Monday 20 May 2019

Trichet like a broken record when what we need is fresh thinking

Dan O'Brien

Dan O'Brien

Jean-Claude Trichet ended his near decade-long tenure as head of the European Central Bank exactly two-and-a-half years ago. Time and semi-retirement have not changed him.

On Tuesday the Frenchman gave a rare speech in Brussels. Despite no longer having the responsibility of having to weigh his every word, he repeats the same mantras of officialdom he used while in office.

Nor has freedom from the extreme constraints of his former job loosened his tongue.

There were no insights into the obscure workings of the ECB or self-criticism of the role of central bankers, and the function of central banking more generally.

It is perfectly understandable that Trichet would not wish to say anything that might appear critical of his one-time colleagues who still work at the ECB or make comments which might undermine his successor, but the broken-record quality to his talk was depressing in what it says about the mindset of central bankers in Europe today.

Trichet continues to place huge emphasis on the dangers of consumer price inflation.

While preventing constant increases in the prices of goods and services which everyone buys every day is of huge importance, consumer price stability – the ECB's sole mandate – is not just about making sure prices don't rise too much, it is also about ensuring that they don't fall too much.

For Frankfurt – during Trichet's time and still today – too-high inflation is a greater cause for concern than too-low inflation, despite the latter being potentially more damaging than the former, for two reasons. First, there are fewer policy tools to break a deflationary spiral than an inflationary one, as Japan's decades of experience shows. And second, in a high-debt environment, such as the one Europe is currently mired, falling inflation makes debt harder to pay back (just as high inflation erodes the real value of debt).

The ECB's formal mandate is to keep the annual rate of inflation "close to but below 2pc". In April, the rate stood at 0.7pc, more than a full percentage point below its target. The chart shows clearly how inflation is now unusually low, that it is still weakening and that the downward trend is not accounted for by price-volatile energy and seasonal foods.

In Ireland inflationary pressures are, if anything, even weaker than the average across the eurozone and the price level today is almost identical to that of six years ago – something that has not happened since the 1930s.

In January, the last time this column assessed the risk of a deflationary spiral in the eurozone, it concluded that the risk was then still low.

Developments since point to a clear, albeit limited, heightening of the risk, despite the recovery in the bloc's economy which is causing demand to stir, which in turn should (with a lag) put upward pressure on prices.

But the risk is great enough to warrant action. Despite this risk, little has happened in the six months since Frankfurt cut interest rates causing one to wonder how different Draghi is from his predecessor.

Compare this response to the bank's actions under Trichet when inflation rose above target. On his watch from 2003-2011, inflation picked up in 2007/8 and 2011, to reach a percentage point or more above target. The ECB reacted aggressively by raising interest rates on both occasions despite most of the increase being driven by volatile energy prices, as the accompanying chart shows, and very little evidence that either increase was driven by anything other than temporary factors.

Trichet's raising of interest rates in the final months of his tenure in 2011, and in the midst of the eurozone crisis, must rank as one of the worst monetary policy mistakes in recent times.

Although his successor, Mario Draghi, has appeared to be less hawkish, the response of the ECB to the risk of deflation has been lacklustre, despite calls for more radical action from such redoubtable organisations as the IMF and, just this week, from the OECD. But yesterday, yet again, inaction was the course chosen.

The monthly rate-setting meeting of the 24-member governing council of the ECB decided to take no new measures despite its own forecasts which show that inflation will not be back to target for another two years. In other words, the bank is prepared to accept three straight years of missing its target. It is very hard to see it accepting such a prolonged period of above-target inflation.

This is doubly damaging for the bank. Not only is its credibility eroded by missing its targets, its unwillingness to use all the tools available to it to meet its target suggests that either it does not have the courage of its convictions or it is divided internally on deploying the (unorthodox) measures that could bring inflation back to target. Whichever it is – and it is almost certainly the latter – it reflects badly on the bank.

If deflation is avoided, the ray of light for indebted Irish businesses and households in all of this is, as Draghi confirmed yesterday yet again, that official interest rates would remain at close to zero in the medium term. This gives more breathing space to manage heavy debt burdens – if interest rates were to rise back to normal historical levels, say 5pc, the effect on many households would be more serious than a huge dose of budgetary austerity.

The normalisation of interest rates is, thankfully, almost certainly still some years away.

Twitter @danobrien20

Irish Independent

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