ECB independence and inflation targeting

Accountability arrangements remain suboptimal

There is this view, particularly among economists, that a central bank’s commitment to an inflation target is a sufficient benchmark for its accountability and institutional independence. A view along those lines is expressed by Lucrezia Reichlin in her recent opinion piece for Project Syndicate:1

While some central banks have more flexibility than others in managing price stability, they have all publicly committed to numerical targets. Without such accountability (and transparent communication), their independence would be hard to justify.

In the following sections I explain why this approach needs to account for the specifics and why it remains inadequate in its current form.

Difference between price stability and inflation

In the European Union—and insofar as the European Central Bank (ECB) is concerned—there is an important distinction to be made between (i) price stability and (ii) the actual inflation target. The Treaties define monetary policy as an exercise in controlling the aggregate price level, so that over time money becomes constant or ‘neutral’, or so the thinking goes.

The mandate given to the ECB is to guarantee “price stability”, without any further qualifications as to what that may actually entail. No temporal horizon is envisaged. No methodology. No conditions of any sort. It is a generic commitment to a monetary policy that does not engender erratic swings in the aggregate price level. It could, in principle, justify a disinflationary or outright deflationary economic environment. Whereas the quantification of that notion, the much-vaunted “below, but close to, 2%”, is an indicator provided by the ECB itself.

Even the ECB admits that the Treaties offer no clear guidance as to what monetary policy in the EU ought to be about. Here are their own words on price stability (emphasis original):2

While the Treaty clearly establishes the primary objective of the ECB, it does not give a precise definition of what is meant by price stability.

The ECB’s Governing Council has announced a quantitative definition of price stability:

“Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.”

Elsewhere on their website they proceed to obfuscate that definition, by appending the notion of “medium term”.3 Price stability is to be realised as an inflation rate that is “below, but close to, 2%, over the medium term”. As with its mandate, the ‘clarification’ provided by the ECB does little to empower legislators, or any authority for that matter, to exercise control over the monetary function. It creates confusion rather than make things specific.

The set of constraints presented by this state of affairs, can be outlined thus:

  • Conflicting roles. The fact that the ECB has defined the criterion for its own accountability means that it has the power of interpretation over it. Only the ECB can enlighten us as to whether it is succeeding in its task or not, for only it can put in concrete terms the notion of “medium term” as well as the meaning of “close to” 2%.
  • No fallback. There is no alternative to the policy of price stability in the way it is understood and exercised by the ECB. Legislators cannot scrutinise the monetary institution for its failure to meet its own target (because the target is unclear) and, hence, they cannot suggest any kind of alternative—a different interpretation—, not even in the form of a formal recommendation that could guide the ECB into adopting a different strategy in times where its “price stability” fails.

It falls on the ECB to communicate its actions in a ‘transparent’ fashion, which is to say, to conveniently interpret its own objective in a way that fits its case. This is far from the ideal when it comes to the level of accountability we expect from all officials, especially those wielding considerable power (and in the case of the central bank that has social and economic effects, such as the [re-]distribution of wealth).

Independence should not mean omnipotence

Every modern republic is founded on a set of constitutional principles, such as limited government, the rule of law, and the separation of the state’s functions. Monetary policy is one such function. It is entrusted to an institution that enjoys operational or else institutional independence from the rest of the state’s functions, such as the executive, the legislative, and the judiciary. There are at least three closely related reasons why the separation of powers is a sound foundation for a democracy:

  • it prevents the concentration of power, or at least makes it difficult for authoritarian forces to capture the entirety of the state apparatus;
  • it provides each institution with the flexibility and autonomy of action it needs to fulfil its mandate in the best way possible;
  • it allows each institution the necessary space for checking on its peers without fear of reprisal that could entail a permanent diminution of its competences.

In principle, the independence of the ECB is both necessary and desirable. As I explained in a previous analysis:4

European leaders have designed this institutional arrangement under the impression that a central bank can only be effective when emancipated from the short-term temptations of the political process. Price stability presupposes consistency and that requires long term planning and execution. Monetary policy trickles down to the economy in an incremental fashion. The transmission mechanism is not immediate. Macroeconomic changes reflecting the impact of the central bank’s actions take time to materialise. To this end, the monetary authority cannot be bound by the will of politicians, whose role forces them to focus on the short term. A money supply that would be tailored to the needs of politics, would risk becoming erratic and, hence, ineffective at achieving price stability.

This explains the independence of the ECB as a precondition for its output legitimacy (legitimacy based on results). What it does not tell us is the relationship between its status as independent from the political process and its overall accountability. Which brings us back to the mandate of the ECB, price stability, interpreted as an inflation target that approximates 2% over some medium term. Given that it rests on the ECB to both (i) define the criteria for its accountability (the quantification of “price stability”) and (ii) interpret the temporal horizon over which these are met, we can suggest that its current design is problematic. Its independence is excessive. Its accountability leaves much to be desired.

