Friday, March 4, 2011

Inflation Targeting Gets Another Black Eye

Inflation targeting just got a black eye in the United Kingdom.  Now its about to get another one as the European Central Bank (ECB) President Jean-Claude Trichet signaled interest rates will probably be increased in April.  As was the case in the United Kingdom, the motivation for this move is concerns about maintaining the central bank's  inflation target.  And like the United Kingdom too, the inflation concerns are not warranted given that core inflation is low and inflation expectations remained well anchored according to the ECB.*  Morever,  aggregate spending is still well below any reasonable trend.  For example, the figure below shows Eurozone nominal GDP is below its 1995-2004 trend.  (This time period is chosen to show that nominal GDP is still below trend even after accounting for the housing boom run-up in spending.)  

As Kantoos notes, all of these facts mean that tightening monetary policy in  April  makes no sense.  Especially if the ECB wants to prevent a crackup of the Eurozone.   The Eurozone is  not an optimal currency area and inflation targeting is about to make that even more apparent.   This will definitely be another black eye for inflation targeting.

*The ECB reports in its February, 2011 Bulletin the following on page 54: "Inflation expectations over the medium to longer term continue to be firmly anchored in line with the Governing Council’s aim of keeping inflation rates below, but close to, 2% over the medium term."


  1. as the ECB does not target core inflation, what does low core inflation have to do with their decision?

  2. The CPI is a noisy measure of inflation because food and energy have relatively high variance. Core inflation is a more reliable indicator in any given month of the central tendency in prices than the full CPI.

    So if one wants to stabilize the full CPI, basing decisions on core CPI might be the way to go. That way one isnt chasing transient spikes and dips in volatile components, but rather the central tendency in prices. Thats the argument as I understand it anyway.

  3. Anonymous:

    Yes, the ECB does not target the core, but that is the problem. Core inflation does a better job indicating where trend inflation is going. As noted by econsophism, headline inflation is misleading. Thus, I mentioned core inflation and expected inflation to show the focus on headline inflation is misguided.

    If a central bank is going to do inflation targeting--and that is not my ideal, NGDP targeting is--it should at least do it right.

  4. i'm aware of that argument. so is the ECB. the fact remains that they disagree, and target headline. arguing over what they SHOULD be doing instead is something i will leave to the academics. to borrow from jim grant, investors get paid to see the world as it is, not as it should be.

  5. Anonymous:

    "Investors get paid to see the world the way it is, not as it should be."

    Exactly. That is why markets responded as they did to Trichet's speech. They understood the dire implications of such a move. They know that a rate hike in the current environment will only serve to make matters worse in the Eurozone and are therefore pricing it into the market. In short, investors realize how misguided of a move it is to raise rates now given the low core inflation and stable inflation expectations.

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  7. See here:

  8. 1) eurostoxx finished higher on the day
    2) so did TW EUR
    3) rates rose across the curve (not just the short-end)
    4) implied vols fell

    none of the above is consistent with a market that sees the CB making a policy mistake.

    you point to peripheral yields - but what do you think the liquidity is in cash govies compared to the markets i mentioned above?

  9. I point to peripheral yields, low core inflation, stable inflation expectations, below trend NGDP growth, and the obvious fact that the Eurozone is still in crisis. Do you really think that tightening monetary policy given the above makes sense?

    The only place in Europe where tightening might make sense is in Germany. It seems, then, the ECB is once again catering to German needs while ignoring the rest of the Eurozone.

  10. i'm not debating whether or not it's a policy mistake - i'm debating whether or not the move in asset prices suggests financial markets think it's a mistake, which is what you claimed ("markets responded as they did...[because] They know that a rate hike in the current environment will only serve to make matters worse").

  11. as a follow-up question, why, exactly, do you think that the ECB would do anything other than "cater to German needs"?