The European Central Bank should follow the U.S. Federal Reserve in putting more emphasis on welfare when it’s setting policy, even if that would mean inflation exceeded its target temporarily, ECB Governing Council member Olli Rehn said.
The Fed said recently it would let the jobs market run hotter in the future to help lower-income families, an unusual foray into social policy that has historically been off-limits to central banks.
But Rehn argued that the new economic realities guiding the Fed also applied to Europe. Low unemployment no longer comes at the cost of rapid inflation, so central banks can afford to boost social inclusion.
“If this is the case, from the point of view of economic and social welfare, it makes sense to accept a certain period of overshooting while taking into account the history of undershooting,” Rehn, Finland’s central bank governor, said in an interview.
Rehn is among the first European policymakers to publicly discuss the social impact of policies, especially on low-income workers. His comments suggest a departure from the narrower interpretation of the ECB’s inflation-fighting mandate.
French central bank chief Francois Villeroy de Galhau also argued recently that besides inflation, the ECB should also look at employment and income distribution when setting policy.
At issue is a guiding principle of modern central banking, that inflation accelerates as unemployment falls, so central banks have to cool the jobs market to stop prevent inflation.
While the euro zone created around 10 million jobs in the seven years before the coronavirus, inflation stayed well below the ECB’s target of just below 2% despite extraordinary stimulus.
Rehn added that the ECB should also study the merits of making up for lost inflation, as the Fed plans to do as it moves to average inflation targeting by letting inflation rise above target after a period of misses.
“While price level targeting as suggested by (Former Fed Chair) Ben Bernanke or average inflation targeting is open to criticism from the point of view of communication, in this context is nevertheless worth exploring in depth,” Rehn added.
The ECB is currently reviewing its policy strategy and is expected to refine its own target late this year or early next year.
While the discussion is still open, Rehn advocated setting on a single-point target, ditching its current formulation of “below but close to 2%,” since this created an impression of asymmetry.
“This would also imply that we would accept inflation overshooting the point target or undershooting the point target for a period of time, as long as we’re on path to converging to our medium term, symmetric price stability target,” he added.
Rehn admitted that a greater emphasis on social issues could at some point conflict with its primary inflation mandate, but said any such conflict was well beyond the medium term, the bank’s usual focus horizon.
In fact, near-term prospects are at risk of underperforming the ECB’s own muted expectation as a fresh wave of the pandemic forces governments to impose more restrictions on everyday life, Rehn said.
“Some recent indicators, especially from the service sector, have been somewhat disappointing, which amplifies the downside risk to the economic recovery,” he added. “The shape of the recovery in my view could be best described as a truncated square root.”
He added that initial 2023 growth and inflation projection to be published in December will be key, but inflation risks were on the downside and it was better for the ECB to be safe than sorry when it comes to providing stimulus.