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Full circle

Wed, Nov 19 2008, 15:30 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

ECB President Trichet delivered a very thoughtful and interesting speech yesterday in London, laying out very clearly how the ECB approaches the complex challenges and trade-offs posed by the current crisis. The speech is especially significant as the ECB has been facing sharp criticism from many observers (myself included) for being behind the curve in its monetary policy response to the real economy impact of the credit crisis. Trichet outlined the arguments for a measured policy response, including the importance of safeguarding anti-inflation credibility—a point that was also highlighted in the Bank of England’s minutes released today. But it was in the Q&A that he made the most vivid and effective case, when he was asked about the risk of deflation. He noted something with which I fully agree, namely that we seem to have come full circle, and it is somewhat unnerving to see the resurgence of deflation concerns, when it was exactly the fear of deflation that guided the previous excessively long monetary easing. As Trichet put it, not that long ago we were also worrying about deflation, not realizing that we were instead fuelling a dangerous asset price bubble. I would still argue that the current downturn is dramatic enough to warrant a more aggressive policy response, to be reversed equally quickly once the economy recovers and inflation revives. This is the attitude that the Fed signaled earlier in the crisis, but which ECB Board member Bini Smaghi recently argued would not fit the less elastic structure of the eurozone. But Trichet’s point that the current crisis itself should remind us of the value of a measured and pondered policy response cannot be easily dismissed. Bottomline: I still expect a 50bp cut next month and maintain a 2.0% target for the Refi rate— even if this downturn is much deeper than the previous one, Trichet’s defense of measured policy action sends a clear message.

Trichet’s speech started by placing the ECB’s policy strategy (and that of other central banks) in the context of the theoretical and empirical economic literature, which has shown that monetary policy works best not through policy surprises, but through a transparent communication of both the objectives and the framework and strategy used to pursue them. Trichet noted that several studies have proved that inflation targeting leads to greater stability in inflation expectations, which become less responsive to macroeconomic shocks. In the eurozone, consensus expectations for long-term inflation have been stable in 1.7-2.0% range since the launch of the single currency in 1999, a powerful testimony to the anchoring effect of a numerical inflation target combined with a credible policy implementation.

In this context, Trichet noted that market-based measures of inflation expectations deviated temporarily from target last summer, reflecting the commodity price shock, but where then brought back under control— implicitly arguing that the July rate hike was both necessary and effective in preventing an un-mooring of inflation expectations with attendant second round effect.

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Published on  Wed, Nov 19 2008, 15:37 GMT