06 December 2019

Project Syndicate: The European Central Bank needs a new mandate

The ECB needs a more realistic and flexible mandate, defined by a broader price-stability objective. But timing is everything: If the ECB tries to move the goalpost while it is missing the shot, the blow to its already diminished credibility could be serious, writes Marcel Fratzscher.

The European Central Bank’s decision in September to pursue more monetary-policy easing was controversial, with one board representative, from Germany, resigning over the move. But one of the most remarkable features of the ECB’s position has not gotten enough attention: the admission that inflation expectations have become de-anchored, and that without fiscal-policy support, the central bank will probably fail to fulfill its price-stability mandate for the foreseeable future.

In fact, many observers, and even several members of the ECB’s Governing Council, now argue that the bank needs to adapt its mandate with a new definition of price stability in mind. They are right – but there is one crucial caveat.

Since central-bank independence was strengthened in the 1990s, it has become clear that, in normal times, the specific mandate does not matter much. The United States Federal Reserve managed to guide expectations and achieve price stability with its dual mandate (price stability and maximum employment) just as well as the Bank of England or the ECB, with their narrower price-stability mandates.

After the global financial crisis, however, the traditional mandate proved inadequate to cope with large-scale financial instability, fickle market confidence, and political paralysis. Developed-country central banks had to devise policies on the fly, without a guiding framework. Each in its own way pursued unprecedented monetary easing, massively expanding its balance sheet, in order to provide much-needed support to the economy.

In many ways, these measures succeeded: monetary expansion played a major role in pulling the economy back from the brink. But, over time, central banks’ capacity to affect the real economy declined. Today – and for the foreseeable future – domestic inflation is increasingly affected by global, rather than local, developments, and financial (in)stability and fiscal policy are far more influential than monetary policy.

For the ECB, this generates a particularly serious challenge. After all, unlike other central banks, it must account for the preferences of 19 sovereign national governments, with little to no structural or fiscal-policy coordination. The eurozone is also highly fragmented financially, lacking a common capital market, a unifying safe asset, or macroeconomic stabilization tools.

The ECB needs a more realistic and flexible mandate. Given the eurozone’s fragmented nature, that mandate should probably still be centered on price stability. But it should also recognize that the current definition of price stability – “below, but close to, 2% inflation over the medium term” – is too narrow.

A broader definition is needed, according to which the ECB pursues a symmetric inflation target of 2%, within a 1.5-2.5% band, over a longer time horizon. Some advocate an even higher target: for example, Olivier Blanchard, a former International Monetary Fund chief economist, has proposed re-anchoring expectations at 4%. A different proposal, from New York Federal Reserve President John Williams, is to target a price level, rather than an inflation rate.

A commitment to more broadly defined price stability in the long term would give the ECB more space during times of crisis, thereby enabling it to account better for risks to financial stability and the real economy. This would help it to stabilize prices more quickly, bolstering its credibility.

Full article on Project Syndicate

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