The ECB’s Continuing Deflationary Bias

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"The ECB’s Continuing Deflationary Bias"

Eurozone inflation has turned positive but only very slightly, a 0.6 percent annualized rate in November:

However the latest rise was driven largely by higher oil prices, although Eurostat gave no details. “Core” inflation, excluding volatile energy and food prices, is still on a downward trend. With economic activity still significantly below pre-crisis levels – resulting in widespread under-utilisation of production capacity – economists see little prospect of any early return to headline inflation rates within the ECB’s target of an annual rate “below but close” to 2 per cent. [...]

The ECB is expected at its governing council meeting on Thursday to leave its ultra-loose monetary policy largely unchanged, and financial markets expect the main policy interest rate to remain at 1 per cent – a record low – for most of 2010.

However, Jean-Claude Trichet, ECB president, is expected to announce further gradual moves to unwind the exceptional measures taken to support financial markets since the collapse of Lehman Brothers in September 2008. These are expected to include the ending of the provision of unlimited one-year liquidity.

The European Central Bank’s decision-making is very hard to understand. As Willem Buiter noted in October, the ECB’s attitude seems to be that it should switch between focusing on core and non-core inflation according to which metric will justify tighter policy. Thus in 2008 when we had high headline inflation but low core inflation, they raised rates. But then in early 2009, they say there was no need to move to a Zero Interest Rate Policy because core inflation was still positive, albeit below the target level and heading downward. Now that energy prices are on the rise, this becomes a reason to stand pat even though core inflation continues its downward trend and both core and non-core inflation are below the ECB’s target.

Instead of talking about going looser, Jean-Claude Trichet is talking about unwinding extraordinary measures. But why? Inflation is low-to-nonexistent in the Eurozone and unemployment is high and rising. This seems totally insane. The ECB has the sturdiest independence in the world, since even if European politicians wanted to try to pressure it to do something the decision-making mechanisms of the EU are so cumbersome that they’d probably fail. But that only further underscores central bankers’ responsibility to do their jobs correctly. Instead the ECB seems to revel in its ability to cause human suffering without consequence.

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