Pablo Balsinde // 10 February 2017

Mario Draghi´s latest comments expressing his support for continuing the European Central Bank´s Quantitative Easing drew much controversy from northern Eurozone countries, especially Germany, which have been trying to end the asset purchasing program for months. Since Eurozone-wide inflation reached 1.8% in January, they criticize Draghi for maintaining the policy and going against the ECB´s mandate of keeping inflation around and below 2%. Although this target was determined specifically to be about inflation as measured by the Harmonized Index of Consumer Prices (HICP), the Bank has justified its continuation of the program on the basis that core inflation remains around 0.9%. This contradiction over which inflation measure the ECB targets has caused much confusion about how they determine policy, which has in turn caused inefficiencies and contributed to the problem of a lack of transparency the ECB has had for years. Although one would think that this disparity is caused by the Bank´s official structure, it is actually rooted in political divisions among Member States.

Core inflation is usually defined as inflation excluding volatile items like food and energy prices, reflecting the fundamental inflation of the economy in question. In the case of the Eurozone, the large difference between the two measures in January was caused by the surge in oil prices resulting from the oil production deal OPEC and many oil producing countries signed in December, which drove energy  price inflation above 8%. It is clear that rational arguments can be made for using each of the two inflation measures. For example, because of the unprecedented success of this deal, German euro sceptics could argue that energy prices will remain stable, so the Bank should stick to HICP. On the other hand, proponents of core inflation argue against the popular conception and see it, for example, as the best predictor of future inflation (Smith 2004) – which would support the ECB´s justification of it as the proper measure of inflation.

Regardless of which measure is more appropriate, one could argue that the confusions and inefficiencies are caused by the ECB´s single mandate of price stability, positing that this individual focus unnecessarily restricts its room for action.  However, the mere clause in the Maastricht treaty for the European System of Central Banks to assist in broader economic policy suggests that the ECB does much more than simply control inflation. Historic policies, then, show that the ECB´s single mandate is no different from the American Federal Reserve´s dual mandate of price stability and sustainable employment (Svensson 1999). Having the effective mandate of economic growth, Draghi would then be justified in maintaining the Quantitative Easing program (assuming such market intervention and distortion is effective) since it is clear that some southern European countries, especially Italy and Greece, have not come out of the recession yet.

As such, specific HICP targeting is just a policy in name, as is the case for operating based on core inflation. The different measures have become retroactive justifications for economic policies and have therefore become politically oriented. Quantitative Easing, then, lies at the heart of the Union’s strongest divisions. In the midst of persistent economic disparities between northern and southern nations, the policy and its implications have become politically tied to national interests. Whereas German ECB critics complain about the lack of savings returns due to inflation, suddenly ending the program would prove extremely damaging to crucial economies such as Italy, which is running out of time to implement structural reforms, and still maintains a low normal inflation rate of 0.9%.

The confusions and quarrels over what measure of inflation should guide policy do not reveal consensus about what the goal of monetary policy is. Rather, the lack of consensus it reveals the internal political divisions of the monetary union and epitomize Milton Friedman´s hallmark prediction that the European monetary union would not succeed without political unity. Like he argued, a lack of consensus to establish and agree on proper shock absorbing mechanisms would result in the demise of the Euro, and the lack of consensus over the definition of inflation and its implications to bond buying programs is a perfect example of this.

References:

Smith, Julie (2004) ‘Weighted median inflation: is this core inflation?’ Journal of Money, Credit and Banking 36, 253-63

Svensson, L (1999), “Monetary Policy Issues for the Eurosystem,” Carnegie-Rochester Conference Series on Public Policy 51: 79-136.