The ECB's New Monetary Policy Strategy: Is the Temporary Acceptance of Overshooting Inflation Justified?

Hennecke, Pe e A icle The ECB's New Mone a y Policy S a egy: Is he Tempo a y Accep ance o O e shoo ing In la ion Jus i ied? In e economics Sugges ed Ci a ion: Hennecke, Pe e (2021) : The ECB's New Mone a y Policy S a egy: Is he Tempo a y Accep ance o O e shoo ing In la ion Jus i ied?, In e economics, ISSN 1613-964X, Sp inge , Heidelbe g, Vol. 56, Iss. 5, pp. 295-298, h ps://doi.o g/10.1007/s10272-021-1002-9 This Ve sion is a ailable a : h ps://hdl.handle.ne /10419/247763 S anda d-Nu zungsbedingungen: Die Dokumen e au EconS o dü en zu eigenen wissenscha lichen Zwecken und zum P i a geb auch gespeiche und kopie we den. Sie dü en die Dokumen e nich ü ö en liche ode komme zielle Zwecke e iel äl igen, ö en lich auss ellen, ö en lich zugänglich machen, e eiben ode ande wei ig nu zen. So e n die Ve asse die Dokumen e un e Open-Con en -Lizenzen (insbesonde e CC-Lizenzen) zu Ve ügung ges ell haben soll en, gel en abweichend on diesen Nu zungsbedingungen die in de do genann en Lizenz gewäh en Nu zungs ech e. Te ms o use: Documen s in EconS o may be sa ed and copied o you pe sonal and schola ly pu poses. You a e no o copy documen s o public o comme cial pu poses, o exhibi he documen s publicly, o make hem publicly a ailable on he in e ne , o o dis ibu e o o he wise use he documen s in public. I he documen s ha e been made a ailable unde an Open Con en Licence (especially C ea i e Commons Licences), you may exe cise u he usage igh s as speci ied in he indica ed licence. h ps://c ea i ecommons.o g/licenses/by/4.0/ ZBW – Leibniz In o ma ion Cen e o Economics 295 In la ion DOI: 10.1007/s10272-021-1002-9 Pe e Hennecke, FOM Uni e si y o Applied Sci- ences o Economics and Managemen , Hambu g, Ge many. Pe e Hennecke* The ECB’s New Mone a y Policy S a egy Is he Tempo a y Accep ance o O e shoo ing Infl a ion Jus ifi ed? The ECB upda ed i s mone a y policy s a egy o he i s ime in 18 yea s in July 2021. The ein, he ECB announced ha i is willing o accep a ansi o y pe iod o mode a e in l a ion o e shoo in i s e o s o push in l a ion upwa ds a e a long pe iod o unde shoo ing i s a ge . This s udy explo es whe he such an o e shoo can be economically jus i i ed employing a simple Phillips cu e model. The esul s poin o he conclusion ha he a e age in l a ion a e o e he business cycle consolida ed abou one pe cen age poin below he ECB’s a ge a e. A empo a y asymme y o he ECB’s mone a y s a egy seems he e o e jus i i ed o ealign in l a ion and in l a ion expec a ions wi h he a ge a e. To main ain he symme y o i s infl a ion a ge , he Go e ning Council ecognises he impo ance o ak- ing in o accoun he implica ions o he e ec i e lowe bound. In pa icula , when he economy is close o he lowe bound, his equi es especially o ce ul o pe sis- en mone a y policy measu es o a oid nega i e de- ia ions om he infl a ion a ge becoming en enched. This may also imply a ansi o y pe iod in which infl a- ion is mode a ely abo e a ge . (ECB, 2021a) The Eu opean Cen al Bank (ECB) upda ed i s mone a y policy s a egy o he fi s ime in 18 yea s in July 2021. Mos no ably, i s infl a ion a ge was se o exac ly 2% annual inc ease o he Ha monised Index o Consume P ices (HICP) o e he medium un ins ead o he o me defi ni ion o “below bu close o 2%”.1 While his change appea s o be o a me ely seman ic na u e, he ECB u - he announced ha i is willing o accep a ansi o y pe- © The Au ho (s) 2021. Open Access: This a icle is dis ibu ed unde he e ms o he C ea i e Commons A ibu ion 4.0 In e na ional License (h ps://c ea i ecommons.o g/licenses/by/4.0/). Open Access unding p o ided by ZBW – Leibniz In o ma ion Cen e o Economics. * Da a used in his a icle a e a ailable a h ps://jou nalda a.zbw.eu/ jou nals/abou /in e economics. 