FRANKFURT (Reuters) - The European Central Bank's vaguely defined inflation target leaves it open to interpretation, which is likely to fuel a debate in the coming months as policymakers contemplate curbing stimulus.
With both headline and underlying inflation slowing in April, the ECB could also come under pressure to exit stimulus even more slowly.
WHAT IS THE TARGET?
The ECB "aims to maintain inflation rates below, but close to, 2 percent over the medium term."
WHAT IS VAGUE ABOUT IT?
"Medium term" is not defined and the ECB does not say how much below 2 percent is considered hitting the target. "Medium term" is flexible, depending on the size of any particular inflation shock. But the ECB has undershot the target for five straight years and will remain below its objective at least through the end of the decade.
WHY DOES IT MATTER?
The ECB promised to end its 2.55 trillion-euro ($3.1 trillion) bond purchase scheme once it made "sufficient" progress towards a "sustained adjustment in the path of inflation".
Again, "sufficient" and "sustained" are ill-defined concepts, fuelling debate among policymakers. Some argue the ECB is almost there, but most disagree, for now.
Inflation fell to 1.2 percent in April and the ECB expects it to hover around 1.5 percent for the rest of the year. While that is below target, the ECB could still end the bond purchases this year if it concludes that growth would generate the necessary inflation within a reasonable time [nL8N1SA35B].
HOW DOES THE U.S. FEDERAL RESERVE DO IT?
The Fed has a dual mandate of price stability and maximum employment. While the Fed targets inflation at 2 percent, almost like the ECB, it does not look at headline inflation but has a preferred gauge, the price index for personal consumption expenditures, or PCE.
CAN THE TARGET BE CHANGED?
The target was set in 1998, the year the ECB was founded. It was later clarified in 2003.
Targets are difficult but not impossible to change. Norges Bank recently lowered its own target. Some ECB policymakers have argued for a more flexible interpretation. But most policymakers argue that any debate about the target is inappropriate while the bank is undershooting.
HOW DO THE HAWKS SEE IT?
Opponents of the ECB's ultra-easy monetary policy argue that the ECB is too strict in defining the target and 1.5 percent is close enough, given that the bloc it experiencing its best growth since before the financial crisis.
They say that as long as the bloc is expanding above its potential, spare capacity will be soaked up eventually, leading to wage and price inflation. That gives the ECB room to be patient so it can withdraw stimulus and preserve some of its firepower for the next downturn.
They also say that cheap cash fuels bubbles -- already visible, albeit limited to certain segments of the real estate market -- sowing the seeds of the next crisis.
HOW DO THE DOVES SEE IT?
Internally, the ECB defines the target as 1.9 percent. When asked if 1.7 percent was close enough, ECB President Mario Draghi once said "not really".
The doves, who are in the majority, often argue that giving up before 1.9 percent would signal that the ECB will not fulfil its mandate. That will affect expectations across the economy and companies will permanently lower their inflation expectations when setting wages. That could put inflation into a downward spiral.
Lower permanent inflation would also reduce the ECB's neutral interest rate, the rate at which the ECB neither stimulates nor cools the economy. A lower neutral rate would mean the ECB has less room to cut rates when the next downturn come, so it would hit zero more quickly and could support the economy less.
($1 = 0.8335 euros)
(Reporting by Balazs Koranyi, editing by Larry King)
Disclaimer: No Business Standard Journalist was involved in creation of this content
