Is the ECB Practising Opportunistic Disinflation?
(Formerly Swiss Macro and History)
Inflation in the euro area has exceeded the ECB's 2% target every year since 2021. That is surprising. In principle, a sufficiently determined central bank can always bring inflation back to target by raising interest rates. Why, then, has the ECB tolerated inflation above target for so long? Could it be that the costs of returning inflation from around 2½% to 2% have become higher than in the past?
One possible answer emerges from a recent speech by Isabel Schnabel entitled The Quiet Erosion of Central Bank Independence. She argues that the sharp rise in public debt across advanced economies has increased the tension between price stability and fiscal sustainability. Although she stresses that the ECB demonstrated its determination to fight inflation after the pandemic, she also warns that high public debt may increasingly narrow the room for monetary policy.
If the costs of bringing inflation “the last mile” from, say, 2.5% to 2% have risen because of weak growth and high public debt, should the ECB still seek a rapid return of inflation to target? Or is there another way of conducting monetary policy?
One possible answer can be found in an idea first analysed by Athanasios Orphanides and David W. Wilcox at the Federal Reserve during the 1990s. They called it opportunistic disinflation.
Under this approach, the central bank aims to reduce inflation rapidly if it exceeds some threshold level. However, if inflation is only moderately above target, it does not maintain a sufficiently restrictive policy to force it rapidly back to target. Instead, it stands ready to respond aggressively to any renewed increase in inflation while waiting for favourable economic developments, such as weaker demand, lower commodity prices or a recession, to bring inflation down gradually.
When that happens, the central bank maintains a restrictive policy stance so that inflation settles at a lower level. While inflation remains in this intermediate range, the central bank places greater weight on stabilising output than on returning inflation quickly to target.
The strategy recognises that deliberately engineering a recession to eliminate the last bit of inflation may impose costs that exceed the benefits. Rather than creating those costs intentionally, policymakers wait for an economic slowdown that would probably have occurred anyway and use it to complete the disinflation process.
The approach makes most sense when inflation is only moderately above target and inflation expectations remain firmly anchored. In those circumstances there is less urgency to force inflation down immediately because households and firms continue to believe that inflation will eventually return to target. It is also attractive when unemployment is already elevated or when policymakers are concerned about financial stability or fiscal sustainability. Aggressive monetary tightening may then create larger economic problems than the inflation itself.
The attraction of opportunistic disinflation is that it reduces the economic cost of lowering inflation. But it also carries important risks. Inflation may simply fail to decline if demand remains resilient or wage growth stays strong. The public may then begin to doubt the central bank’s commitment to price stability, leading inflation expectations to drift upwards. Once credibility is lost, restoring it generally requires much larger interest-rate increases later, precisely the outcome the strategy was intended to avoid.
The strategy is also difficult to communicate. Any suggestion that a central bank is prepared to wait for inflation to decline gradually would almost inevitably be interpreted as a weakening of its commitment to the inflation target. This is probably why no central bank has ever explicitly adopted opportunistic disinflation. Nevertheless, the behaviour of many central banks has at times been broadly consistent with its underlying logic.
The current euro-area environment has many of the characteristics that make opportunistic disinflation attractive. As Schnabel argues, high public debt has increased tensions between price stability and fiscal sustainability. At the same time, growth remains subdued and inflation has proved more persistent than expected. Further aggressive monetary tightening would increase borrowing costs for governments, raise the risk of recession and could rekindle concerns about fiscal sustainability and financial fragmentation.
None of this means that fiscal dominance has already emerged. But it does suggest that the Governing Council may place greater weight on the costs of engineering a rapid return to 2% than it would have done in the past.
In practice, this could mean that the ECB raises interest rates less than it would normally do, while maintaining a restrictive policy stance for longer and allowing inflation to return to target gradually as favourable economic developments occur. The Governing Council would almost certainly never describe such an approach as opportunistic disinflation. But its behaviour might increasingly resemble it. Whether that is indeed how the ECB now thinks is impossible to know, but it is a question investors should keep firmly in mind.