Light and shadow – the new goal of European monetary policy

The realignment of the European Central Bank’s (ECB) monetary policy target resembles a revolution: After twenty years, the Central Bank Council has changed the target figure on which monetary policy is based and against which it wants to be measured. From now on, the inflation rate targeted for the euro zone will no longer be „below but close to two percent“, but two percent in the medium term. And it has done so in such a way that deviations from this target rate, both upward and downward, are equally undesirable, as the statement on the ECB’s monetary policy strategy puts it. This means that if the actual inflation rate in the euro area is below the target rate, this is considered just as negative as if the inflation rate is above the target rate.

In practice, this symmetrical valuation means more leeway for the central bank to tolerate a rate of change in the eurozone consumer price index when it rises above two percent for a while. Then the ECB does not have to react quickly with interest rate hikes. In other words, a kind of compensation is made possible between periods of too low and periods of too high macroeconomic price increases when target misses have occurred. And unambiguously, it defines what „too low“ and what „too high“ means: „The Governing Council considers that price stability is best maintained by aiming for two per cent inflation over the medium term.“

Symmetry did not exist in the previous target definition, which put the ECB under pressure to act as soon as the observed inflation rate rose even a few tenths of a percentage point above the target. When there was a downward deviation from the target, on the other hand, there was no formal pressure, or at least less.

But what is revolutionary about this change, which in purely quantitative terms has turned out to be vanishingly small – the medium-term target itself, at 2 percent, has hardly changed at all –, which can be scientifically justified and which was therefore long overdue? It is the fact that it took place at all.

Traditional resistance of the neoliberal mainstream

At least in Germany, influential neoliberal economists were (and presumably still are) strictly opposed to such a redefinition of price stability, which they see as a softening. For example, former ifo institute president Hans-Werner Sinn wrote in a guest article for Handelsblatt in July 2019: „In the Maastricht Treaty, the ECB was given the non-negotiable goal of ensuring stable prices, which, if taken literally, means an inflation rate of zero.“ In 2016, together with Gunther Schnabl, he had criticized the ECB’s bond purchases as the „drug of cheap money“ in the FAZ and called for „snatching the bazooka“ from then ECB chief Mario Draghi. Literally, the article says: „The ECB should once again orient its inflation target more strongly to the Maastricht Treaty, which prescribes price stability and not, for example, an inflation rate of close to two percent. There should be an end to the semantic reinterpretation of the mandate.“ (It should be noted in passing that Hans-Werner Sinn, together with Michael Reutter, had still advocated an ECB inflation target of 2.5 percent in 2000).

The former chairman of the German Council of Economic Advisers, Lars Feld, is also likely to have reservations about the ECB’s changed target, having said in an interview in April of this year: „I think the ECB’s monetary policy will only become more restrictive if we have higher inflation over a certain period of time and not just one or two months. But I also say that it is not necessarily good if the ECB allows overshooting. Because it has an inflation target of just below two percent and should stick to it.“

Bundesbank President Jens Weidmann, known as a proponent of a tighter rather than looser monetary policy, does comment on the Bundesbank’s website regarding the statement of the ECB Governing Council, which was adopted unanimously – i.e. including by him – as follows: „A medium-term inflation rate of 2 per cent is a clear and easily understandable objective. We are not striving for either lower or higher rates. That was important to me.“ But the text goes on: „Mr Weidmann said that temporary deviations from the target in either direction could occur. ‚However, we do not make our monetary policy contingent on targets not met in the past: our strategy remains forward-looking and takes into consideration the new challenge of the effective lower bound.'“ That already sounds less convinced of the symmetric treatment of target deviations. After all, how is symmetry supposed to work if values from the past are not included in monetary policy decisions?

According to the FAZ, at the beginning of July 2021 Jens Weidmann is said to have „spoken out against the concept of flexible inflation control [in which] a temporary overshooting of the inflation target is tolerated. Overall, such a concept does not convince him, Weidmann said on Thursday according to the text of the speech before the Friends of the Ludwig Erhard Foundation.“

Asymmetry in interest rate setting options

The problem any central bank has is that its options for action are asymmetrical: From a purely technical point of view, it can raise key interest rates indefinitely, but lowering them is limited to zero or just below, as any layman can see in the eurozone today. The ECB calls this the „effective interest rate floor.“ This is because negative interest rates, i.e. costs for storing money in banks instead of returns on savings, can be avoided to a certain extent by hoarding money outside the banking system. This is not free of charge either, because „safekeeping costs“ are incurred, but they are not unlimited.

