ECB’s de Cos Highlights Virtues of Modifying Inflation Objective

1 October 2020

By David Barwick – FRANKFURT (EconoStream) – European Central Bank Governing Council member Pablo Hernandez de Cos on Thursday warned of the danger of persistently low inflation and added his voice to the chorus of those favouring a change in the ECB’s inflation objective.

In a speech at a meeting of the alumni of Deusto Business School in Madrid, de Cos, who heads the Bank of Spain, said that the ECB could still take further conventional policy measures, but acknowledged the limited space left for rate cuts.

Sustained weak price pressures ‘can lead to a dangerous vicious circle’, he said, because when economic agents realize that the central bank will regularly bump into the lower bound and thus run out of policy room to manoeuvre, they ‘will expect deviations of inflation above the target to be quickly corrected, but not deviations below the target.’

As a result, below-target expected inflation can become entrenched, implying lower nominal interest rates on average that more often run into the lower bound, hampering monetary authorities’ ability to ease policy and further undermining expectations, he said.

With respect to the newly resumed strategy review of the ECB, the price stability definition will be ‘[o]ne of the key aspects’ and ‘is apt to be reformulated’, he said.

In particular, it may be ‘necessary to clarify the specific level of inflation to be achieved’ and ‘possible to give this target a more symmetric nature, making it clear that the degree of tolerance for inflation deviations above the target will be the same as when such deviations occur below it’ he said.

With inflation currently low and rates near their lower limit, he said, ‘inflation objective will have to take into account the need to allow for a sufficiently high cushion above zero, which will give more room for manoeuvre to conventional interest rate policy.’

De Cos said that while ‘the door is open to future additional cuts in this interest rate, it seems clear that conventional monetary policy - that is, one based on controlling the short-term interest rate - has relatively limited room for manoeuvre under the current circumstances.’