Denyse Godoy and Clovis Rossi at FOLHA interviewed Jean Claude Trichet on November 8, 2008, and here is the headline question: FOLHA – "It is a (paradigm) dogma that central banks should only pay attention to inflation and not to other points of the economy like jobs or consumer spending. You have indicated that you are, now, more concerned about growth than about inflation. In times of a severe crisis like these in which we are, isn’t that dogma correct anymore?” Rebecca here. First, this question is inherently incorrect; an inflation target is not a policy rule, where the latter takes any discretionary policy response out of the equation. For example a Taylor rule tells the policy maker exactly what an inflation target should be under the current economic conditions as given by relative measures of current inflation and output. Although an inflation target is certainly less discretionary than a dual mandate, promoting maximum sustainable growth with low and predictable inflation (the Fed's dual mandate), but it is never-the-less an objective, rather than an explicit rule. Trichet could have eased.
Certainly, Trichet could have made a case for easing in order to relieve some of the downward risk to growth. But still, he clings to his mandate:
JEAN-CLAUDE TRICHET – “I didn’t say that. We are not changing the way we look at our monetary policy strategy. We consider that our primary mandate has been – it is today and will be tomorrow – to deliver price stability in the medium term. This is the mandate that we were asked to fulfill by the Treaty of Maastricht. In this perspective, we decided to decrease interest rates by 100 basis points in less than one month because we have observed a significant alleviation of inflationary pressures. We also took into account that we had regained control of medium term inflation expectations. That being said, I profoundly trust that by delivering price stability, we are contributing to sustainable growth, job creation and fostering financial stability. By being credible in delivering price stability over time, and by solidly anchoring inflation expectations, we are fostering, in very difficult times, the confidence of households. Our fellow citizens have to be reassured on the fact that their purchasing power will be preserved in the period to come. It is also very important for sustainable growth that all economic agents take appropriate decisions because they can rely on the credible delivery of price stability. A solid anchoring of inflation expectations also allows to have medium and long term market interest rates more favourable to growth and less volatile, which is essential in an episode of financial turbulences.
As regards these turbulences, we have been one of the first central banks in the world to react immediately, on August 9th, 2007, when we had the first tensions on the money markets. We decided to provide liquidity in order to put the market in a situation where it would function as normal as possible under the circumstances. But it is important to note that we apply a separation principle between our monetary policy stance, which is designed to deliver price stability in the medium term, and the implementation of this policy – at the level of interest rates decided to deliver price stability – which is managed with a view of appeasing the tensions in the money market.” Rebecca here: I am sorry for all of the households and firms in the Eurozone because the economy is set to suffer comparatively longer than the U.S.; the central bank took too long to ease.
Trichet acted too late and didn’t protect the economy from a possible crash in the credit system, which came to pass. Nor did the ECB protect the economy from a possible recession, which also came to pass. The Fed has lowered its target rate 3.5% to 1% since November 2007 , while the ECB lowered just 0.75% to 3.25% over the year, including an 0.25% rate hike early in 2008. The 100 bps rate cut that he refers to did occur in the last month, but this will take a while to filter into the macroeconomy. And by the time it does, a severe recession will likely be underway.
It make sense that the ECB is easing right now. In some sense, it should be “printing money” just as the Fed is doing; the ECB's claim to fame as "acting first" on August 9th just isn't the same as easing substantially and printing money. With credit markets in shambles, central banks have a rare window of opportunity to print money in an attempt to buy the economy out of a severe credit crunch without any short-term inflation cost. The outcome: a deep and prolonged recession is avoided.
European labor markets are different than the U.S. labor market (see this post). Many European economies index wages heavily to inflation rates – Germany, Spain – and so the ECB is wary of the infamous "wage-price spiral". But still, the short-term economic stresses will far outweigh any medium term inflation pressures (wages or final goods prices) that may arise from the ECB markedly easing.
It is good for the European economies that Trichet finally figured this out, but I believe that he should have been easing months ago. It is almost like thi central banker was waiting for inflation to actually subside, which as any reasonable economist knows, by then it is too late.
Inflation pressures will re-emerge, and at this point, some could argue that this would be a good thing. Over the short term, price pressures have been mitigated almost completely, and central banks are free to ease to their liking. However, the real risk is that central banks get it wrong; they extract the liquidity too late and inflation booms.
I believe, though, that the Fed has proved itself to be forward-looking and it will take back the liquidity, once the economy is capable of surviving without life support. Not so sure about the ECB.