So, technically, it is easier for a central bank to fight an inflation rate above a target level than one below it, when the target level itself is already close to zero. In other words, the smaller the margin between the target and the effective lower bound, the easier it is for monetary policy to be distorted „downward“ in the medium term: Because monetary policy is better able to enforce its target against inflationary forces than against deflationary ones, it runs the risk of remaining below its target on average in the medium term if it does not explicitly allow this target to be exceeded „in reserve“ – not to mention compensating for past undershoots. The point is to build up a buffer between the target rate and the effective interest rate floor, which prevents monetary policy from getting stuck near the floor, as has been the case in the euro area over the past ten years. The President of Deutsche Bundesbank does not seem to be fully convinced of this view of things, as evidenced by the above quote.

The New Inflation Target, Inflation Expectations and Structural Change

Now, one may well ask what sense an average view of past inflation rates makes in the orientation of current monetary policy. If, in view of past undershoots, current overshoots are allowed, some fear that this could be misinterpreted as tolerating permanently higher inflation rates above the target level. And this would, it is believed, then inevitably form the basis for actually higher rates of price increases.

This argument is not very convincing. After all, all the players, especially the wage bargaining parties, know that the central bank can raise key interest rates at any time if it considers the inflation rate to be too high. So why should they increase their demand sharply and thus drive up prices solely on the basis of increased inflation expectations and, above all, overstretch wage agreements after all the experience they have had since the first oil price crisis in the 1970s up to the euro crisis of the 2010s? Last but not least, the existing high base of unemployment hangs like a millstone around the neck of any wage negotiations in the eurozone. Anyone who considers rising inflation expectations to be a real threat to price stability must explain how, under the current circumstances, they can translate quite concretely into permanently higher inflation rates above the ECB’s target. In a market economy, prices are formed in markets under certain power constellations and not in the heads of financial analysts.

The argument of expectation formation, however, supports the ECB’s new strategy if one looks at it the other way around: The central bank’s assurance that it will not immediately respond to any rise in the price level above the two percent mark by raising its key interest rates gives rise to confidence that noticeable relative price shifts can occur without deflationary pressures. This encourages private investment, which is needed for the inevitable structural change. Investment is the driving force behind positive economic momentum, enabling the economy to emerge not only from unemployment but also from the zero interest rate policy. And that is precisely what monetary policy wants to get out of without stifling the economy. It therefore makes sense for the central bank to take the lead, so to speak.

The faster the necessary structural change is to take place, the greater the scope we need for relative price shifts. After all, they are the be-all and end-all for structural adjustment processes that we will have to face in view of climate change – be it to prevent or at least limit it, or to adapt to its consequences. It makes a big difference whether prices (and with them profits) in sectors that are in demand for decarbonization, for example, rise at an above-average rate, thus signaling that innovations, investments and capacity expansions there are worthwhile, or whether these prices barely rise more than the overall economic target rate and at the same time other sectors record price reductions. The arithmetical effect for the relative price shift may even be the same. But the signal character for investors as to where there are profit-promising bottlenecks is clearer and stronger in the first case and not combined with a deflationary stalling in areas that must lose in relative terms in the long run.

In other words, the rebalancing of the ECB’s monetary policy objective improves the prospects that the European economy can manage the development it desperately needs. The ECB has defined a buffer against the effective interest rate floor (namely two percent) and intends to protect it through the symmetry rule. This is a good thing.

Justifications for the inflation buffer – the dark side of the „revolution

Less convincing, however, are the four reasons given by the ECB in the policy paper for the inflation buffer: the „pronounced trend decline in the equilibrium real interest rate,“ „the facilitation of cross-country macroeconomic adjustment within the euro area, downward rigidities in nominal wages and measurement errors.“

By measurement errors, the fourth argument, we mean a potential overestimation of price developments, so that the calculated inflation rate may systematically turn out to be higher than the „actual“ one. This is related to many statistical details, such as the assessment of technical progress, which are not at issue here. They may be a good argument for a calculated inflation buffer, but they are also no more than a technical parameter.

