The ECB is today widely expected to introduce a number of measures to ease monetary conditions in the euro zone and it seems like the ECB is finally beginning to recognize the serious deflationary risks facing the euro zone.
But how far behind the curve is the ECB? There are a lot of measures of that, but if we look at the ECB’s own stated goal of 2% inflation then we will see that the ECB has basically failed consistently since 2008.
Below I look at the the level of the GDP deflator (which I believe is a better indicator of inflation than the ECB’s prefered measure – the HCIP inflation).
I think the graph very well illustrates just how big the ECB’s policy failure has been since 2008. From 1999 to 2008 the ECB basically kept the actual price level on a straight 2% path in line with its stated policy goal. However, since 2008 GDP deflator-inflation has consistently been well-below the 2%. As a result what I here call the price gap – the percentage difference between the actual price level and the 2% path – has kept on widening so the gap today is around 4%.
This is a massive policy mistake – and this is why the euro zone remains in crisis – and given the fact that we are basically not seeing any broad money supply growth at the moment the price gap is very likely to continue to widen. In fact outright deflation seems very likely if the ECB once again fails to take decisive action.
What should be done? It is really easy, but the ECB is likely to make it complicated
At the ECB in Frankfurt they are happy to repeat Milton Friedman’s dictum that inflation is always and everywhere a monetary phenomenon. So it should be really simple – if you have less than 2% inflation and want to ensure 2% inflation then you need to create more money. Unfortunately the ECB seems to think that it is in someway ‘dirty’ to create money and therefore we are unlikely to see any measures today to actually create money.
Most analysts expect a cut in ECB’s deposit rate to negative territory and maybe a new LTRO and even some kind of lending scheme to European SMEs. But all of that is basically credit policies and not monetary policy. Credit policy has the purpose of distorting market prices – and that shouldn’t really be the business of central banks – while monetary policy is about hitting nominal variables such as the price level or nominal spending by controlling the money base (money creation).
The ECB needs to stop worrying about credit markets and instead focus on ensuring nominal stability. So to me it is very simple. Today Mario Draghi simply should announce that the ECB has failed since 2008, but that that will now change.
He should pre-commit to bringing back the price level to the ‘old’ trend within the next two years and do that he should keep expanding the euro zone money base (by buying a basket of GDP weight euro zone government bonds) until he achieves that goal and he should make is completely clear that there will be no limits to the expansion of the money base. The sole purpose of his actions will be to ensure that the price level is brought back on track as fast as possible.
Once the price level is brought back to the old trend it should be kept on this 2% trend path.
How hard can it be?
PS Yes, I fundamentally would like the ECB to target the nominal GDP level, but targeting the GDP deflator price level would be pretty close to my preferred policy.
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