Economy & Markets

2019-12-04 Donato Masciandaro

Lagarde, A Wise Owl Between Hawks and Doves

The new president of the European Central Bank has stated that her goal is to be a wise owl between hawks and doves. It won't be easy, since the coming months will see an intensification of the conflicts on the path the ECB must follow; starting with questions linked to the definition of monetary policy.

The handover of responsibility from Mario Draghi to the new president of the European Central Bank Christine Lagarde was marked by three aspects: two results, and one question. The two results regard the ability to implement unconventional monetary policies and the reliability of the Bank's institutional structure. The question regards the future.

The first result can be appreciated by remembering that Draghi's term coincided with macroeconomic events that were extraordinary, in the literal sense of the term. The dual recession that the European Union suffered in the years between 2008 and 2013 placed the ECB in front of a new challenge: avoiding stagdeflation. What is this? Stagdeflation is a toxic economic mix: the decisions of families, businesses, and banks are blocked by a deep lack of confidence in the future. This lack of confidence leads to an aversion to risk, that in turn triggers a domino effect that starts with a drop in consumption, investment, and bank lending, and ends with the stagnation of production and consumer goods prices. Stagnation, through the mechanism of expectations, feeds the lack of confidence, with the risk of triggering a vicious cycle between the stoppage of production and falling prices. The ECB has addressed the challenge of stagflation with a three-pointed attack: short-term rates in bilateral relationships with banks in zero territory for loans and negative territory for deposits, systematic purchases of securities on the financial markets – including those with long maturity and issued by private entities – to push the whole structure of yields downwards, and binding announcements to influence the fall of rates in the future as well. To date, empirical evidence has backed up the ECB: unconventional monetary policy has produced results both in terms of reduction of short and long-term rates, and – as a consequence – stimulated economic growth and consumer price rises.

The second result regards the important role that the institutional design of the ECB has had in determining the efficacy of the monetary policy described above. This is a point stressed repeatedly by Draghi himself: European monetary policy has been credible precisely because it is coherent with the mandate of the ECB. That mandate gives a priority role to the protection of monetary stability, the pillar on which other economic policies rest, in a positive-sum game for economic growth. Summing up: the ECB ship, following the Draghi route, has allowed the European Union to avoid the rocks of stagdeflation.

Now the question becomes: will the Draghi route be valid for captain Lagarde as well? An initial litmus test could be the question of the monetary policy target. Christine Lagarde's presidency could start well if the ECB raised explicit, complete, and transparent questions regarding the strategy of monetary policy; starting with the definition of its goal. Today – as recalled above – the ECB's main goal is that of monetary stability, understood as a variation of consumer prices – in the euro area as a whole and over a medium-term horizon – that is less than, but close, to 2 percent.

The priority of monetary stability can be considered out of discussion, given that, being sanctioned in the EU Treaty of 1992, a unanimous vote of the Member States would be necessary to modify it. Yet the ECB could reconsider the operational definition of the macroeconomic goal. Indeed, a change of the operational target has already taken place in the past. Until 2003, the ECB defined its target simply as a variation of consumer prices of below two percent, without further specification. The ECB then preferred to add that 2 percent must be close, to indicate that it considers both upward and downward deviations of price trends, the risk of inflation and disinflation, or worse, deflation, to be unwelcome.

Today, a reconsideration of the ECB's goal has become necessary in light of the fact that a variation in consumer prices of two percent no longer seems to be an achievable target as in the past – and not only in the euro area. On the subject of the target of monetary policy – and remaining within the debate that continues to consider monetary stability to coincide with the dynamic of consumer prices – there are at least three positions in play. The first position is what we can call conservative, identified with the official position held until now by the major central banks of advanced countries: 2 percent is untouchable. The conservative position can be justified with two different arguments. First of all, there is no guarantee that the reduction of the natural rate is structural; it could be transitory. Secondly, modifying the inflation target means affecting the mechanisms of expectations, opening up a sort of Pandora's box; there is in fact no guarantee that the reactions of families, businesses, and banks will be predictable.

A second position is what we can call "long," i.e. that of the doves: the optimal inflation rate must be increased. The reasoning is as follows: the optimal inflation rate must be correlated with the trend of the natural interest rate. The natural rate is the real return of capital in a long-term horizon. It is assumed that in a state of equilibrium, the nominal rate must be equal to the sum of the natural rate and the optimal inflation rate. We can thus call the corresponding nominal rate a neutral rate, since it corresponds to a monetary policy that must be neither expansive nor recessive.

