Ifo Viewpoint No. 45: New Inflation Targets for the ECB
21 May 2003
This month’s long-awaited revision of the European Central Bank’s inflation target was a disappointment. Although the ECB paid lip service to greater tolerance of inflation, nothing has really changed. The ceiling for eurozone inflation will remain at 2 per cent. This is bad news for eurozone countries since they need a dose of inflation to get moving again.
Controlling the average inflation rate alone makes no sense as long as the span in national eurozone inflation rates, which averaged 2.7 per cent over the first four years of the euro, remains as large as it is. This divergence has systemic causes that are likely to persist for the foreseeable future. Although the member countries already have very similar prices for traded goods, great differences prevail in prices for non-traded goods such as services, rents, building materials and catering. This is because of different wage levels, which in turn reflect differences in development. In the course of the economic convergence that will take place over the next two decades, wages as well as prices for non-traded goods and services will converge in all eurozone countries.
This adjustment in relative prices is a natural and desirable process that the ECB's monetary policy should tolerate, especially as it is advanced by the euro. The euro led to a convergence of interest rates in Europe and has lowered the real cost of capital in soft-currency countries that previously had to pay high risk premiums with their interest rates. For this reason the euro is stimulating investment in these countries, supporting real growth, boosting wages and increasing the rate at which prices are converging.
If the ECB tries to curb this transitional inflation with a restrictive monetary policy based on an ambitious inflation target, it will adversely affect the more developed countries, which will be forced towards too low a rate of inflation. Since nominal wages and prices in the core eurozone economies tend to be resistant to change, some inflation is always advisable because it facilitates real wage and price cuts in weak sectors. If inflation is too low, real wages and prices in these sectors will remain too high, triggering bankruptcies and job losses. The German and French economies are the main victims, because they have high wages and high prices for non-traded goods. Moreover, both countries have lost the interest-rate advantage they enjoyed when they had their own currencies. Aggravating this is the possibility that the euro may have been introduced too early, before the D-mark and the French franc were able fully to realign after the 1992 currency crisis.
The real wage restraint necessary for restoring competitiveness in Germany and France could be more easily accomplished if the ECB had a higher inflation ceiling. This would enable Germany and France to become more competitive by just waiting for inflation in other countries, whose price levels are currently too low. With separate currencies, they could induce the same effect with an open devaluation. Unless monetary policy is loosened, such a level of competitiveness could take a decade to attain.
It is sometimes argued that the ECB should not consider country-specific inflation rates because the US Federal Reserve looks only at the US average. That argument is not convincing. First, unlike the dollar, the euro is young. Currently, Europe is undergoing a real convergence process with huge differences in inflation rates; this problem has long since been overcome in the US. Second, unlike Europe, the US has no extended social welfare net that prevents nominal wages from falling. European states offer unemployment benefits that depend on previous wages and welfare payments that are defined in nominal terms. These high replacement incomes keep a floor under nominal wages. Even if unions are willing to accept or unable to prevent real wage cuts, real wages cannot fall unless there is inflation. Yes, political reforms that cut unemployment and welfare benefits are also a possibility, but such reforms are very tricky.
For this reason the ECB should set an inflation ceiling of 2.5 per cent until eurozone convergence is concluded, at the same time ensuring that no country falls to very low inflation levels, say below 1.5 per cent. It should pay particular attention to the inflation floor, because deflation or low inflation in single countries would pose great dangers to the stability of the European economy.
Professor of Economics and Public Finance
President of the Ifo Institute
Published as "A shot of inflation would be good for Europe", Financial Times, May 21, 2003, p. 15; see also "Die Euro-Bank sollte mehr Inflation akzeptieren", Financial Times Deutschland, May 16/17, 2003, p. 19 and "2,5 Prozent sind besser", Süddeutsche Zeitung, May 2, 2003, p. 20.