A Good Thing Could Happen at the ECB: An Improvement of the Eurosystem’s Definition of Price Stability∗

The Eurosystem’s definition of price stability, “HICP increases below 2%,” is ambiguous and asymmetric, and less effective as an anchor for inflation expectations than a point inflation target. A speech of Otmar Issing’s in Milan, June 2002, can be interpreted as a modification of the definition as “HICP inflation of 1—2%.” This would make the definition of price stability unambiguous and symmetric and, for several reasons, be a significant improvement. As noted by many observers and argued in Svensson [7], a reform of the Eurosystem’s monetary-policy strategy is increasingly urgent. The strategy has a “definition of price stability” and “two pillars.” Both the definition of price stability and the two pillars need to be reformed. Regarding the two pillars, as has been said over and over again (including in [7]), the only sensible choice is a one pillar strategy, where all relevant information (including any information in monetary and credit aggregates) is combined into inflation and output-gap forecasts that guide monetary policy, precisely as is done by, among others, the Bank of England, the Swedish Riksbank, the Swiss National Bank (since abandoning monetary targeting in December 1999, see [9]), and the Bank of Norway (a new explicit inflation targeter since March 2001, recently reviewed by Svensson, Houg, Solheim and Steigum [8]). The Eurosystem’s definition of price stability is “an increase in harmonised consumer prices of below 2%.” As discussed in [7] and in some more detail in Svensson [5], the definition of price stability is problematic, because it is ambiguous and asymmetric, and therefore less effective as an anchor for inflation expectations. A symmetric explicit point inflation target, say 1.5%, ∗Briefing paper for the Committee on Economic and Monetary Affairs (ECON) of the European Parliament for the quarterly dialogue with the President of the European Central Bank. I thank Kathleen DeGennaro for editorial and secretarial assistance. Expressed views and any errors are solely my own responsibility. 2% or 2.5%, would be better and provide a better anchor for inflation expectations. Having an explicit point target is more important than the precise level of the target, 1.5, 2 or 2.5%. As long as there is a clear point target to aim for, it is not important whether there is range or not. Unanticipated shocks will in any case make ex post inflation deviate from the target. The definition is ambiguous because it is unclear about the lower bound of the inflation range. About a month after the definition was announced on October 13, 1998 (European Central Bank [2]), Duisenberg [1], in a speech on November 10, clarified that the word ”increase” should be interpreted as excluding deflation. The precise lower bound has since then been left unspecified, with occasional reference to uncertain measurement bias between measured and true inflation. In Issing’s [3] words, the Eurosystem has been “maintaining flexibility as to the lower bound.” The definition is asymmetric because the upper and lower bounds are not announced with the same precision; the upper bound is precise whereas the lower bound is imprecise. If uncertain measurement bias were the reason for the ambiguity, logic would seem to imply that both the lower and the upper bound would be equally affected. An unambiguous and symmetric definition would be, for instance, “an increase in harmonised consumer prices of between x and y.” Interestingly, a speech by Issing [3] at the Conference on ECB and Its Watchers IV in Milan, June 2002, could be interpreted as a modification of the definition to a symmetric one, where x is 1% and y remains 2%. I believe 1—2% would be a significant improvement over the current definition. First, 1—2% is unambiguous and symmetric. Second, 1—2% is such a narrow interval that it is clear that inflation, because of imperfect control and unavoidable shocks, will sometimes be above 2% and sometimes below 1%. Thus, this is a sensible soft-edged rather than hard-edged interval (see Svensson [6], for instance, for a discussion of hard-edged versus soft-edged target ranges). It is indeed equivalent to a point inflation target of 1.5%, with the understanding that this is a target to aim for ex ante, but that inflation ex post will normally deviate from the target. Hence, the target can only be met as an average over several years. Third, there is a certain continuity in 1—2%, since a 1.5% point inflation target is what the Eurosystem seems to use when calculating its reference value for the unfortunate first pillar (see Svensson [4] for details of the calculation). Indeed, the Eurosystem is probably best interpreted as having an effective point inflation target of 1.5%, so the 1—2% is completely consistent with this. Why could Issing’s speech be interpreted as specifying 1—2%? In discussing the Eurosystem’s definition of price stability with reference to the lower zero bound in nominal interest rates and the risk of a deflationary spiral, Issing [3] states (emphasis added): “Research has not clarified yet the extent to which pursuing an inflation objective closer to zero indeed implies substantially larger risks of getting trapped in a deflationary spiral. What is clear is that a small positive inflation rate, say between 1 and