The first three of the four reasons mentioned, however, provide deep insights into the economic thinking of the members of the Central Bank Council, which give little hope that the redefinition of the monetary policy target would also have brought a new understanding of macroeconomic relationships into the minds of all members of this body.

Real Equilibrium Interest Rate – Fig Leaf and Declaration of Bankruptcy at the Same Time

What is to be made of the first argument for an inflation buffer, the trend decline in the „real equilibrium interest rate“? First, it is necessary to clarify what is meant by the „real equilibrium interest rate.“ „Real“ means inflation-adjusted. The „equilibrium interest rate“ is, as the ECB writes, the „the rate at which all factors of production are at full capacity and inflation is stable.“ It „cannot be directly observed and instead has to be estimated,“ which, as a side note, applies to many „equilibrium variables“ invented by economists, which cannot be observed precisely because equilibrium never prevails in a permanently changing world.

Be that as it may, the „real equilibrium interest rate“ estimated by the ECB must have something to do with capital supply and demand. For the fact that „the real equilibrium interest rate in the euro area has fallen markedly over the past 20 years“ indicates „that the supply of capital is matched with relatively low demand – in other words that the desire to save is meeting with a comparatively low propensity to invest.“ The ECB economists attribute this development primarily to declining trend growth in the economy and this to declining productivity growth as well as demographic change (see ibid. slide 12 and also in the ECB’s strategy paper cited at the beginning under item 1).

The concept of the „real equilibrium interest rate“ is associated with the idea that monetary policy has no influence on this interest rate and can only play around it, so to speak, with its key rates in order to control the inflation rate in the course of the business cycle: It can set key interest rates above this exogenous real interest rate plus the prevailing inflation rate if it considers inflation to be too high, and below it if it considers the prevailing inflation rate to be too low. However, it cannot escape the trend of this exogenous real interest rate, but must follow it. If it fell, monetary policy would have a systematic problem for which it could not be held responsible. For then the scope for interest rate cuts to stimulate the economy and inflation would diminish continuously all by itself.

The desire for a protective inflation buffer to prevent the economy from sliding into deflation therefore seems quite obvious. With this construct of thought, monetary policy can justify an occasional acceptance of higher inflation rates to the „small saver“ and all other critics of the low interest rate policy who are annoyed by low or even negative real interest rates.

But the price for this fig leaf is high, because it could render the new inflation target ineffective for concrete future monetary policy. The fact that the Governing Council presents productivity growth as an exogenous phenomenon, at least one over which monetary policy has no influence in the long term and to which it can only adapt, is tantamount to declaring monetary policy bankrupt. This is the monetarist position of the neoliberal school: The level of long-term interest rates is, in their view, the result of market processes between the supply of capital (savings) and the demand for capital (investment); technical progress falls from the sky and is implemented on earth all the sooner, the more profits entrepreneurs can expect thanks to flexible labour markets, i.e. low wages, and thanks to low taxes; and monetary policy, with its key interest rates, merely accompanies the short-term cyclical ups and downs of the economy, but has nothing to do with the long-term trend of economic development. This familiar refrain is not explicit in the strategy paper, but it follows automatically from the concept of the „real equilibrium interest rate“ referred to there.

How is it possible, after the ECB’s bailouts in the financial crisis of 2008/2009, after its failed blackmail policy – measured by unemployment figures – toward Greece and other southern European states in the euro crisis, and after its current role in pandemic management, to assume as a matter of course that monetary policy has no long-term influence on the trend of real economic development remains, to put it mildly, a mystery. That the neoliberal „hawks“ in the Governing Council of the ECB agreed to the strategy paper after having placed this Trojan horse in it is not surprising. However, it would be urgently necessary to overcome the monetarist thought construct so that monetary policy can finally assume the responsibility for real economic development that is its due and credibly demand the support of wage policy that is indispensable for this purpose.

Downward spiral for all

The second reason given by the ECB for the inflation buffer, „facilitating cross-country macroeconomic adjustments in the euro area“, leaves the naive reader wondering: Since when has smoother macroeconomic adjustment between euro area countries been a problem? Hasn’t there been a constant call for greater flexibility and better adaptability to promote the convergence of euro countries? Now, all of a sudden, simplifying macroeconomic adjustment is supposed to be a problem? This vague formulation has nothing to do with clear communication to the interested public, as the ECB has set itself the goal of doing.

