Is Inflation Targeting Failing? ECB Cuts Rates on Growth Fears as Inflation Lingers

These are not your father’s or grandfather’s central banks. Oh, the names are the same (well, except for the ECB which didn’t exist ‘a generation’ ago). The behavior would be unrecognizable to those who knew Fed policy under Paul Volcker/Alan Greenspan or Bundesbank policy under Karl Otto Poehl and his legacy mates.

What has happened? Is it inflation targeting or is it something more?

INFLATION TARGETING IS FAILING...Instead of working as Ben Bernanke said it would, getting markets to see what central banks want and then acting to make that happen reinforcing the target goal, Central banks have instead used targeting as crutch to promise the target and deliver something else. This dissonance will eventually weigh on central bank credibility and undermine the process that Bernanke said would help banks to achieve their target.

ECB HICP inflation is not that far from its target, but momentum is in the wrong direction and inflation has been over target since early 2021 (38 consecutive months). Core inflation in the EMU is far too high (data lag by one month) and core inflation is accelerating- again moving in the wrong direction.

Some weakness, yes, but is it all that serious? The ECB speaks of a concern about weaker growth, but few of the early reporting EMU members display GDP declines in Q2. Among the 14 EMU members, I have data for only Austria, Germany and Ireland log declines in GDP Q/Q as of 2024-Q2. Austria, Finland, and Ireland log declines in GDP on four-quarter changes – that’s a more serious issue. Among the five EMU member countries that report composite PMI data to S&P, only Germany has a diffusion reading below 50 (indicating contraction). The EMU reading is 51.1 and it improved in August. EMU composite data ranked over the last 4 ½ years has a 51-queue percentile standing putting just above its median for the period (median occurs at 50). France, Italy, and Spain all have queue-standings above their respective 50th percentiles. Ireland and Germany are exceptions; Germany’s queue-standing is weak at the 28.6 percentile. The EMU’s largest economy has been weaker in terms of year-on-year growth only about 25% of the time.

Do central bankers want to boogie with the Boogie-man? Still, there is a priority here on maintaining growth that is only weak and not especially looking threatened at a time that inflation is and has been overshooting and is even accelerating. It’s a strange choice that ‘old-timers’ will find hard to understand. Cutting rates with inflation above its target pace and accelerating is a strange choice.

Unintended consequences? Inflation targeting may have had an unintended effect on central banks, allowing them to express their fealty to a particular inflation number even though they are not hitting it. When central banks did not have an inflation target, the inflation rate simply was what it was. We discovered that central banks found that pace acceptable or not by their actions, and (to some extent) that was supported by their rhetoric. A central bank during these times choosing to cut rates with inflation above 2% and accelerating and with core inflation at 3% and accelerating, no longer seems unusual. But, in an earlier age, that central bank would likely not have received good grades as a hard money central banker. Now markets are fine with it, and even want more of it.

AKA: Bait and Switch? With an inflation target, central bankers can claim they're close to it and they are dedicated to it. Even if inflation isn't close to it, they can claim that they are determined to get back to it. And without expressing a timeline for the return of inflation to their target, they could continue to miss the inflation target to which they are allegedly dedicated and instead swerve policy to cut rates and promote growth.

Simply the wrong course of action Of course, one of the problems here is that inflation is running over the top of the target and it's accelerating and that when central banks act to cut rates to stimulate growth the likely impact is that inflation won't fall or won't fall as much as it otherwise would have. Central bankers are focused on growth and convincing us that the rate cuts will soften the impact on the economy from what they have been selling as a ‘tight’ policy. But those rate cuts will, instead, have the impact of causing them to miss their inflation target by more.

Summing up This is exactly how you expect central banks to act if they're not serious about their target. Central bankers are using the existence of a target to give them flexibility to pursue less austere policies rather than to remain determined to reach that target quickly and assert their credibility. Central bankers, in their arrogance, simply assume they have credibility. But credibility is a strange currency- it does not spend well. It is best saved and displayed as an ample reserve. When it is spent, it goes fast and its value quickly declines. In short, central bankers are using words as a replacement for action and this is never good. It remains to be seen how much trouble central bankers will get themselves into and how long they are going to be willing to pursue this strategy that winds up watering down their policy and impeding their ability to achieve their inflation target.