Draghi’s high-class problem rears its head as ECB views exit

Bloomberg

European Central Bank officials are starting to consider a topic President Mario Draghi dismissed as a “high-class problem” — whether to let the economy run hot.
Even with recent signs of a slowdown, the euro-zone economy is growing faster than its long-term trend. Allowing that boom to continue even at the cost of higher inflation is arguably one way to repair the damage from a decade of financial crises and a double-dip recession, for example by luring back workers who had given up hope of a job.
The option has become more relevant now, as officials discuss how slowly to withdraw monetary support. Governing Council member Erkki Liikanen hinted at the possibility of overshooting last month, only for his colleague Jens Weidmann to push back against the idea. Both are possible contenders to succeed Draghi next year. Executive Board member Benoit Coeure has also weighed in.
“If you start normalising late and go slowly about it, you will have to overshoot,” said Paul Mortimer-Lee, chief market economist at BNP Paribas. “After being below target for such a long time, they may want to overshoot and run the economy above potential for a while, to strengthen expectations about future inflation.”
Policy makers will meet next week, though the immediate focus is more likely to be economic weakness. Inflation was 1.4 percent in March, compared with the medium-term goal of just under 2 percent, and first-quarter economic reports have generally proved disappointing.
That could change quickly though. Mortimer-Lee says the chance of inflation surprises is rising. For the ECB, any such spike is bound to call up memories of 2011, when the central bank raised rates just before the economy plunged back into recession.
It’s a subject close to the hearts of the world’s major central banks as they puzzle over whether inflation is near a tipping point after staying so low since the global financial crisis. US Federal Reserve Chairman Jerome Powell’s plan of gradual interest-rate hikes will be tested by President Donald Trump’s fiscal stimulus, while the Bank of Japan could be on the verge of giving up on hitting its consumer-price goal after pushing monetary policy to the limit.
One argument for stubbornly weak inflation is that the crisis permanently damaged economic potential, with investment opportunities mis-sed and unemployed workers losing their skills.
“After years of missing its target, the ECB is probably more willing to risk a slight overshoot of price increases by letting the economy overheat somewhat than a continued miss induced by a rapid exit from its quantitative easing program, especially after the failed experiment of tightening just before Mario Draghi arrived at the helm, says David Powell, Bloomberg Economics.
Economists label the process of temporary developments becoming entrenched as ‘hysteresis’ and, as Coeure noted, some say the solution is to keep the money taps open.
“It may be the case that only targeted structural reforms or a ‘high-pressure’ economy created by unusually loose macroeconomic policies can provide a solution,” he said in Paris this month. “The impact of a long period of above-potential growth on the supply side would in turn constitute ‘reverse hysteresis’.”

NO MYSTERY
Coeure wasn’t convinced though, at least for the euro area. He argued that the region’s economic capacity is still largely intact — that the scars of the crisis may turn out to be only deep scratches which will, given enough time, heal.
“A larger output gap in recent years is consistent with recent inflation dynamics,” he said. “If we are primarily seeing normal effects of the cycle, there is no real mystery about why inflation is so low in many economies, and there is also no need to run the economy hot to undo the damage of the crisis.”