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Economy in Brief

Credibility or Not Here We Come Central Bankers on Parade
by Robert Brusca  April 10, 2014

Central banking has been through a number of ups and downs. Currently central bankers are under a good deal of pressure for the regulatory missteps during the financial crisis as well as what are construed by some as inappropriate incursions into fiscal policy.

When we look at the European Central Bank, we're looking at a bank that has a fairly straightforward mandate. Its mandate is keeping inflation close to 2%. Since the euro area has been formed, the inflation rate it targets, the HICP, has averaged 1.99%. That's a pretty good record.

However, the ECB has hit this target by introducing some considerable problems into the euro area. One of the main reasons the inflation rate in the euro area has been so close to the 2% mark is that Germany has run a compounded annual rate of inflation of 1.6% since the euro area was formed. Because of its large size, its weight in the euro area helped to suppress the inflation rate for the euro area as a whole as other members overshot the ECB target rate. Apart from Germany and France, every other euro area country (among the original members plus Greece) is averaging inflation above 2% during this period gauging from their compounded annual rates. Belgium comes close to 2% at 2.08% after that the Netherlands moves up to 2.13% and Ireland is at 2.18%. At the high end we've got Luxembourg at 2.69%, Greece at 2.65%, and Spain at 2.62%, and so on. Because country units matter in the European Monetary Union much more than do the differences between states in the United States, political problems have developed in the euro area resulting from these inflation differences, and therefore competitiveness, divergences.

However, the ECB has never been given any charge to smooth over or ameliorate regional or state level inflation differences. We therefore regard the ECB as successfully pursuing its mandate. ECB President Mario Draghi has come under some pressure with this program of asset purchases (LTRO, long term refinancing operations), but the euro area may have recently come to terms with that.

Although the ECB has had its inflation target from the euro area's inception, like the Federal Reserve in the United States, since October 2008 inflation has run persistently under its target. Inflation in the euro area has run at a pace of 1.65% over this period. This is for the entire union and it is notable that this is the pace Germany used to run all by itself with inflation rates in the rest of the euro area higher.

The Fed has a similar problem as inflation in the US has been lower than the Fed's notion of 2%, too. Looking back to October 2008 and ahead, if we assume the Fed hits its targets for the PCE out to 2016, the Fed will have run a period of over eight years with inflation below its target. If we calculate what actually is in prospect, inflation over this eight-year-plus period of time comes out to less than 1.5% per year. That is considerably below its 2% target. Imagine the stink the hawks on the FOMC would make if the Fed policy were to la-tee-dah as inflation ran at 2.5% for a period of eight years.

When central banks formed their targets, they were obviously mostly concerned about having inflation credibility meaning that they would keep inflation from getting much higher than the number that they chose to target. However, a target is a target. Central banks now find credibility under siege as they find their targeted inflation rates are under the level that has been targeted, and staying there for long a period of time.

The ECB is feeling pressure over this and is looking into some sort of program like quantitative easing that it might employ. On the other hand, the Fed is scaling back its program of quantitative easing even though it's inflation rate has been below 2% and is expected to stay below 2% all the way out to the end of 2016.

In the middle of 2013, the Fed was forced to add some boilerplate to its monthly statement as Jim Bullard (St Louis Fed President) noted that the Fed was essentially ignoring its inflation target. As a result, the Fed added `language' to its monthly statement noting that inflation remaining below the 2% target could be damaging to the economy. However, after that statement was added, nothing in Fed policy changed except for the Fed to undertake its program of tapering by the end of the year, thereby cutting its boost to the economy.

In early 2014, new voting member Narayana Kocherlakota has brought back this dissent, arguing that the Fed's inflation target lacks credibility since the Fed is willing to absorb such persistent misses on the downside. Kocherlakota argues that in this situation the Fed should be more aggressive in trying to boost growth and lower the unemployment rate, both of which are low. The Fed has been vocal about undertaking a mandate to boost the labor market under both Bernanke and Yellen.

The ECB and the Fed seem to be facing similar kinds of targeting problems. However, the nature of their difficulties is quite different as the ECB is making policy in a monetary union without fiscal cohesion. In that case, the country-level shortfalls in growth or overshoots for inflation fall at the feed to the local fiscal authorities more than at the feet of the central bank.

While the US does have a centralized fiscal authority, fiscal policy has been hamstrung by political wrangling for a number of years. There's an argument among economists about whether it's proper for the central bank to try to step in and make up for deficient fiscal policy with a more aggressive monetary policy. While the Fed for the most part has done that, its efforts have fallen short as it is missing both its unemployment objective and its inflation objective.

The ECB has been inflation targeting for a long time. As you can see from the table, its success in keeping the rate close to 2% has brought it a great deal of credibility. Even so, the ECB is under some pressure for its recent shortfall of inflation. The Federal Reserve - which would argue with the statement I am about to make - still has not adopted an inflation target. The Fed has identified an inflation rate at 2% where, it argues, the economy functions best. The Fed applies this rate to the PCE headline although it sometimes speaks in terms of the PCE core, but it never commits to hitting this rate as a target; nor has it done so in a de facto manner. There is no time horizon over which the Fed has promised to enforce this inflation rate. Since the Fed is new to the inflation targeting game, having finally latched onto it in the wake of having abandoned monetary targets, the Fed needs to bolster its credibility. By not adopting any inflation rate as a target, and by falling short of its `alleged target' persistently, the Fed looks insincere. When the Fed says that the economy functions best with the PCE at 2%, and does not try too hard to make that happen, Fed credibility is undermined.

Europe is not about to adopt more fiscal stimulus since it is gone the other route to impose austerity on a number of member countries where the local inflation rates had been too high for too long and where fiscal imbalances had developed. But the ECB is pondering engaging in some sort of quantitative easing program to try to boost growth amid a good deal of uneasiness among its most conservative central banking members. For its part, the Fed is simply missing its target. It obviously has given up on quantitative easing; it is engaged in a policy of pulling back on this program even as the economy is crying out for more stimulus. Fortunately, it looks like political gridlock in the US has let up and the fiscal drag that the Fed has been fighting against will be less in 2014. However, market interest rates have risen and the housing market that has been a driving force in the economy has showed signs of slowing. US consumer confidence remains impacted and it's unclear what will boost the growth rate in the US. Since worldwide growth projections have been cut recently by the IMF and the World Bank, longing for more export growth will not be productive. Apparently policy-makers are expecting some exogenous improvement in business and consumer confidence to be the mainstay of an economic revival. Let's hope they're right. Sometime you do draw to an inside straight.

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