BL: Trichet's Inflation Aim Proves `Fiction' After Decade (Update1)
By Simon Kennedy
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May 27 (Bloomberg) -- Jean-Claude Trichet's European Central Bank hasn't had much success hitting its inflation target. The fault may lie with the goal itself.
``The ECB's keeping up a fiction,'' says Joachim Fels, co- chief economist at Morgan Stanley in London. ``The trade-off between growth and inflation has really changed. They should be as open as possible by adjusting the target.''
The Frankfurt-based central bank, marking its 10th anniversary June 1, has failed in each of the last eight years to achieve its aim of bringing inflation below 2 percent. The goal may become even more elusive as fast-growing eastern European countries adopt the euro and push up costs within the region at the same time it faces price jolts from emerging markets in Asia.
That forces an unpleasant choice on President Trichet and his colleagues: They can keep striving to force inflation lower by holding interest rates higher, at the cost of crippling faltering economies such as Italy's. Or they can yield to demands to set an easier target -- something Trichet says he won't consider ``for one second'' -- and risk letting inflation erode stronger economies such as Germany's.
Sticking with the current number may result in ``a pyrrhic victory by pushing inflation within target but having destroyed the real economy,'' says Thomas Mayer, chief European economist at Deutsche Bank AG in London.
Trichet's Defense
Trichet, 65, recently stepped up defense of his goal, arguing May 8 that a revision would ``unanchor'' inflation expectations. He maintains that investors ``have not lost faith'' in the ECB's ability to deliver price stability and that only temporary ``shocks'' have caused its ceiling to be breached. Support for his view came this month as an ECB survey of private forecasters showed they expect long-term inflation to slow to 1.9 percent.
The short term is a different story. Prices rose at an annual rate of 3.6 percent in March, the fastest pace in almost 16 years, and Barclay's Capital and Societe Generale SA say inflation has yet to peak.
Even the ECB's own economists, who have underestimated inflation every year since 2001, are predicting prices will rise at a 2.9 percent rate this year, the biggest increase since 1993. The outlook is forcing the ECB to hold its key interest rate at a six-year high of 4 percent, even as growth slows.
Investors' inflation expectations, as measured by French inflation-indexed 10-year bonds, rose as high as 2.38 percent last week from 2.07 percent in February.
Bernanke's Goal
Containing those expectations is one of the reasons for establishing a numerical inflation target, a strategy the Reserve Bank of New Zealand pioneered in 1990 and Ben S. Bernanke embraced as a goal before he became Federal Reserve chairman in 2006.
Bernanke, 54, and other supporters say that by setting a specific target, rather than simply pledging to hold inflation down, central banks can keep expectations of future inflation under control and provide more clarity about the direction of interest rates.
The ECB's governing council, which decided to establish a target during its first year of existence, isn't alone in shooting wide of its mark. Fels estimates that of the 24 major central banks with official targets, about 80 percent are missing them, including those in the U.K., New Zealand, India and Mexico.
Faced with opposition in Congress and the need to fight the credit crisis, Bernanke has been forced to scratch an explicit target off his ``to-do'' list, says David M. Jones, a former Fed economist who has written several books on the central bank.
`Given Up'
``Bernanke came into office determined to establish an official inflation target at the Fed, but he's completely given up on the idea,'' Jones says.
Nobel laureate economist Joseph Stiglitz dismisses targets as ``a fad.'' Central banks that cling to them are courting ``disaster,'' he said in a May 21 interview with Australian Broadcasting Corp. ``Countries that follow inflation-targeting are likely to get themselves into trouble.''
The ECB's efforts are being thrown off by forces over which it has little control. Manufacturers in emerging markets such as China are raising the prices of goods they export, while growing international demand is driving up costs of oil, metals, grains and other commodities.
European food prices rose 6 percent in April from a year ago, while energy costs jumped 10.8 percent. German import-price growth held close to its fastest pace in more than 1 1/2 years in March.
`Inflationary Pressures'
``Globalization might be a major driver of inflationary pressures,'' Bundesbank President Axel Weber said in a speech May 22.
Another inflationary force is right next door as poorer, faster-growing nations in eastern Europe begin to adopt the euro and their prices rise to catch up with those of the 15 current euro zone nations. Greg Fuzesi, an economist at JPMorgan Chase & Co. in London, says this will put ``significant upward pressure'' on the inflation rate for the entire euro area, adding as much as 0.3 percentage point a year.
The ECB's adherence to a target is already accentuating tensions as individual economies within the euro area diverge.
During the first quarter, Portugal's economy contracted, and Spain's growth was the slowest since the third quarter of 1995; Italy's economy grew at a year-over-year rate of just 0.2 percent in the first quarter. Meanwhile, expansion in Germany, Europe's largest economy, is the fastest in 12 years. Inflation in the region ranges from 1.7 percent in the Netherlands to 6.2 percent in Slovenia.
`Contentious' Choice
``Germany doesn't want inflation, and the weak countries don't want deflation,'' says Bernard Connolly, chief global strategist at American International Group's Banque AIG unit in London. ``The choice between the two alternatives is likely to prove contentious.''
The current inflation target is a relic of the past, when globalization and technology-enhanced productivity gains helped keep a lid on prices, says Charles Wyplosz, director of the International Centre for Monetary and Banking Studies in Geneva.
``The ECB was too ambitious and miserably failed its own criteria,'' Wyplosz says. ``They are losing credibility and will continue to do so until they change.''
Alternatives to the status quo include raising the target to 2.5 percent, as Morgan Stanley's Fels suggests, or emulating the Fed by focusing more on core prices, which exclude food and energy costs. French President Nicolas Sarkozy and Italian Prime Minister Silvio Berlusconi have also urged the ECB to follow the Fed by giving more weight to fostering growth.
The ECB may already pursue a more ``pragmatic approach'' than its mandate implies, says James Nixon, an economist at Societe Generale. Even with inflation accelerating, the global credit squeeze's threat to growth prompted the bank to shelve a planned rate increase last September.
Precedent for Change
In 2003, the ECB's governing council modified its inflation goal, providing some precedent for change. Before then, the bank targeted an inflation rate between zero and 2 percent. Now, it aims to have prices rise less than, but close to, an annual rate of 2 percent in the medium term.
If the ECB sticks with that mark, it may have no choice but to keep interest rates elevated as inflation proves more persistent. Gilles Moec, London-based senior economist at Bank of America Corp., estimates the ECB will tend to maintain its key rate about a percentage point above the 3.06 percent average since 1998.
``The ECB will have to be even more tough,'' says Lex Hoogduin, who advised former ECB President Wim Duisenberg and is now chief economist at Rotterdam-based Robeco NV. ``Keeping inflation on target will be more difficult than in the last 10 years.''
To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net
Last Updated: May 27, 2008 02:26 EDT
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