Now, the optimal inflation rate has until now been considered 2 percent when the estimates of the natural rate were also 2 percent. Therefore, the corresponding neutral nominal rate ended up being equal to 4 percent. Given those features of interest rates, in the event of a recession the central banks had 400 base points of room to lower rates before reaching the floor of 0.

Today all estimates indicate a natural rate of below 1 percent, often close to 0. This empirical evidence leads doves to the following conclusion: to again give central banks the same maneuvering room they had before the great crisis, it would be necessary to raise the inflation target to at least 4 percent. Moreover, the higher inflation rate would make the central banks' desire to implement ultra-expansive monetary policies more credible. Greater credibility of the central banks could increase the ability of monetary policy to affect expectations in the right direction. Indeed, we recall that today the following chain of transmission is considered valid: the necessary condition – even if not sufficient – for the efficacy of monetary policy is that expectations incorporate actions or words of a central bank considered credible.

The same mechanism is the basis for the other proposals of the doves, that can be summarized with the perspective of defining the target of monetary stability not in terms of variation in consumer prices, but looking at the level of those prices. The difference is substantial. If the target is expressed in terms of the level of prices, each time prices go below the target level, in order to return to the path of growth of inflation that has been abandoned, it is necessary for the inflation rate to be higher than in the past.

Here is a numerical example, with some rounding: let us imagine a country that in year 0 has a level of prices equal to 100, and wants to increase consumer prices by 2 percent per year. This means that after 4 years the level of prices must be equal to 108. What happens if the country is hit by a disinflationary shock, such that for three years the level of prices remains stuck at 100? The central bank's goal for the fourth year will again be price growth at 2 percent if its strategy is set in terms of inflation rate. If, on the other hand, it reasons in terms of price levels, in order to recover the lost purchasing power the inflation rate goal will have to be 8 percent. Concretely: using a price level target means that if the ECB does not reach 2 percent for a certain period of time, it must then have an inflation goal of greater than 2 percent.

The third position is the "short" position of the hawks. The hawks agree with the doves on the assumption that the optimal inflation rate must be correlated with the natural interest rate. But the consequence is diametrically opposite. If the natural rate has structurally fallen, it is simply necessary to acknowledge this, and as a consequence reduce any illusion of reaching 2 percent, as "in the good old days." Furthermore, the hawks suggest the possibility that the lowering of the natural rate is the "fault" of over a decade of expansive monetary policies. Monetary expansion that is never interrupted sends an implicit message that economic stagnation continues, such that the effect on expectations is the opposite of that hoped for by the doves: families don't consume, businesses don't invest, and banks don't lend.

As a consequence – continue the hawks – the decision to raise the inflation target, or to use a goal in terms of price levels, reduces the credibility of the central bank; the opposite of raising it, as the doves claim. From this standpoint, the hawks smile at the perspective of raising the inflation target proposed by the doves: they compare it to the performance of a high jumper who after failing to clear the bar at two meters, announces an even higher goal. Who believes it?

Between conservatives, long and short positions, what should Christine Lagarde do? Simply, reconsider the target. Perhaps to bring out intermediate positions. For example, redefining the goal as a variation of 2 percent, eliminating the words "below" and "close." If the inflation target must be symmetrical, why not be clear and simple? Or modify the target, expressing a range of values, rather than a number. If the inflation target were between 2 and 3 percent, the greater flexibility of the monetary rule would increase the ECB's ability to face the reality of a macroeconomic system in which the performance of all the variables – including the natural rate – appears characterized by great uncertainty and risk. Or, the ECB could confirm the target, justifying that choice.

It would be a mistake, however, to pretend that nothing has happened. The issue exists. Actually, after the goal, it is also necessary to consider the tools. One thing is certain: it won't be simple for Lagarde to be a wise owl between the hawks and the doves, as she has stated.

Donato Masciandaro is a Professor of Political Economy at the Bocconi University, where he holds the Intesa Sanpaolo Chair in Economics of Financial Regulation. Since 1989 he has written for the newspaper il Sole 24 Ore. Since 2005, he has contributed to Economia & Management drawing on and developing his comments and analysis published in that economic-financial daily.