Weidmann: Current inflation target remains appropriate

Bundesbank President Jens Weidmann has defended the euro area’s medium-term inflation target. "I am convinced that our euro area inflation target of below, but close to, 2% remains appropriate," said Mr Weidmann at a joint conference of the Bundesbank and the Banque de France in Paris. One of the topics discussed by economists at the event was the issue of whether central banks should raise their inflation targets. In his speech, Mr Weidmann warned of the impact that raising inflation targets could have on macroeconomic stability, adding that he is confident that the euro area is on the right track as far as inflation is concerned.

Stable equilibrium in jeopardy

The proponents of a higher inflation target argue that it would widen the safety margin to the lower bound on interest rates, thus broadening the scope for monetary policy countermeasures in times of crisis. In his speech, Mr Weidmann explained why this effect might not be as pronounced as hoped by the supporters of a higher inflation target. The higher the inflation target, the more enterprises become forward-looking and raise their prices accordingly, he remarked. This decreases the relative importance of marginal production costs, and therefore that of the aggregate output gap, too. Ultimately, Mr Weidmann noted, this results in a flattening of the short-run Phillips curve, with the inflation rate thus becoming less sensitive to variations in current economic output – in other words, the central bank then has to change its policy rate to a greater extent in response to any given change in the inflation rate. "It therefore loses some of the additional wiggle-room gained through the higher target," explained the Bundesbank President.

Mr Weidmann also warned that a higher inflation target could culminate in a de-anchoring of inflation expectations. The Bundesbank explains what this means in the latest edition of its Monthly Report. Inflation expectations play a major role in the actual path of inflation. If expectations are not firmly anchored – consistent with the central bank’s inflation target – it is harder to stabilise the inflation rate.

Not a call for cherry-picking

In his speech, Mr Weidmann also touched on current monetary policy developments, making reference to the Eurosystem’s latest projections for the euro area. According to these projections, core inflation – which does not factor in energy and food prices – will rise from 1.1% this year to 1.9% in 2020, while headline inflation will hover at 1.7% between 2018 and 2020. "But even this figure would be broadly in keeping with our definition of price stability over the medium term," said Mr Weidmann.

In Mr Weidmann’s view, another indication that inflation is on a sustainable path towards the ECB’s Governing Council’s target is revealed when comparing the Harmonised Index of Consumer Prices (HICP) with inflation measures that include owner-occupied housing in the basket of goods. He remarked that the HICP, which serves as the basis for measuring the inflation rate in the euro area, does not take into account the cost of owner-occupied housing – unlike the US consumer price index, which does. The Bundesbank President referred to studies showing that measures which include owner-occupied housing as well as rental prices have, in recent years, yielded inflation rates for the euro area that are slightly above the official HICP rate. Mr Weidmann was quick to clarify that this was not a call for cherry-picking measures of inflation. "That would be a sure-fire way to jeopardise credibility," he cautioned.

Getting the ball rolling

Mr Weidmann is confident that the euro area is on the right track as far as inflation is concerned. The ECB Governing Council signalled last Thursday that it intends to end net purchases of government bonds and other securities by the end of the year. "Ending the net purchases is most likely just the first step on a multi-year path of a gradual monetary policy normalisation. And that’s precisely why it has been so important to actually get the ball rolling," said Mr Weidmann.

Another speaker at the conference in Paris was Banque de France Governor François Villeroy de Galhau, who addressed the fiscal problems of individual euro area countries. According to Mr Villeroy de Galhau, gross government debt in the euro area has risen from 65% to 85% of economic output since 2007. "We cannot fully compensate for the uncertainty created by other policymakers, nor can we fully offset their effects," said Mr Villeroy de Galhau. He pledged that the ECB Governing Council would continue to do everything necessary to fulfil its price stability mandate.