What is the ECB’s ‘medium term’?

Let us have a look at the data to understand why the ECB can practically escape scrutiny. From December 2011 to December 2016, average inflation in the euro area was 0.9%.5 That is well below 2%. So the ECB’s understanding of the medium term cannot possibly be what we would typically think by that term, as a range between 3-5 years, because then the ECB would have already failed to deliver on its mandate.

How about 6-8 years? That would be highly unlikely, if we are to draw inferences from the information available to us, in particular the January 19, 2017 press conference, where Mr. Draghi, the ECB chief, noted the following (emphasis mine):6

The monetary policy decisions taken in December 2016 have succeeded in preserving the very favourable financing conditions that are necessary to secure a sustained convergence of inflation rates towards levels below, but close to, 2% over the medium term.

He did not say something like “over the coming year or two”. Just recycled the same vague statement. So if a ‘medium term’ is to be appended to the medium term we have already gone through, that will bring us to something around a 10-year period. Can we rely on such a hypothesis? Is a decade what the ECB has in mind? Not really. It may be plausible, though ultimately it is the ECB that will tell us—and those who ought to hold it accountable—whether it has met its targets or not.

Accountability and democratic control

In recent times, it has become something of a trend or elitist group mentality to label anyone who uses the notion of “democratic control” in relation to central banking as a ‘populist’. The implication is that such calls can only be made by ignoramuses or power-hungry demagogues. No credible analyst can hold those views. Which is to say that there is supposed to be nothing untoward with the way central banks—in our case the ECB—have come to conduct their operations.

This whole exercise of stigmatising any opposition to the status quo as ‘populist’, is nothing but dogma. It paints everyone with the same brush. There is strong evidence to suggest that the orthodoxy of central banking that came to form in the 1990s is profoundly flawed. The idea that central banks need only ‘communicate’ their policy based on some vague target is fundamentally misguided, for it provides too broad a scope of discretion. A further misconception is that “independence” means immunity to everything that happens in the political process, whereas the concept is much more limited: independence of the operational sort (independence between institutions), not independence from the demos at-large.

The flaws in the European Union’s constitutional order with regard to monetary policy suggest that Treaty amendments are necessary. Even if the ultimate telos of “price stability” is to remain constant, it needs to be framed by the following:

  • Specificity. Provide a definition of “price stability” or, at the very least, bestow the power to formulate such a definition to the EU executive, subject to approval by the legislature.
  • Temporality. A temporal horizon should be made explicit. The target[s] of monetary policy should be gauged in accordance with a specific time range of, say, 3-5 years.7
  • Scope. Any further refinement of monetary policy targets would have to be ancillary to the main task enshrined in the Treaties. In no way should the quantification of a certain provision, or measures to that end, anyhow endow the ECB with additional discretionary power.

That is the baseline. If we were to ask for a modern monetary policy, one that tackles social issues as well, in particular inequality and unemployment, we would be arguing against the very fixation on the inflation rate. Again though, we would expect things to be crystal clear. Accountability matters regardless of the monetary authority’s mandate.

Alas, what we are dealing with here in the euro area, is an ECB mandate that is trapped in the neoliberal logic of the 1990s,8 which completely disregards the social implications of monetary policy while making evidently false hypotheses about the economy (rational expectations, efficient market hypothesis, etc.), all while the ECB enjoys an excessive degree of independence that practically renders it immune to democratic scrutiny.

Our only hope, what consoles us, is the ECB’s commitment to “transparent communication”. That may be enough for some, but to the present author it seems largely suboptimal and undesirable. At any rate, we express our views in hope of arriving at some sort of synthesis. If the establishment, or anyone who uncritically adopts its discourse, wishes to rely on the dogmatism of labelling every dissenting voice as ‘populist’, then bad constitutional arrangements and policies derived therefrom shall persist. That leaves us worse off as a society.

  1. The ECB on price stability^

  2. The ECB on its medium term orientation^

  3. That quote is from my previous book, Little Guide to the European Union, in particular the chapter about the independence and accountability of the ECB. Published May 9, 2016. ^

  4. Data about euro area inflation. By the ECB. ^

  5. ECB press conference on January 19, 2017^

  6. If the EU were to function like a typical republic, the Finance Minister could be the one to set the inflation target on an annual basis, subject to further conditions by the Union’s co-legislative institutions. Such could even be envisaged as a fallback option when the ECB could not deliver on its objective (as is currently the case, litanies to the contrary notwithstanding). ^

  7. For some of my thoughts on the underlying thinking of Europe’s Economic and Monetary Union, refer to my recent analysis: What future for the euro area? ^