A little translation help is needed here: If the macroeconomic developments of the euro countries are adjusting to each other faster and this justifies the need for an inflation buffer in the eyes of the ECB, the sentence is supposed to express in a convoluted way that a slipping price level in one country will quickly drag the price levels of other countries with it – at least faster than before. Or translated even more clearly: If deflationary processes take place in one eurozone member country, such as Germany, the other countries must now follow very quickly. After years of losses in competitiveness and corresponding trade imbalances, they have no choice thanks to the Maastricht debt criteria and the European Fiscal Compact. German wage agreements are now setting the pace for the euro partner countries: If the German wage bargaining parties slam on the brakes, this will quickly spread to the rest of the EMU.

The Governing Council of the ECB knows this, too. But it has apparently not been able to agree on directly addressing the mechanism (inflation as a result of unit labour cost development), naming the steed (wage policy) and criticizing the rider (Germany). This is a serious mistake. In line with the neoliberals, the Governing Council has missed the opportunity to link the reorientation of its strategy with a reference to the responsibility of wage policy for price developments. If, in the aftermath of the Corona crisis, wage developments in the euro zone fall even more behind than in the past ten years – which, unfortunately, has many aspects in favour because of high unemployment and the expected renewed focus on the debt brake – monetary policy will not be any more successful despite the readjustment of its objective. This can then discredit this readjustment, although the failure would have nothing to do with the change in strategy. Such a development would be grist to the mill of neoliberal monetarists. Which shows that one should not only choose the right target, but also provide the right justification for it. The „hawks“ in the Governing Council have obviously managed to prevent this.

Wage Rigidities – Scapegoat or Central Building Block of the Inflation Buffer?

And this brings us to the third reason cited by the ECB for the inflation buffer, namely „downward rigidities in nominal wages“. This argument destroys any hope that it will be possible to agree on a clear, logically sound line of monetary policy within the Governing Council of the ECB as it is currently constituted. After all, if downwardly rigid nominal wages are supposed to justify an inflation buffer, this means conversely that such a buffer would be superfluous or at least less necessary if nominal wages were flexible on the downside. Such ideas come from the neoclassical thought drawer. In it, it looks like this: When prices fall and nominal wages do not, i.e., are rigid, real wages rise in purely arithmetical terms. This puts a burden on firms because their sales decline while costs remain constant, and therefore their profits decline. Companies react to falling profits with less investment and with layoffs, which damages the economy as a whole. To avoid such a constellation, it is therefore a good idea for the central bank to tolerate higher inflation rates for a while so that real wages fall again or do not rise at all. From this perspective, the inflation buffer thus serves to compensate for the downward rigidity of nominal wages.

The catch of this argument is that it does not explain when and why prices fall. This important point is merely assumed, completely unrelated to all other variables. In a market economy, however, the background to a price reduction on a broad front is a sharp drop in demand. This is essentially related to the development of mass incomes, which in turn are mainly determined by wage developments. Downwardly rigid nominal wages are therefore extremely important in the fight against a slide of the overall economy into deflation!

Thus, it could have been logically consistent to argue that downwardly rigid nominal wages constitute a fundamental condition for protection against the deflation trap, i.e. that they are themselves the essential component of an inflation buffer, so to speak. Instead, they are cited in the ECB’s strategy paper as a reason why an inflation buffer is necessary. This shows that there is disagreement or even ignorance among the ECB’s Governing Council about an essential macroeconomic context regarding deflation. The topic of wages is and remains taboo in the ECB’s communication or, if it does occur, as at this point, then exclusively in a neoliberal style.

This easily explains the unanimity of the Governing Council in adopting the strategy paper: The neoliberals were able to fully place their construct of ideas in it and, once the worst waves of the pandemic will have subsided, will continue to pursue their economic policy dogmas single-mindedly and at the expense of the lower income class. After all, the ECB paper also states that „the appropriate monetary policy response to a deviation of inflation from the target is context-specific and depends on the origin, magnitude and persistence of the deviation.“ This wording leaves much room for interpretation. It is to be feared that the glimmer of hope associated with the realignment of the inflation target will be followed by much monetary policy shadow.


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