Tuesday, March 2, 2010

Criticisms of ECB

A while back, I looked at the case for placing less emphasis on an inflation target of 2%.

Axel Weber, a leading contender to succeed Jean-Claude Trichet as the next president of the European Central Bank has criticised Olivier Blanchard, chief economist at the International Monetary Fund, for his suggestion inflation targets should be raised to 4 per cent to help in fighting the economic crisis. Weber states raising the inflation target to 4% is not just “playing with fire”, but is “reckless and deeply damaging”. This highlights the predominance, the ECB, give to low inflation at all cost. via ( Telegraph)

The ECB have a very strict attitude to keeping inflation low. This model of low inflation has generally served the German economy well. The post war period has been an era of prolonged expansion, against a backdrop of low inflation. After the trauma of the hyperinflation in Germany in the 20s and hyperinflation in countries like Austria and Hungary in 1945, 46, it is at least understandable that the, Bundesbank dominated, ECB want to keep a low inflation target. The problem is that there is a difference in targeting 2% inflation for German economy and targeting 2% inflation for Eurozone.

The Case for 2% Inflation Target

Having a low inflation target has reduced inflation expectations. It would be a real shame to throw away these hard won gains. If an inflation target is revised upwards, people may no longer take the inflation target seriously. Once you lose these low inflation expectations, it may be difficult to keep inflation under control. It may require a situation of permanently higher interest rates.

Criticisms of ECB View

The problem with sticking to a 2% inflation target is that:
  • Inflation increasingly volatile. The UK has been experiencing swings in the headline inflation rate. Often spikes in inflation are temporary events which don't reflect the underlying situation of excess demand. If you target inflation at 2% there is a risk of ignoring a wider economic picture.
  • True, high inflation has costs. But, it is not at all clear that inflation of 3% of 4% is really as damaging as some Central Banks make out.
  • By targeting low inflation of 2%, it means that some areas in the Eurozone - especially those suffering from a lack of competitiveness i.e. Greece and Spain face the risk of deflation. Whilst the costs of moderately higher inflation are uncertain, the costs of deflation should be crystal clear. Deflation raises the prospect of prolonged downturn and creating a deflationary debt cycle. Exactly the last thing, economies in the south of Europe need.If I sound repetitive repeating the dangers of deflation it is only because deflation could be catastrophic and the powers that be in the ECB seem too quick to dismiss it.
  • Liquidity Trap. - We are still effectively in a liquidity trap with interest rates close to zero; but, some economies remain sluggish and stuck in recession. Higher inflation and higher nominal interest rates would be a good thing not a bad thing.
A higher inflation rate would give monetary policy more flexibility and enable it to be more pro-growth. It would lead to a weaker Euro. But, at the moment, a weaker Euro is no bad thing. The EU need to realise the biggest problem facing the Eurozone is not some absurdly remote threat of inflation, but, the real potential of deflation and continued mass unemployment.


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