1 Beside he adjus men s o i s infl a ion a ge , he ECB announced an ambi ious clima e change ac ion plan which is no add essed in his s udy. iod o mode a e infl a ion o e shoo in i s e o s o push infl a ion upwa ds a e a long pe iod o unde shoo ing i s infl a ion a ge . This willingness was la e ei e a ed in a p ess con e ence by ECB P esiden Ch is ine Laga de (ECB, 2021b). The ECB also announced ha i will include he cos s o owne -occupied housing in i s infl a ion meas- u e in o de o be e ep esen he infl a ion a e ha is ele an o households (ECB, 2021a). In o de o measu e he ex en o which he ECB missed i s a ge in he a e ma h o he fi nancial c isis, one can compa e he de elopmen o he ac ual HICP le el since 2009 wi h a coun e ac ual in which he ECB had exac ly hi i s o me a ge , which is se a 1.9% annual infl a- ion a e (Figu e 1). This compa ison shows ha he ECB s ayed close o an ideal pa h un il 2013 bu signifi can ly de ia ed om i since hen. In pa icula in 2014, 2015, 2016 and 2020 he ac ual infl a ion a e in he eu o a ea ba ely a oided en e ing defl a iona y e i o y. In 2020, he ac ual HICP le el was 8.4 pe cen age poin s below he ideal HICP le el. Conside ing ha he ECB deployed un- p eceden ed measu es o push infl a ion back on ack, e.g. ze o o nega i e policy a es, quan i a i e easing and o wa d guidance, his esul is sobe ing bu may well ha e a oided an e en g ea e de ia ion om i s infl a ion a ge . Ta ge de ia ion and capaci y u ilisa ion E en hough he ECB s essed he symme y o i s infl a- ion a ge , i.e. ackling o e - and unde shoo s equally, he willingness o accep a empo a y o e shoo , e en o a ansi o y pe iod, can be c i icised as asymme ic (Reu e s, 2021). Gi en ha he HICP le el conside ably de ia ed om an ideal ajec o y, one can a gue ha a In e economics 2021 | 5 296 In la ion Figu e 1 HICP le el o he eu o a ea, 2009-2020 No e: Annual da a o he eu o a ea wi h changing composi ion: EMU16- 2009, EMU17-2011, EMU18-2014, EMU19-2015. Sou ce: Eu os a , own calcula ions. empo a y o e shoo me ely b ings he p ice le el back on ack. Howe e , ha igno es he main unde lying mac- oeconomic sou ce o low infl a ion, he unde -u ilisa ion o p oduc ion capaci ies. Acco ding o he es ima es o he Eu opean Commission, he a e age ou pu gap o he eu o a ea be ween 2014 and 2020 was -1.2%, beginning wi h -2.5% in 2014, peaking a +1.3% in 2019 and ending wi h a s agge ing -5.9% in 2020, due o he pandemic- induced ecession. (1)  πi = c + βy i + εi Building on Hennecke (2018), he ela ionship be ween infl a ion and he capaci y u ilisa ion can be modelled and es ima ed using he signifi can he e ogenei y o in- fl a ion a es and capaci y u ilisa ion o he 19 Economic and Mone a y Union (EMU) membe s a es be ween 2014 and 2020. Equa ion (1) o mally s a es his simple Phillips cu e in a linea ashion, whe e  π deno es he de ia ion o he ac ual infl a ion a e in pe cen o coun y i in yea om he infl a ion a ge , c he cons an e m, β he slope pa ame e , y  he ou pu gap in pe cen o he p oduc ion po en ial and as an al e na i e measu e o he unemploy- men gap in pe cen age poin s and ε he e o e m. The unemploymen gap is calcula ed as he di e ence be- ween he non-accele a ing wage a e o unemploymen (NAWRU) and he ac ual unemploymen a e. Fo infl a- ion, he yea -o e -yea change in he headline HICP in pe cen is used, ob ained om Eu os a ; o he ou pu gap and he NAWRU es ima es, da a om he Eu opean Commission a e used, collec ed om hei AMECO on- line da abase om which he da a o ac ual unemploy- men a es was ga he ed as well.2 This model has he ad an age ha he cons an e m yields he a e age de ia ion o he infl a ion o e he busi- ness cycle, since he ou pu gap as well as he unemploy- men gap should a e age ou o ze o. Hence, he es i- ma ed cons an e m should no signifi can ly de ia e om ze o i he ECB mee s i s a ge . The eg ession esul s wi h he ou pu