(Bloomberg) — Central banks can better control inflation expectations if they use a range for price growth rather than a precise goal, according to a European Central Bank study that could have implications for the institution’s strategic review.
The working paper by Michael Ehrmann, head of the monetary policy research division and a former Bank of Canada official, looked at inflation-targeting strategies in 20 advanced and emerging-market economies.
It found that defining a band within which consumer-price growth is considered acceptable bolsters the central bank’s credibility because it is less likely to miss the goal.
“The evidence therefore favors the adoption of some sort of interval, be it in the form of a range or a tolerance band around a point target,” Ehrmann said.
The ECB is debating whether its inflation goal of “below, but close to, 2% over the medium term” should be changed, as part of wide-ranging review of its policies. While multiple officials have signaled that the phrase is too vague, there is so far no consensus over what should replace it. The decision is due later this year.
The U.S. Federal Reserve completed its own review last year with a decision to pursue average inflation targeting, keeping its 2% goal but allowing an overshoot after periods of low price growth. The Bank of England has a target of 2%.
The ECB paper also noted differences between jurisdictions should the central bank miss its target. In emerging economies, the worst outcome would be to set a range and fall outside even that, leaving forecasters confused. In advanced economies, the greater danger lies with failing to hit a hard goal.
“Missing a target range is particularly damaging for credibility in emerging economies,” Ehrmann wrote. For advanced economies, however, “we find that point targets perform relatively poorly when inflation strays far from target repeatedly, in the sense that inflation expectations become more dependent on realized inflation. This suggests that the economic context matters.”
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