By Leonardas Marcinkevičius is an expert at the Lithuanian Free Market Institute
Last Thursday, as predicted, the Governing Council of the European Central Bank (ECB) decided not change the key interest rates. These were left within the range of 4.00-4.75 %. However, contrary to previous occasions, ECB President Christine Lagarde made it clear this time that an interest rate cut could be expected as early as next summer.
Many borrowers eagerly await when their installment will start decreasing, and businesses will have opportunities to borrow at lower rates. However, it is essential not to forget that the entire euro area faced a record-breaking surge in inflation driven by “money printing”.
By adjusting the benchmark interest rates, the ECB aims to achieve its primary goal of “price stability,” which policymakers understand as 2 % annual inflation. However, tracking this goal has not been straightforward throughout the 25 years since the euro’s inception. One of the complicating factors has been the lack of clearly defined time frames.
Good Morning on #ECB day from #Germany where key interest rate should be at 6.7% & so 2.2ppts higher than current rate, acc to Taylor Rule w/German inflation at 3.7% & unemployment at NAIRU. The spread has risen again recently & there is a risk that inflation will pick up once… pic.twitter.com/2k4Z0m53h5
— Holger Zschaepitz (@Schuldensuehner) January 25, 2024
The definition of “price stability”
Since the creation of the euro area, the central bank has aimed for 2 % inflation, but this goal has been adjusted several times. The objective of “maintaining price stability” was entrusted to the European System of Central Banks (ESCB) in key EU documents. However, neither the 1992 Maastricht Treaty nor the ESCB Statute provided quantitative or qualitative criteria by which to evaluate whether prices had indeed remained stable.
Even before the introduction of the euro, it was agreed that “price stability” would be considered as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 %” with the added note that the highest acceptable limit of inflation should be reached “over the medium term.” In 2003, this definition was supplemented by specifying that HICP growth should not only be lower but also “close” to 2 %.
The concept of price stability was further amended in 2021, stipulating that, in the medium term, inflation should neither exceed nor fall below the 2 % threshold. This means that the central bank considers not only high inflation but also the opposite process – deflation – an undesirable phenomenon.
The lack of clear definition serves as an opportunity to evade responsibility
However, the main problem for price stability in the euro area arises not from a lack of criteria but by setting goals within an undefined timeframe. The 2 % annual inflation target is understandable and straightforward, but “medium term” is not described in any document – which complicates matters.
According to the ECB, such “flexibility” allows them to apply appropriate monetary measures, taking into account constantly changing circumstances and economic shocks. The fact that their goal is variable was confirmed by statements from the central bank’s management: “The length of the “medium term” – which is an integral part of its definition of price stability – will vary over time”, said Isabel Schnabel, a member of the executive board of the institution, in February 2020, adding that the duration of this concept depends on various factors.
So, while the ECB has an obvious quantitative indicator, monetary policymakers can always say that the “medium term” has not yet passed, so high inflation is not a problem. This happened during the pandemic when prices began to rise rapidly.
The post-pandemic surge changed the entire inflation landscape
Although the central bank does not explicitly specify the framework within which we can assess the success of its policy, it is always helpful to have a common historical context in mind. Many economists repeat that despite negative interest rates and constantly increasing money supply, the central bank had not been able to raise inflation to the desired level until the pandemic.
However, the economic stimulus measures implemented during the pandemic were a few times larger than ever before, and such a policy significantly changed the historical picture of inflation in the euro area. Looking at the price statistics, from 1999, when the euro was created, until the end of 2023, prices increased by more than 68 %. This means that the average annual price growth throughout the entire history of the euro area is 2.7 % – significantly more than the “price stability” definition suggests.
If policymakers were to set a goal that 2 % annual inflation should be achieved not in the “medium term” but by evaluating the entire history of the euro area – the ECB should ensure that the overall price level does not grow practically for a decade – until 2033.
Of course, the central bank is even more afraid of falling prices than the growth of it, so it is naive to expect that the extent of currency depreciation throughout the entire history of the euro area would be taken into account. However, such a mental exercise allows us to understand the impact of record inflation in the context of the entire history of the euro.
Time to change policy
In October 2022, the peak of inflation exceeded the goal and was five times higher than the goal, so there is no need to return inflation to the 2 percent level rapidly. According to December’s data, inflation in the euro area still stands at 2.9 %. Despite this, policymakers are already discussing the possibility of reducing interest rates in about six months. However, even considering the “medium term,” the central bank should allow recovery after the record-breaking price surge and refrain from implementing cheap monetary policy.
Another easing of monetary policy before reaching the “stable” price level poses a risk that Europeans might have to deal with another surge before recovering from the record inflation.
— Holger Zschaepitz (@Schuldensuehner) January 31, 2024