gap as a measu e o capaci y u ilisa ion a e shown in Figu e 2 and Table 1. The B eusch-Pagan es o he e ogenei y ejec s he null hy- po hesis o homogenei y and he e o e ejec s he pooled OLS model. Hence, unobse ed he e ogenei y needs o be aken in o accoun which is done in model 2 by in- cluding coun y-specifi c andom e ec s. Modelling ime- specifi c andom e ec s (model 3) o bo h coun y- and ime-specifi c andom e ec s (model 4) does no inc ease he quali y o he model as he adjus ed R² dec eases con- side ably. Hence, model 2 p o ides he bes fi o he da a. 2 The da a we e ob ained in July and Augus 2021. Figu e 2 The EMU Phillips cu e wi h ou pu gap No e: Annual da a o he EMU19 coun ies. Sou ces: Eu os a , Eu opean Commission AMECO da abase, own cal- cula ions. Table 1 Es ima ion esul s: EMU Phillips cu e wi h ou pu gap No es: *** 99% signifi cance le el; ** 95% signifi cance le el; * 90% signifi - cance le el; - alues in pa en heses. Sou ce: Own calcula ions. Model 1 Model 2 Model 3 Model 4 Pooled Coun y- specifi c e ec s Time-spe- cifi c e ec s Coun y- and ime-specifi c e ec s Cons an -0.94*** (-12.09) -0.93*** (-8.81) -0.99*** (-4.90) -1.01*** (-4.50) Ou pu gap 0.16*** (7.71) 0.17*** (7.81) 0.10*** (4.92) 0.08*** (3.07) Obse a ions 133 133 133 133 Adjus ed R² 0.31 0.31 0.15 0.06 B eusch-Pa- gan (p- alue) 0.00*** - - - 95 100 105 110 115 120 125 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Eu o a ea ( eal) Eu o a ea (on a ge ) index, 2009 = 100 -4 -3 -2 -1 0 1 2 3 4 -15 -10 -5 0 5 10 15 Ta ge de ia ion (%) Ou pu gap (%) ZBW – Leibniz In o ma ion Cen e o Economics 297 In la ion When he unemploymen gap as a measu e o capac- i y u ilisa ion is used ins ead (Figu e 3 and Table 2), he B eusch-Pagan es o he e ogenei y does no ejec he null hypo hesis o homogenei y. Hence, unobse ed he - e ogenei y does no need o be aken in o accoun . Fo obus ness checks, andom e ec s models we e es i- ma ed none heless (models 3, 4 and 5). Compa ing he models’ adjus ed coe fi cien o de e mina ion also shows ha he pooled model is p e e able. Rega dless o he measu e o capaci y u ilisa ion, he e- g ession esul s indica e ha he e is a s a is ically signifi - can ela ionship be ween he HICP infl a ion a e and he capaci y u ilisa ion o he eal economy. Wi h a one pe - cen age poin inc ease in he ou pu gap, infl a ion picks up by 0.17 pe cen age poin s o by 0.2 pe cen age poin s o he unemploymen gap. Mo e in e es ing o he pu - pose o his s udy is ha he cons an e m is signifi can ly below ze o in all models. Thus, o e he cou se o a ull business cycle, he ECB unde shoo s i s infl a ion a ge by abou one pe cen age poin .3 O pu di e en ly, in o - de o mee i s new a ge o exac ly 2% annual infl a ion a e, he ou pu gap would ha e o be a +5.5% and he unemploymen gap a +4.7 pe cen age poin s. Gi en ha he models a e linea and he ela ionship is expec ed o u n non-linea , he mo e he ou pu gap exceeds ze o and 3 Ca ea : The ECB’s infl a ion a ge is defi ned o he EMU as a whole. The eg ession yields he a e age infl a ion o an a e age EMU coun- y. Hence, he coun ies a e no weigh ed acco ding o hei sha e in he EMU agg ega e. posi i e eedbacks a ise, he g ea e he chance ha he 2% a ge a e would in eali y p obably be me a a much lowe posi i e gap, as demons a ed by model 2 wi h he unemploymen gap as a measu e o capaci y u ilisa ion. None heless, all models indica e a sys emic unde shoo o infl a ion as he linea model is p obably a good app oxi- ma ion a ound an ou pu o unemploymen gap o ze o. Infl a ion ou look and policy implica ions In ligh o hese esul s, he ECB’s announcemen o a empo a y accep ance o an infl a ion o e shoo seems jus ifi ed and can be seen as an a emp o a oid a u he loss o c edibili y and a s abilisa ion o infl a ion and infl a- ion expec a ions below he ECB’s a ge . The la es ECB Su ey o P o essional Fo ecas