This article from Bloomberg News about Dragi’s explanation of the short term funds rate cut reads rather strangely. Here’s the part where I’m having a problem:

Inflation stayed close to the lowest level in almost four years in November with a reading of 0.8 percent, according to the median prediction of 44 economists polled by Bloomberg News. Data published at the same time on Nov. 29 might also reveal the euro-area jobless rate remained at a record 12.2 percent.

They’re right that Europe is in line for a period of too little inflation, but not deflation,” said Richard Barwell, an economist at Royal Bank of Scotland Group Plc in London, whose inflation estimate matches the survey median. “They’re going to try to keep the market on high alert that they’ll move if they need to.

Just to get it straight, here’s my translation:

1)      The ECB is undershooting its inflation target by more than 50%.

2)      The economy is decidedly bad in the EZ with unemployment “at a record 12.2%”

What is the definition of “if it needs to?” How bad do things have to get before people start comprehending these simple sentences, right there in black and white on Bloomberg? Undershooting the target on a persistent basis is NOT price stability – it’s disinflationary! It’s disinflationary if one chooses to consider headline numbers; but if considering core, the only half way rational measure from my point of view, the EZ is likely already in monetary deflation.

Even if I believed in headline inflation targeting, it wouldn’t be hard to figure out that allowing inflation to sink 50% below target on a persistent basis, the lack of price stability just might have something to do with the labor market being in a state of perpetual disequilibrium.

In one of Bernanke’s papers on the subject of inflation targeting from the late 1990s, there is a section where he discusses the natural rate of unemployment if the inflation target is set too low, stating that under such conditions, the NRU will become elevated. I don’t remember reading whether that elevation is permanent as long as the target is too low, but I would suppose that if the ECB’s target is more of a ceiling, money can naturally become tighter as various events of the wider economic crisis unfold with everyone at the ECB in a blissful slumber.

I don’t advocate inflation targeting, and it doesn’t make much sense to raise the inflation target when, in the eyes of those at the ECB, being as far below target as possible is hitting the sweet spot. It should go without saying that if the target is 2%, the rate should be at 2%, not 0.8%.  At the very least governments in the periphery should start raising a stink about the lack of price stability at the macro level. The target is 2% and they want their price stability at 2% every year. They should also demand a level target, meaning the ECB has to make up for years of undershooting.

Of course this is a bad approach to monetary policy, but it is less bad than what is going on over in Europe now. It’s bad for several reasons, among them being that inflation targeting with something like a Taylor rule is probably more useful as a maintenance mode framework in normal times, not as something that can prevent or mitigate deflationary pressures. With a damaged financial system, persistently high unemployment, and the public in hoarding mode, there’s not much point to the assumption that a .25% interest rate cut will matter as much as it might have 5 years ago.

An even less bad approach would be targeting growth of the money supply because inflation isn’t really what people want. But they don’t want perma-recession either and a reasonable justification for conducting monetary policy in such a way that leaves no other option just doesn’t exist. Targeting the growth of the money supply would be one way the ECB could contribute to putting the EZ economic crisis in the rear-view mirror with practically no chance to overshoot its mandate either in the short or medium term given the severity of the employment situation.

Lastly, the best solution is would be to return EZ NGDP to trend and do NGDP level targeting thereafter. My suggestion would be to use the money supply growth target to get there and then transition to the NGDP level target to maintain it. It is a slightly similar approach the Bank of Japan is taking; the only twist is instead of having 2% inflation be the end goal, returning the EZ NGDP to trend would be the transition goal, then ~5% growth thereafter.

These last two approaches take inflation out of the discussion, putting the appropriate weight of the measure on rational conduct of monetary that is due. Anything else, in the absence of an inflation problem in the 1970’s flavor, or even only one quarter the problem, is just purely sadistic.

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