Today is a big day for the ECB. Mario Draghi and other monetary officials are expected to add further monetary stimulus via additional interest rate cuts and a possible expansion of the ECB's QE program. Many observers are getting excited and expecting big market moves.
Here is the thing. Even if the ECB cuts rates and adds more QE and even if there are big positive swings in market prices, these changes will only be tolerated up to the point they push core inflation to between 1.00 and 1.25 percent. That seems to be the ECB's true inflation target range per revealed preferences. Not only is that well below the ECB's stated inflation target of being "below, but close to 2 percent", but it is nowhere near enough to create the kind of catch-up spending growth needed to restore full employment in the Eurozone.
The real reason for this failure [to create a robust recovery] is the Fed’s firm commitment to low inflation. Like a governor placed on a truck’s engine to control its speed, a commitment to low inflation helps prevent the economy from growing too fast. Normally, this is a good thing. But sometimes it can backfire. A truck driver may need to temporarily go faster to make up for lost time after being stuck in traffic. Similarly, an economy may need to temporarily speed up to get back to its full potential after a recession. Neither can happen with a rigid adherence to the speed limit.
Put differently, both the ECB and the Fed are constrained by inflation-targeting straitjackets. These straitjackets are more than the outcome of central banks actions. They are the product of what the body politic expects and so they are tough to remove. But that is exactly what is needed.
To be clear, we want to keep long-run inflation expectations anchored but allow for the temporary deviations in inflation when needed to generate catch-up growth in nominal spending. The best way to do it, in my view, is through level targeting. Here is an earlier post showing a counterfactual where the Fed adopted a NGDP level target in mid-2009. What it reveals is that inflation would have had to temporarily hit between 3 and 4 percent before settling back down to 2 percent in order to stabilize demand. Something similar would be needed in the Eurozone. But this is not going to happen anytime soon.
The world sorely needs predictable, rules-based level targeting. Until it gets some, we should continue to expect weak recoveries from recessions.
P.S. I made this same point in a BoomBust interview this week.