John FitzGerald: What Europe could do about low inflation

Too much inflation is a bad thing, and can risk spiralling out of control. But too little inflation – price changes at or near zero – makes legacy debt more burdensome and can accentuate economic stagnation by encouraging consumers to postpone spending.

Since it was set up, the European Central Bank’s chief task has been to maintain a stable inflation rate in the euro zone, defined as close to but below 2 per cent. Over its first decade the ECB proved reasonably successful in achieving this target. However, today the euro area inflation rate is well below target and likely to remain so for at least two years. With falling oil prices, each day that passes sees the objective slip further out of the bank’s reach.

Last year, the ECB announced plans to buy large quantities of financial assets to try to tackle the problem. However, in a speech last August, ECB president Mario Draghi signalled that, whatever action was taken by the central bank, some help from European fiscal policy would be much appreciated.

While much of the debate has focused on whether the ECB will buy government bonds, there is a bigger problem: how effective will the purchase by the ECB of any financial assets be in restoring an acceptable rate of inflation?

In a more normal world, where the economy was growing and interest rates began at 3 or 4 per cent, low inflation could be tackled by cutting interest rates. The ECB would make cheap money available to banks and they would make credit available to the public at lower rates of interest, encouraging households and companies across the EU to invest.

By reducing the cost of borrowing for governments it would also encourage more infrastructural investment. Taken together, this would increase demand in the European economy, putting upward pressure on prices and, indirectly, on wage rates. However, these are not normal times: the EU economy is not growing and short-term interest rates are zero. Even long-term rates are exceptionally low and so there is little the ECB can do to lower interest rates. In addition, households and companies in Europe are heavily indebted and depressed about their future. There is evidence that credit is not growing because households and businesses don’t want it, rather than because banks won’t or can’t lend.

Government bonds

Under these circumstances, buying more Irish or German government bonds will not change the Irish or German governments’ budgetary plans and, hence, there will be no direct effect on demand from this source. Instead the purchase of the bonds will affect the European economy indirectly, with the ECB buying government bonds and other assets from financial institutions that already hold them.

Any resulting reduction in interest rates will be likely to be small, given that rates are already so low, and it will have a limited impact on investment.

Instead the key channel through which the ECB policy of buying financial assets will affect the rate of inflation will be through its effects on the value of the euro relative to other currencies, especially the dollar. Whatever the nature of the financial assets bought by the ECB, if they are bought from financial institutions outside the euro zone, this will serve to raise the value of the dollar and depress the euro. This will have two beneficial effects: it will increase inflation, through boosting the price of imports, and it will result in higher foreign demand for EU exports.

However, all of this involves a complex chain of events, with the ECB hoping that, directly or indirectly, the financial assets it is buying will come from financial institutions outside the euro zone. Because of the indirect channels through which this policy will operate, it may take some time to come to fruition.

Direct effect

It would be simpler if the ECB just went out and bought US government bonds. This would be likely to have a more direct and immediate effect on the exchange rate, rather than relying on financial institutions outside the EU selling assets, directly or indirectly, to the ECB.

This will not happen, however, not only because the Bundesbank would not like it but, more importantly, because the rest of the world would find it unacceptable, possibly provoking retaliation. It is not the "done thing" to unilaterally intervene to change exchange rates.

All of this highlights why Mr Draghi would like to see a more stimulatory fiscal policy in Europe. If governments that have the wherewithal to stimulate the EU economy did so, under current circumstances this would have a more direct, and probably more rapid, impact on the inflation rate and on growth.

While we may support Mr Draghi’s call for fiscal action, we also know that he has little chance of having his wish fulfilled.

The problems the ECB is facing in operating a successful monetary policy have given rise to questions about the target itself. Olivier Blanchard, chief economist of the IMF, has suggested that, instead of targeting a 2 per cent rate of inflation, the ECB would be much less likely to face today's problems again if the target were 3 per cent or 4 per cent.

This would make it easier for the ECB as the “normal” rate of interest would then be one or two percentage points higher, making it less likely that we would ever face a situation where interest rates return to zero, as they are now.

However it seems that politics, not sensible economics, is in the way of taking up this suggestion.