ECB rate and steady inflational rate

Senna

Just a hypothetical question, but say the ECB drop the base rate to 1% and keeps it at that regardless of whether the eurozone goes into deflation or not. Then in a few years time inflation rises to 2%, a figure that the ECB want to keep inflation at (ECB still 1%). Is it likely that the ECB would keep the base rate unchanged unless inflation rose above 2%?

Are the eurozone (German) savers of paramount importance to the ECB and they would rather a rate closer to 4%, even if raising it goes against their previous statements?

Économiste Monétaire

It's not quite that simple. Short-term fluctuations in the HICP aren't assigned a specific rule vis-à-vis the minimum bid rate. There's also not a 1:1 minimum bid rate:inflation rate causality, because the effects of influencing money market interest rates are uneven over time. Estimates of, say, a 1 per increase in the headline minimum bid rate will lead to between 0.09-0.15 percentage change in the price index for the first year, going to about 0.4-0.5 3 years post facto for the Euro Area. Food and energy prices are fairly volatile and it's generally considered not a good idea to track their every movement, unless it's a wild upswing (like the middle of 2008). You need to look at the sub-indices for an indication of a rate rise.

The growth of the broad money supply would be of concern going forward, but the ECB won't have to make to the debilitating decision to raise the headline rate for some time. Right now, the Euro Overnight Index Average (EONIA) rate is well below the target rate of 1.25%, something around .6% average last week and .5% yesterday. That's because the ECB has moved to un-rationed main refinancing auctions in lieu of the financial crisis and banks' unwillingness to lend to other banks. That effectively means there's too much money in the system, because the overnight interbank rate is not reflecting the ECB's target rate. We can move to rationed and variable rate auctions over about 3 months to soak some of that up, that's probably the first sign of an incoming rate increase.

If inflation is low, rates won't rise just to support savings. Just remember the hard rule that the ECB defines price stability as inflation close to, but below, 2% over the medium term. Watch for large, precipitous increases in the HICP and the broad money supply (M3). The objective is to keep inflation expectations anchored at the near 2% and make this commitment credible.

Senna

Thank you for the very concise answer, i wont pretend i understand every line but i got the answer.

Just one more question, no point starting a new thread. If the ECB decide to inflate their way (not just quantitative easing) out of this mess (again highly hypothetical, pie in the sky, amuse me type thing) and this then pushed up inflation, say inflation when to 15%. If the ECB did instigate such a move, could we expect to see an ECB rate to reflect this, maybe in the 20%-30% range?

Économiste Monétaire

15 percent inflation, induced by the ECB via monetary expansion, would probably end in the collapse of the Eurosystem. The German's have consistently followed a non-accommodating policy for inflation, if German HICP went above 5 or 6 percent then you're looking at serious political friction.