e s conduc ed in he hi d qua e o 2021, which can be seen as a p oxy o wide infl a ion expec a ions, al eady yielded highe infl a ion o ecas s o all ho izons. In pa icula , he infl a ion a e o 2021 is expec ed o be almos on a ge wi h 1.9%, up by 0.4 pe cen age poin s compa ed o he p e ious su ey one qua e ea lie and be o e he ECB’s announcemen . Howe e , he main easons a e inc eased ene gy p ices, a be e g ow h ou look and he cu en supply sho ages in some ma ke s (ECB, 2021c). The e ised mone a y s a - egy mos likely did no play a subs an ial ole ye . Figu e 3 The EMU Phillips cu e wi h unemploymen gap No e: Annual da a o he EMU19 coun ies. Sou ces: Eu os a , Eu opean Commission AMECO da abase, own calcu- la ions. -4 -3 -2 -1 0 1 2 3 4 -15 -10 -5 0 5 10 15 Ta ge de ia ion (%) Unemploymen gap (pp) Table 2 Es ima ion esul s: EMU Phillips cu e wi h unemploymen gap No es: *** 99% signifi cance le el; ** 95% signifi cance le el; * 90% signifi - cance le el; - alues in pa en heses. Sou ce: Own calcula ions. Model 1 Model 2 Model 3 Model 4 Model 5 Pooled linea Pooled non-linea Coun y- specifi c e ec s Time- specifi c e ec s Coun- y- and ime- specifi c e ec s Cons an -0.94*** (-11.4) -1.02*** (-11.2) -0.93*** (-9.5) -0.98*** (-4.14) -1.00*** (-3.95) Unemploy- men gap 0.20*** (6.40) 0.35*** (5.5) 0.21*** (6.09) 0.15*** (5.60) 0.11*** (3.43) (Unemploy- men gap)² 0.04* (1.90) (Unemploy- men gap)³ 0.00 (1.26) Obse a ions 133 133 133 133 133 Adjus ed R² 0.23 0.26 0.21 0.19 0.08 B eusch-Pa- gan (p- alue) 0.13 - - - - In e economics 2021 | 5 298 In la ion Whe he he ECB’s upda ed s a egy is success ul in el- e a ing infl a ion back o a ge – and ealigns expec a- ions wi h i – emains o be seen. Fo he nex wo yea s, he o ecas e s expec infl a ion a es o me ely 1.5%. Fo he longe e m, i.e. 2026, he su eyed o ecas e s ex- pec infl a ion o be a 1.8%, and he e o e seem ancho ed nea he a ge a e (ECB, 2021c). In any case, he ECB is likely o back up i s announcemen wi h ac ion, as long as he infl a ion emains below i s a ge and a pe iod o inac ion, as soon as infl a ion exceeds i s a ge . Hence, low o nega i e policy a es and conside able asse pu - chases, wi h all hei po en ial side e ec s, a e p obably he e o s ay o he o eseeable u u e. Wha migh help he ECB o b idge some o he infl a ion gap a e i s plans o g adually inco po a e he cos s o owne -occupied hous- ing in i s infl a ion measu e. G os (2018) es ima ed ha he inclusion o he cos s o owne -occupied housing could inc ease measu ed infl a ion by 0.5 pe cen age poin s, i.e. abou hal o he sho all iden ifi ed in his s udy. Howe e , he ECB (2016) i sel calcula ed he impac wi h a ma k-up o me ely 0.2 pe cen age poin s. Re e ences ECB (2021a), The ECB’s mone a y policy s a egy s a emen . ECB (2021b, 22 July), Ch is ine Laga de, P esiden o he ECB, Luis de Guindos, Vice-P esiden o he ECB, Mone a y Policy S a emen P ess Con e ence. ECB (2021c, 23 July), Resul s o he ECB Su ey o P o essional Fo e- cas e s in he hi d qua e o 2021, P ess elease. ECB (2016), Assessing he impac o housing cos s on HICP infl a ion, Economic Bulle in, 8/2016. G os, D. (2018), Pe sis en low infl a ion in he eu o a ea: Mismeasu emen a he han a cause o conce n?, Mone a y Dialogue, Feb ua y 2018. Ha ik, K., K. Mc Mo ow, F. O landi, C. Planas, F. Racibo ski, W. Röge , A. Rossi, A. Thum-Thysen and V. Vande meulen (2014), The P oduc ion Func ion Me hodology o Calcula ing Po en ial G ow h Ra es & Ou - pu Gaps, Eu opean Economy, Economic Pape s, 535. Hennecke, P. (2018), A Simple Pos -C isis EMU Phillips Cu e – Impli- ca ions o Mone a y Policy, In e economics, 53(6), 333-336, h ps:// www.in e economics.eu/con en s/yea /2018/numbe /6/a icle/a-sim- ple-pos -c isis-emu-phillips-cu e-implica ions- o -mone a y-policy. h ml (23 Sep embe 2021). Reu e s (2021, 8 July), Reac ions o ECB’s s a egy e iew.