Getting it Right: The ECB in the Covid-19 Crisis

At age 21, the ECB delivered a spot-on policy response to the emerging economic downturn. Even ECB-President Christine Lagarde’s remark in mid-March about yield differentials being the remit of “other actors” was well timed. It sent a powerful message to governments about the limits of the ECB’s mandate and the urgent need to fix the foundations of the euro area. Equally powerful was nonetheless the policy response: The ECB increased its asset purchases in mid-March 2020, introduced a new pandemic purchase program (PEPP) allowing the ECB to focus its purchases on government bonds experiencing market stress, and improved the conditions and the scope of its refinancing operations.

Currently, the ECB is in the process of reviewing its strategy. The review will scrutinize the ECB’s policy instruments and aims, the inflation target as well as the ECB’s communication with governments and the public at large. Since the last strategic review in 2003, the ECB has come a long way in refining its monetary policy approach. The most important features to preserve during the strategic review are flexible inflation targeting with a symmetric target and cognizance ofhysteresis effects.

In the current crisis, the ECB’s aim is to stabilize the economy by exerting downward pressure on interest rates and preventing liquidity shortages from aggravating the downturn. Inflation was already very low before Covid-19, with headline inflation at 1.4 percent in January 2020 and the more policy-relevant core rate at 1.1 percent. As unemployment rises, inflationary pressures will undoubtedly weaken and deviate even further from the ECB’s inflation target of 1.9 percent. Furthermore, it would be a grave mistake to interpret the ECB’s mandate solely as the goal of achieving stable low inflation. Price stability is the ECB’s primary goal not because it is a prominent goal in itself but because high inflation is not conducive to economic stability and employment. As one of only two macroeconomic policies, monetary policy is also responsible for ensuring that aggregate demand is sufficient to allow high employment – insofar as bolstering aggregate demand does not conflict with price stability.

Inflation targeting: a flexible strategy in support of low inflation and high growth

During the presidency of Mario Draghi, the ECB’s strategy evolved into genuine inflation targeting, with three crucial elements – a specific inflation target, a well-founded inflation forecast, and an intelligible monetary policy analysis – as the basis for accountability. The inflation target, redefined in 2003 as “below but close to 2 percent”, is still rather cryptic but Draghi began to use the common shorthand of 1.9 percent and it is likely that the current review will define a target of 2 percent without the bias towards undershooting. The current strategy stipulates that the ECB should aim to reach the target in the “medium term”, which means that the ECB adjusts its instruments in line with its own inflation forecast. If inflation is expected to undershoot the target in the medium term, the ECB loosens the monetary policy reins, if an overshoot looms, monetary policy is tightened. During the presidency of Mario Draghi, tightening was never an issue – the ECB has been in crisis mode since 2009 and, aside from oil price shocks, inflation has been weak ever since.

Shortly before Mario Draghi took over in 2011, Trichet had increased rates twice – in April and July 2011 – in response to an oil price shock that sent headline inflation above 2 percent. At the time, euro area GDP was already stagnating and core inflation (without energy, food, tobacco, and alcohol) was well below 2 percent. Under Draghi, the ECB began to emphasize measures of core inflation rather than headline inflation. This is crucial because a policy response to temporary price shocks – like an increase in food prices due to a bad harvest or a rise in oil prices resulting from geopolitical turmoil – influences the affected prices minimally, if at all, but lowers underlying inflation and results in a lower inflation rate once the temporary price hike abates. Inflation is a process kept in motion by a wage-price spiral – one-off price shifts do not require any monetary policy action. That is why the US Federal Reserve targets a core inflation rate and the ECB’s target is defined for the medium term, allowing the ECB to ignore temporary or one-off effects.

The key challenge for central bankers is to discern changes in underlying inflation. Core rates provide some orientation, as do wage increases, but distinguishing temporary from longer-term effects requires vast and detailed knowledge of facts and theory. For example, in general wage increases in euro countries are compatible with price stability if they equal the sum of the ECB inflation target and the rate of medium-term productivity gains. The ECB therefore needs to gauge medium-term productivity gains that are determined by many factors, such as the investment rate.

Neither macroeconometric models nor mechanical rules can serve as more than sounding boards, because they generate results based on specific assumptions which themselves need to be subject to continuous scrutiny given the complexity and perpetual transformation of our economies. In particular, the estimate of potential output is an unavoidable and consequential assumption of macroeconomic models and strict monetary policy rules alike.

