Is It Time to Bet on an Inflation Overshoot?

Our main story today is a skeptical note following [ECB head] Christine Lagarde’s press conference [on July 27]. What became clear to us is that the ECB is still reliant on its forecasting model to determine whether it is on a trajectory to reach the 2% inflation target. This is not a technical issue, but rather it is critical for the assessment of what to expect. Since this model is biased in favor of forecasting the target, we conclude that the potential for a policy error is growing.

The big problem with data dependence is that it does not tell you what you need to know. You may know that inflation is coming down, but you don’t know whether or not it is coming down to 2%. Lagarde told us yesterday that the ECB was using the forecast, or projection as they call it these days, to make that determination. That alone tells us that the ECB will from now on tread more cautiously, because the forecast is hard-wired to predict outcomes in the vicinity of the inflation-target. In particular, it makes the assumption that the sheer announcement of an inflation target anchors people’s expectations. We know this is not true, but it forms an essential element without which the framework would not work.

The problem with this policy rule is that it would give you the same answer regardless of whether your target is 2% or 3%.

It is interesting that central banks have never subjected their forecast performance to outside evaluation. The ECB’s model has been giving wrong forecasts for the last ten years. It is not the forecast error that is the problem, but the forecast bias. The model is biased in favor of the actual target. If your benchmark is biased in favor of the target, then it is biased in favor of a lower interest rate. The reason we are focused so heavily on discussions of the model here at Eurointelligence is because it is the main source of policy errors.

If this happened in finance or in political polling, these models would have been kicked out a long time ago, along with the staff that produce them. That is not happening in central banks, whose economists are attached to what they like to call their workhorse models.

In its update of its World Economic Outlook, the IMF also warned about the asymmetry of inflation. So did several economists like Olivier Blanchard, Kenneth Rogoff. Some of them may be open to the idea of a higher inflation target.

We conclude therefore that the risk of a permanent inflation overshoot at the ECB is high.

Structural Inflation