Inflation Targeting Gets Another Black Eye

Inflation targeting just got a black eye in the United Kingdom. Now its about to get another one as the European Central Bank (ECB) President Jean-Claude Trichet signaled interest rates will probably be increased in April. As was the case in the United Kingdom, the motivation for this move is concerns about maintaining the central bank’s inflation target. And like the United Kingdom too, the inflation concerns are not warranted given that core inflation is low and inflation expectations remained well anchored according to the ECB.* Morever, aggregate spending is still well below any reasonable trend. For example, the figure below shows Eurozone nominal GDP is below its 1995-2004 trend. (This time period is chosen to show that nominal GDP is still below trend even after accounting for the housing boom run-up in spending.)

As Kantoos notes, all of these facts mean that tightening monetary policy in April makes no sense. Especially if the ECB wants to prevent a crackup of the Eurozone. The Eurozone is not an optimal currency area and inflation targeting is about to make that even more apparent. This will definitely be another black eye for inflation targeting.

*The ECB reports in its February, 2011 Bulletin the following on page 54: “Inflation expectations over the medium to longer term continue to be firmly anchored in line with the Governing Council’s aim of keeping inflation rates below, but close to, 2% over the medium term.”

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