The 2 Percent Doctrine

Is the European Central Bank ready to start tackling the continent’s inflation problem?

Is the European Central Bank finally going to act? Despite 12 straight months of inflation readings below the supposed target for the Eurozone, the folks in Frankfurt haven't changed interest rates since November or brought in any new measures to juice the world's second-biggest economy. But this week, a member of the European Central Bank's (ECB) governing council hinted that it might finally emulate the Federal Reserve's tireless and unconventional fight against deflation. Here are some possible reasons why the ECB has been sitting on its hands -- and may continue to do so at next week's policy meeting.

1. Doing nothing has been fine.

Earlier this month, the media trumpeted a middling forecast for Eurozone growth as enough reason for Mario Draghi, the ECB president, to leave interest rates alone. This may come as little comfort to millions of jobless Europeans; indeed, the Eurozone's unemployment rate in January was the same as a year before. But the ECB's mandate is to maintain price stability over the medium term, not to ensure full employment.

Moreover, neither price stability nor the medium term has an explicit definition for the ECB. Its target for inflation is "below, but close to" 2 percent, and it doesn't give any specifics about time frame. (Economists often think about the medium term as anywhere from three to five years, which doesn't help too much.) So it's anyone's guess how quickly Draghi feels the inflation rate should return to its target, or where that target really is. For him, everything may well be going to plan.

2. It's the Germans, stupid.

In January, Germany's Sabine Lautenschläger replaced compatriot Jörg Asmussen on the ECB's executive board after he decided to get back into politics in Berlin. Though Asmussen routinely insisted the ECB's inflation target was a symmetrical one -- that is, inflation below target was just as bad as inflation above -- he reportedly argued against a suggestion by Draghi to push interest rates to zero. Lautenschläger may be even more hawkish, judging by a nomination hearing where she sounded skeptical of long periods of low interest rates and asset purchases by central banks.

By contrast, Asmussen had strongly backed Draghi's controversial strategy of buying government bonds to improve liquidity, so his recent stiffening on monetary policy was somewhat unexpected. It may have had something to do with the difference between inflation back home in Germany and in the Eurozone as a whole. Though German price increases lagged behind for much of the past four years, since May they have been higher than inflation in the monetary union:

Source: Eurostat data via the Federal Reserve Bank of St. Louis.

In fact, the data since May show inflation of 0.8 percent in Germany and deflation of 0.5 percent in the Eurozone, despite the German contribution. Asmussen's welcome in Berlin might not have been quite so warm if he had stoked fears of higher inflation just months before. But it is more than a little interesting that it was his countryman Jens Weidmann, the president of the Bundesbank, that dropped the hints about more radical moves by the ECB this week, especially given how the two men had tussled over such policies just this past summer. 

3. Hey, the ECB is pretty good at its job.

If the ECB's job is to head off bouts of high inflation and deflation before they happen, it may be doing extraordinarily well by at least one measure: expectations. If the central bank truly can control the inflation rate in the Eurozone, then it has managed to outfox its constituents with remarkable regularity.

Economists have long supposed that people avoid making the same mistakes repeatedly when trying to forecast the future. In other words, their expectations for things like inflation should be decent predictors of the future, and never be systematically too high or too low. And yet that is exactly what seems to be happening in the Eurozone of late. 

Each month, the European Commission surveys people in the Eurozone about inflation in the coming year. They can respond that inflation will be higher, lower, or the same. The commission discards the "same" votes and takes the difference between "higher" and "lower" as an indicator of where prices are going. But what actually happens to prices?

For the past five years, the difference between inflation in the year after the survey (as measured by the European Commission's harmonized index) and inflation in the year before has been almost the opposite of what people expected. Forecasts for faster increases in prices were followed by slower ones, and vice versa:

Source: Eurostat data via the Federal Reserve Bank of St. Louis and European Commission data via OECD.

So are people in the Eurozone just lousy at predicting inflation? Or is the ECB like an expert chef, turning down the heat precisely when inflation is expected to rise and fanning the flames when it looks like falling? If it's the latter, then the people in these surveys must consistently be surprised by the ECB's actions and influence. 

4. Who cares? The ECB can't affect anything, anyway.

Perhaps the ECB doesn't exert quite so much control over inflation. It may indeed be harsh to blame a few technocrats in Frankfurt for the lack of movement in prices across the continent; slack demand for goods and services in the Eurozone probably has a lot to do with poor national policies, widespread long-term unemployment, and an overall lack of confidence in the durability of the economic recovery. Expanding credit further can't solve all of these problems, as at least one pundit has remarked, and may even create other ones. The question is whether, on balance, it can help. 

The ECB may have a symmetrical inflation target, but the costs of erring on either side are not necessarily equal. William Dudley, the president of the Federal Reserve Bank of New York, has frequently pointed out that the economic costs of deflation are likely to be much greater and harder to contain than the costs of a credit glut. Moreover, when the real return to investing falls -- as it did in the United States after the Great Recession, and likely did in the Eurozone as well -- then monetary policy that seems loose may in fact be far too tight.

