Monday, March 15, 2010

ECB Officials Reject IMF-Proposed Inflation Target

By Simon Kennedy and Jana Randow

Feb. 25 (Bloomberg) -- European Central Bank officials dismissed a proposal by International Monetary Fund economists that monetary-policy makers increase inflation targets to 4 percent, arguing that such a shift would damage economies.

“I can only reject the idea of raising inflation rates permanently,” ECB Executive Board member Juergen Stark said in a speech in Seoul today. Bundesbank President Axel Weber wrote in a newspaper column today that the Washington-based lender is “playing with fire.”

The criticisms suggest the Frankfurt-based ECB will ignore this month’s suggestion by IMF economists led by Olivier Blanchard that central banks raise their inflation targets so that they have more scope to react to shocks such as the recent financial crisis. The ECB currently seeks to keep annual inflation rates at just below 2 percent in the medium term.

“The ECB is the most hawkish inflation targeter out there, so it’s unsurprising it doesn’t look at higher inflation targets too kindly,” said Geoffrey Yu, a currency strategist at UBS AG in London.

Stark called the IMF’s proposal “most unhelpful” and calculated a 4 percent inflation goal would shave “no less than” 0.5 percentage point off trend growth in the euro region.

‘More Damage’

Weber, a contender to succeed ECB President Jean-Claude Trichet next year, said in the Financial Times Deutschland that faster inflation causes “more damage than good” and warned the IMF’s discussion threatens to undermine the credibility of central banks.

Executive Board member Lorenzo Bini Smaghi yesterday said the proposal to raise the inflation target “backward looking.” Cypriot central banker Athanasios Orphanides this month called the proposition “counter-productive” and a “most unfortunate suggestion” as it may weaken the “hard-fought achievement” of anchoring inflation expectations.

Pioneered by the Reserve Bank of New Zealand two decades ago and now followed by more than 20 central banks globally, inflation targets are aimed at controlling expectations of future price pressures and providing clarity about the direction of interest rates.

More Leeway

The IMF’s Feb. 12 report said an increase in inflation goals may grant central bankers more leeway to respond in the event of turmoil such as a global recession, terrorist attack or pandemic. The argument goes that if inflation and interest rates are higher entering a crisis, policy makers are able to cut borrowing costs more deeply and keep them lower for longer to revive their economy.

“Should policy makers therefore aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks?” the report said. “To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?”

Asked about the study by U.S. lawmakers yesterday, Federal Reserve Chairman Ben S. Bernanke said while he understood “the argument and it’s not without its appeal” it carries “certain risks.”

“If the Federal Reserve says we’re going to raise inflation to 4 percent, how do we know that later it won’t go to 5 or 6 or 7 percent, and a lot of time to get inflation down,” he said.

Bernanke’s Background

Prior to becoming Fed chief in 2006, former Princeton University professor Bernanke advocated the Fed follow an inflation aim and he has since overseen the introduction of long-term inflation projections that serve as a gauge of the U.S. central bank’s target.

The ECB’s Governing Council decided to establish an inflation goal during its first year of existence as a way of maintaining the inflation-fighting credibility of Germany’s Bundesbank. There is precedent for it to change its inflation target. In 2003, the ECB’s council modified its goal from seeking an inflation rate between zero and 2 percent.

Inflation in the 16-nation euro area has still been above the ECB’s aim in all but one of the last 10 years and its focus on prices has been criticized by economists including Morgan Stanley Asia Chairman Stephen Roach and Nobel laureate Robert Solow.

In July 2008, an inflation rate of 4 percent led the ECB to raise its benchmark interest rate to a record 4.25 percent even as signs were emerging that the economy was slumping along with the U.S. Trichet has since argued that decision allowed the central bank to keep control of inflation expectations while its counterparts fought deflation worries.

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