EDITOR NOTE: In 2019, the Federal Reserve announced a major change to its policy. It would no longer target 2% inflation, as it failed for years to hit that target, but rather attempt a 2% “average" inflation rate. That means the Fed inflation forecasts aim to overshoot inflation for a period of time before pulling back the reins. Most of the world seemed to have accepted the Fed’s new strategy with minimal controversy, criticism, or protest. But for those who accepted it, what’s to assure them that it would actually work? The European Central Bank didn’t buy it, and for many reasons; most of which are discussed below. Perhaps it’s a good thing, as the Fed, seemingly spooked by the rate of its inflationary surge, appears to know very little of the actual effects of its experiment. Most investors seem to hold great confidence in the Fed. The smart ones, however, are hedging the central bank’s folly. Sound money assets are the only investments that would protect them in the case that the experiment might blow up in America’s face. It’s still a little early to call it (and again, all hedges anticipate risk, not react to it), but that’s what appears to be happening right now.
FRANKFURT (Reuters) - Setting out a policy strategy shift on Thursday, the European Central Bank left many questions unanswered but made one point abundantly clear: it would not follow its U.S. counterpart in targeting an average level of inflation.
The fact that it put distance between the two regimes in such a stark way reflects both the ECB's own struggles and the U.S. Federal Reserve's difficulty in communicating how average inflation-targeting actually works and impacts policy.
The following are five takeaways on why the ECB did not copy the Fed.
Average inflation-targeting means making an explicit commitment to overshooting your target after missing it for a longer period. That would be a big no-no for inflation-wary Germany, the region's largest economy.
ECB President Christine Lagarde said a temporary overshoot might happen and in some situations the ECB would put in place policies that resulted in such a swing. But that is still not a goal and falls short of the Fed's overshoot commitment.
This may be seen as a victory for Bundesbank chief Jens Weidmann who has persistently rejected the idea of shooting for price growth above the target.
"Are we doing average inflation-targeting like the Fed? The answer is no, very squarely," Lagarde told a news conference
The ECB's own inflation misses have been much bigger than the Fed's, so getting an average would mean bigger overshoots.
Last year's inflation averaged just 0.3%, well below the ECB's 2% target, while in 2019, before the coronavirus pandemic, inflation was 1.2%.
Offsetting these is all but impossible. It would mean huge overshoots with a nearly depleted policy arsenal, a combination that would challenge the ECB's credibility. Even if there was policy space for such swing, political opposition would be overwhelming. Moreover, gyrations on such a scale would not be healthy for an economy.
The ECB has tailored its entire strategy towards flexibility. It targets inflation over a medium term, an undefined, vague concept, while its tolerance for deviations is similarly loosely worded to give the Governing Council maximum flexibility.
The bank's guidance on future policy moves is also imprecise, so moving to a Fed-style average would actually reduce that cherished flexibility.
Targeting average inflation over a period is messy. It requires the central bank to define a time period and a specific inflation measure it looks at.
Markets then hold the central bank accountable and price assets accordingly. Such a framework either reduces the ECB's flexibility or, if it does not specify the terms of the framework, will leave markets confused, causing asset price volatility.
THE FED'S STRUGGLES
The Fed's own difficulties also dissuaded the ECB.
The Fed decided on Flexible Average Inflation Targeting last August but has been widely criticised for not defining how much of an overshoot would be allowed over what length of time.
A year later the picture is still not clear. In fact, different inflation forecasts and different sensitivities to inflation risk have left a broad division among policymakers. Some see rate increases already next year while some expect the first move only in 2024.
Original post from Yahoo! Finance