The case for more inflation

Olli Rehn is governor of the Bank of Finland and a former vice president of the European Commission. 

HELSINKI — The difficult choices inherent in navigating the COVID-19 crisis and its devasting economic fallout have highlighted a pressing need: It is time for European policymakers to rethink our monetary policy strategy. 

The past year, in which we have learned to live with unknown unknowns, has reminded us that monetary policy is as much an art as it is a science. Faced with economic devastation, monetary and fiscal authorities have shown they are accommodative, joining forces to deliver a swift, forceful economic policy response to the crisis. 

The extraordinary circumstances have also made the reassessment of the European Central Bank’s monetary policy strategy, launched by President Christine Lagarde last year, even more important. 

Major structural trends have reshaped our economies in recent decades. The relationship between the economy’s spare capacity and inflation has changed, natural interest rates — the rate that keeps the economy humming while preventing inflation from rising — have fallen and productivity growth has become sluggish.  

In particular, the long-term decline in natural interest rates has left less room for interest rate cuts, especially as borrowing costs in many parts of Europe have hovered at, or even below, zero — though monetary policy measures that used to be called unconventional have been able to alleviate this constraint to some extent.

The need to better understand what drives inflation dynamics is common to all central banks. The United States Federal Reserve, for example, last year revised its monetary policy framework and found that the economy can stand lower unemployment without rapid inflation, thus enhancing social inclusion.  

The Fed has introduced a new framework that targets an average inflation rate of 2 percent, rather than trying to keep it below that figure, as has historically been the case. The policy takes into account past inflation that has been below 2 percent by targeting temporarily higher inflation in the future. It seems to have gained credibility. Longer-term inflation expectations appear to have moved up in the U.S.  

The European and U.S. economies are not that different when it comes to assessing the slack in the economy or the level of employment, so the Fed’s findings could serve as a relevant benchmark for the ECB’s own strategy review, which will be completed later this year. 

The ECB’s Governing Council has spent six months discussing the definition of the price stability objective, how best to measure inflation and the effectiveness of monetary policy instruments. One of the key issues in the debate is how to anchor inflation expectations in an effective manner. While our formulation of the inflation target — below but close to 2 percent — was fit for purpose in driving down higher-than-desired inflation in the early 2000s, it has also generated a perception of asymmetry and ambiguity on the target. In our current environment of chronically low inflation, this ambiguity is hampering the effectiveness of our monetary policy. 

In my view, it is critical moving forward that we make sure the inflation target is understood as symmetric by the public. This means we need a genuine price stability target at — and not below — 2 percent. We then need a reaction function that delivers sufficiently forceful and equally effective policy actions to deviations from that target in either direction. This would take the increased risk of hitting zero interest rates into account. 

The ECB’s mandate also requires that European policymakers, without prejudice to price stability, advance balanced economic growth, full employment and sustainable development. Other important elements of the strategy review include addressing the digitalization of our payment systems with the potential creation of a digital euro in the future and the role of central banks in addressing climate risks. 

Looking further ahead, the ECB’s strategy review will help us serve Europeans as effectively as possible into the future. As we prepare for our prospective exit from pandemic policy measures, we can capitalize on the strategy review and forward guidance to lift inflation expectations, support economic growth and employment, and help achieve the inflation target in the eurozone in the coming years.