight that even in the ECB’s own measure of finanical uncertainty (slide 12), financial fragmentation has reduced tremendously to the point where it cannot alone justify unconventional intervention. Therefore any further action would be dictated by the need to loosen the monetary policy stance and not by the need to repair transmission channels.
PS: this graph + treating this “weak investment drives weak growth” as a pure private sector story is also misleading if not borderline dishonnest. Quite questionable to take public sector investment out and hide it in other investment so as not to show how fiscal consolidation (cuts in public sector investment) has contributed to GDP contraction.