HomeChallenges Ahead for ECB, Risk of Remaining Behind the Curve

Challenges Ahead for ECB, Risk of Remaining Behind the Curve

The ECB explains the differences between inflation perceptions and measured inflation. Can it cope with inflation, given its definition of price stability?

Last Thursday, the European Central Bank (ECB) issued a much-welcomed explanation on how it views inflation in the Euro area. More precisely, it explained how inflation perceptions differ from measured inflation, and it did so in such a way that was meant to ease the public’s concerns about possible rising prices.

Indeed, such initiatives are welcomed. While the monetary and fiscal easing in the Euro area does not compare to the ones in the United States, it is not to be said that higher inflation risks do not exist.

They do exist, and the ECB prepares the ground for a better understanding of the concept. Higher inflation, for instance, may reach Europe indirectly, as an overheating US economy coupled with accommodative measures may lead to inflation that spills over to its main trade partners, such as the Euro area.

For the ECB, the problems mount as its mandate is now different from the Fed’s mandate. While the ECB still targets 2% inflation, the Fed moved to an average of 2%. In other words, the market will start putting pressure on the ECB once inflation comes close to 2%, but it will not do the same with the Fed since the Fed shifted its mandate. That is a key issue to address in the future, and the ECB’s explanation of the gap between the inflation perceptions and measured inflation is a great starting point.

Is the ECB Behind the Curve?

Yesterday, the Reserve Bank of New Zealand (RBNZ) issued its monetary policy assessment. It took markets by surprise by hinting at a rate hike, mostly on the grounds of higher expected inflation.

This is a central bank that is known as being proactive. In fact, it is the central bank that instituted the inflation-targeting framework that most central banks used for decades after the 1970s when currencies started to float freely.

But the ECB does not have the luxury of the RBNZ nor the Fed. The ECB was already keeping the deposit facility rate below zero well before the COVID-19 pandemic started. Therefore, even if inflation exceeds the ECB’s target, at best the central bank will lift the rate to positive territory, trailing other central banks with similar mandates.

Let’s assume that the ECB will shift its mandate, just like the Fed did in the summer of 2020. And it will target higher inflation. According to calculations, even if the ECB shifts its price stability mandate to 3% annual inflation, it will take until 2029 to make up for the last decade of undershooting it.

Hence, the ECB faces unique challenges. Apart from rising inflation, it will need to study if its definition of price stability remains valid in the current economic context.

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