Potential output: an adjustable boundary

In theory, potential output and potential growth are compelling concepts because they indicate how much an economy is capable of producing on a sustainable basis, i.e. without causing inflation to rise beyond the ECB’s target. Empirically, however, potential output is elusive. Even estimates based on detailed production functions like the European Commission’s potential output calculations produce time series that are ultimately just less volatile versions of the GDP time series.

One important component in the production function-based estimation of potential output is the inflation-stable unemployment rate. It defines the proportion of workers that need to be unemployed for growth to be sustainable. The European Commission views the inflation-stable unemployment rate as a binding limit to sustainable growth. However, empirical analyses have repeatedly shown that estimates of the inflation-stable unemployment rate are determined without any significant input from wage increases.

Empirically, the inflation-stable unemployment rate is nothing more than a trend based on past and expected unemployment rates. For example, the Commission’s current Spring Economic Forecast puts Germany’s inflation-stable unemployment rate at 3.4 percent for 2019 while actual unemployment stood at 3.2 percent. In 2010, when unemployment was 7 percent, the Commission calculated an inflation-stable unemployment rate of 7.9 percent for the same year. As unemployment changes, so do current and past rates of inflation-stable unemployment: From today’s perspective, the inflation-stable unemployment rate for 1999 is more than one percentage point higher than viewed from the year 2006 - even though the wage pressure in the year 1999 has obviously not changed.

The Spanish example is even more baffling. The Commission’s current Spring Forecast asserts that Spain’s unemployment rate of 14 percent in 2019 represented an excessively tight labor market. According to the Commission, 16.4 percent of the Spanish labor force need to be out of work for inflation to be stable and growth sustainable. Almost four million unemployed is in itself an astonishing sustainability requirement. In view of the Spanish core inflation rate – which stood at 1.1 percent in early 2020, in 2019 and in 2018 – it is absurd. In the midst of the euro crisis in 2013, Spanish unemployment soared to 26.1 percent. The Commission’s estimate in 2013 put the inflation-stable unemployment rate at 23.2 percent for that year, essentially redefining a cyclical problem as a structural problem. From today’s perspective, the inflation-stable unemployment rate for 2013 is 4.5 percentage points lower, the main reason for this revision being the substantial decline in actual unemployment since 2013 leading to a flattening of the curve.

The actual value of potential output depends on many factors that are not only difficult to quantify but also influenced by monetary policy itself. There are three main channels: Firstly, lower interest rates encourage investment which raises the capital stock, i.e. production capacities. Secondly, increased investment often implies the implementation of new, productivity-raising technologies or innovative production processes. Thirdly, higher growth rates tend to increase employment by drawing disillusioned workers back into the labor market and thereby reducing structural unemployment. Conversely, an overly restrictive monetary policy – or more generally a macroeconomic policy stance that limits economic growth – can become a self-fulfilling prophecy by reducing investment, slowing productivity advances, and reducing the readily employable workforce as long-term unemployment rises and disillusioned workers retreat from the labor market.

Monetary and fiscal policy should test the limits of inflation-stable growth

The impossibility of correctly estimating potential output and the effects of monetary policy on potential output have led the ECB to pursue its inflation-targeting strategy without relying on potential output estimates. While the ECB is right not to pay heed to potential output estimates, these alleged limits to sustainable growth do provide a basis for fiscal rules. In the past, this has led to considerable fiscal policy mistakes in the euro area, above all to a pronounced fiscal austerity during the euro crisis. Whereas the monetary and fiscal response to the current crisis was strong enough to limit the damage and initiate a rapid recovery, it remains to be seen whether fiscal policy will remain adequate in the years to come.

Scaling back fiscal support before self-sustaining growth has taken hold would jeopardize the euro area’s future. The past nine years have shown that monetary policy alone is unable to boost the economy sufficiently to align inflation with the ECB’s target. Higher growth rates are also necessary to bring down public debt ratios and high unemployment in many regions of the euro area. At the same time, vast investments are essential to bring about the structural transformation required to create a climate-neutral economy. Fiscal policy has to start pulling its weight. The ECB is legally obliged to support the EU’s general economic policies but not to take on responsibilities euro area governments are unwilling to assume.
 

The views expressed in this article are not necessarily those of Friedrich-Ebert-Stiftung.