One size fits none monetary policy

There have been quite a bit of good monetary policy news coming out lately. I’ve written some posts about what I consider to be a tremendous failure of central banks all across the world to do their job in the recent crisis. Not all share equal blame, with the Fed and the Bank of England at least making it look like they are trying to get their respective economies moving again. And after more than 2 decades of slipping in and out of deflation, the Bank of Japan has impressively showed a couple of week backs that central banks are not, as is often argued, powerless once they reach the zero lower bound on interest rates.

While Mario Draghi did bring considerable positive change to the ECB, given the catastrophic levels of unemployment in southern Europe has generally left little room for praise. In a sense, the ECB has a harder time doing what it should be doing due to the rules under which it is forced to operate. Particularly its strict inflation target ties its hands even if it wanted to move to bring down unemployment. It also has the weird “feature” of not even being a really symmetrical inflation target, as any inflation target should be, with the ECBs policy being to keep “inflation below, but close to, 2% over the medium term”. Deviations to the downside should be considered as equally calling for action as deviations to the upside, yet in the past it has too often seemed that this was not the case. Recent actions seem to show that 5 years into the current crisis, the ECB is slowly but surely showing it is capable of learning new tricks. Still, the Eurozone remains in depression essentially because the ECB allows it to.

Two days ago Eurostat released an update (.pdf) on how inflation is looking in the Eurozone, and things are not looking good. In particular, with only a handful of exception, countries in the Eurozone have one thing in common that seems remarkable at first sight: inflation is simply too low. The annual rate of inflation for the entire Eurozone as observed in April were a measly 1.2% points, with that of the France being even lower at 0.8% and even Germany, whose economy is supposed to be booming in comparison to the rest of Europe, having an inflation rate of only 1.1%. None of this should come as a surprise given the current state of European economies. It is often argued that a main problem the ECB faces is having to set one monetary policy for countries too economically diverse. Yet from the data just released, the main problem is not so much that its monetary policy has to be one size fits all. It’s that the ECB has allowed it to become a one size fits none. The chart below tells the full story.

The policymakers seem to be well aware of these numbers, having cut interest rates to 0.5% at the beginning of this month and stating that they would be open to provide further easing, potentially leading interest rates into negative territory if the economy seems to demand it. I would argue that the difficulties with implementing this are vastly exaggerated, but we’ll see if the ECB decides to go there. And while some people might cut the Fed some slack for being at the zero lower bound, the issue does not even yet apply to the ECB. There simply is no excuse for the tight money policy pursued in Europe. In any case, what we have seen lately are at least some baby steps, but they are all steps in the right direction of returning some level of sanity to the ECBs monetary policy – even if it comes almost half a decade too late.

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