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The ECB Needs New Inflation Rules

The European Central Bank has consistently undershot its inflation objective of “close to, but below 2%” for over a decade, potentially threatening its credibility. To maintain credibility, the ECB should adopt a two-pronged strategy focusing on a medium-term inflation target and systematically smoothing financial cycles.

MUNICH – The upcoming change of leadership at the European Central Bank represents an opportunity – if not an obligation – to review the Bank’s policy framework. The ECB can take credit for major achievements during Mario Draghi’s presidency – most importantly, stabilizing the eurozone during the 2007-08 global financial crisis and ending speculation about the possible breakup of the single currency during the sovereign-debt crisis in 2012. But the ECB’s strategy of steering consumer-price inflation has been much less successful.

The ECB’s policies regarding inflation have had some powerful side effects – including increased risk-taking, skewed capital allocation, rising inequality, and growing pension gaps. Yet annual inflation has undershot the bank’s objective of “close to, but below 2%” for over a decade, and has averaged only 1.2% since the financial crisis. To bolster its credibility on inflation in today’s uncertain policymaking environment, the ECB should adjust its rules and adopt a more flexible approach.

The impact of monetary policy on economic activity and inflation has been hotly debated ever since John Maynard Keynes published The General Theory of Employment, Interest and Money in 1936. Although there have always been cracks in the transmission of such policies to the real economy and prices, the financial crisis and its aftermath exposed major ruptures.

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