Mark Gilbert: Time for European Central Bank to face reality on inflation target

Mario Draghi. Photo / AP

Opinion

European Central Bank President Mario Draghi was asked last week whether his institution should consider revising its 2 per cent inflation target.

"It would test our credibility if we were to change the target when it's taking more effort to achieve that target," Draghi replied. "There hasn't been any discussion about changing the target for inflation."

With the ECB cutting its own forecasts for the next three years, however, it's time the central bank faced up to reality and admitted defeat - and no shame should attach to that backtrack.

Consumer prices in the euro zone will rise a paltry 0.1 per cent this year, and some months will probably see prices dropping, Draghi said. Even by 2017, the ECB expects prices to rise at just a 1.8 per cent annual rate. So the 2 per cent target it aims for is a fiction it should bid farewell to in the current environment. Moreover, it seems it can do so safely.

Central banks fret when inflation slows too much.

They fear stagnant consumer prices will lead to deflation, a sustained drop in prices which in turn smothers the economy as consumers stop shopping because they expect to get better bargains in the future.

That explains in part why the ECB, the Federal Reserve, the Bank of England and other central banks have inflation targets - not just to stop inflation from accelerating, but also to stop a slump in consumer prices from stifling growth.

But in the midst of what is arguably the biggest economic experiment ever undertaken, there's scant evidence that consumers are feeling inhibited by how the economic textbooks say they should behave in a climate of what can best be described as slowflation.

Retail sales in the euro region have been rising since the start of last year, climbing by an average of 1.6 per cent even though the mean for annual inflation in the period is a paltry 0.3 per cent and is still barely above zero. It isn't just the euro region that's having this odd experience.

A similar (though less distinct) picture prevails in the United States, which suggests that the deflation-doomsayers may have been jumping at shadows all along.

As Draghi pointed out, many of the factors the ECB cares about are showing signs of improvements. Unemployment is at its lowest in more than three years, credit is starting to flow and money supply, which may be out of fashion but is still a good guide to whether monetary policy is working, is accelerating at a brisk pace - the broad gauge of what's called M3 money supply is climbing at an annual rate of 5.3 per cent.

So while gross domestic product growth of 0.3 per cent in the second quarter was lacklustre, the ingredients for future improvements seem to be in place.

Instead of boosting the quantitative easing programme, which, if it hadn't taken so long to introduce, would probably be more than adequate, Draghi should consider freeing himself from the straitjacket of the inflation target - he can always reintroduce it once the China meltdown, the implosion in emerging markets and the capitulation in the oil price stop clouding the horizon. Bloomberg