Dudley came to his conclusions after studying Japan's deflation and asking why historically low interest rates in the United States had been puzzlingly ineffective at reviving demand. He came away a strong advocate of the Fed's program of enormous interventions in the nation's credit markets, which Japan has since adopted as well. His counterparts in Frankfurt still have time to learn the same lessons.



MH370 and the Secrets of the Deep, Dark Southern Indian Ocean

The world's most isolated ocean has a long history of making things disappear.

In 1900, Jules Verne published The Castaway of the Flag, an adventure novel in the shipwreck fantasy subgenre. To put his Swiss Family Robinson in an excessively remote spot beyond hope of rescue, he plonked them on New Switzerland, an imaginary island in the middle of the Indian Ocean. Then, as now, the region's main features were its remoteness and isolation -- capable of hiding an entire island, or simply vanishing a Boeing 777 in its untrafficked vastness.

On March 24, Malaysian Prime Minister Najib Razak announced that the missing Malaysia Airlines fight, which took off March 8 from Kuala Lumpur en route to Beijing and hasn't been heard from since, "ended in the Southern Indian Ocean." The loss of MH370 has for the first time turned the entire world's attention to this region: Big enough to contain Russia twice, the southern Indian Ocean has been condemned to obscurity by its emptiness and inhospitality. The ongoing search for the wreckage -- none of the 239 people on board is believed to have survived -- is frustrated by the extreme remoteness and the harsh climate of the presumed crash zone, in the words of Australia's Prime Minister Tony Abbott, "as close to nowhere as it's possible to be."

Whoever or whatever caused the plane to crash here could not have found a more desolate locale. The southern Indian Ocean is "out of normal shipping lanes, out of any commercial flight patterns, with few fishing boats, and there are no islands," a U.S. government official familiar with the search effort told CNN. Of all the world's large bodies of water, this may be the one least explored; to be lost at sea out there is nearly as lethal as being stranded in outer space.

Distance is hampering the search effort. The planes taking part in the search fly out from Perth, Australia, the closest city to a debris field floating in the ocean that may be MH370's wreckage. But it's still roughly 1,600 miles away, and the 8-hour round-trip flight from Perth limits the time available for actual reconnaissance.

Not that there are other options besides Perth: There simply isn't anything closer by -- let alone inhabited lands. The closest spit of land is the French archipelago of Kerguelen, uninhabited but for a rotating staff of what must be the world's most bored meteorologists. In the 19th century, the French government even decided against establishing a penal colony on the Delaware-sized island because it would be too cruel on the inmates. The only way off the Kerguelen is via a freighter, which takes 10 days to reach the nearest airport. (Kerguelen is also known, aptly, as Desolation Islands.)

The southern Indian Ocean is not only remote, but it has worse weather than just about any other place on the planet. Storms have hampered the search by grounding flights, reducing the usefulness of the handful of vessels in the area (including an Australian Navy ship and a Chinese icebreaker), and further dispersing and submerging much of the debris floating on the surface.

Storms are the rule rather than the exception in this part of the world, plagued by the Roaring Forties -- the never-ending winds that howl around 40 degrees latitude south. The weather, combined with the fact that this zone, just north of Antarctica, is the only place where water can flow around the globe without hitting land, means that the waves are among the highest in the world. (Surfing is inadvisable.) That these are some of the deepest parts of the Indian Ocean, with a rugged and volcanic ocean floor, decreases the likelihood that the black boxes would be retrievable. All of which adds up to an almost impossible race against time: Those black boxes have limited battery life and will likely stop transmitting around April 7.

The mystery of Flight 370 will be added to the slim corpus of stories set in the southern Indian Ocean. Apart from Verne's delightful fiction (the shipwrecked family brings order and progress to the uninhabited island), one very real horror story keeps floating to the surface. In the 17th century, the Dutch ship Batavia was stranded on the Houtman Abrolhos, a collection of reefs and islands off the western Australian coast. A group of mutineers instigated a reign of terror over the survivors, killing more than 100 before they themselves were executed by the officers arriving in a relief vessel. Despite the infamy thus bestowed on the Abrolhos, these same reefs later proved the undoing of the Zeewijk, a Dutch East India Company ship that crashed there in 1727. Eighty-two of the initial 208 men stranded on the islands managed to reach the Dutch East Indies (now Indonesia) in a craft they built from the Zeewijk's wreckage -- the first boat ever built in Australia.

The Dutch persisted in this dangerous route because they chose to ride the winds of the Roaring Forties due east across the Indian Ocean rather than take the straighter, slower route closer to India to their colonies in the East Indies. If they overshot their trajectory, the ships would crash into the rocks and reefs off western Australia. The original ghost ship, the Flying Dutchman, was said to have perished in a violent storm in these parts.

Over time, sailors learned to keep away from the southern Indian Ocean, the furthest place from anywhere that anyone could ever dread to find themselves -- except if one had the good fortune to land on the shores of New Switzerland. What was the Malaysia Airlines Boeing 777 doing here, thousands of miles off course, disastrously far from any runway, its nose pointed towards Antarctica? Until it gives up the answer, the southern Indian Ocean remains part of the mystery.

Paul Kane/Getty Images