11/ The new monetary policy strategy of the Eurosystem: Part 3

24 November 2021 

Blog post by Gaston Reinesch, Governor of the BCL

This blog is the third and final part of a series of articles on the Eurosystem’s monetary policy strategy review launched in January 2020 and concluded in July 2021.[1] It reviews the outcomes of the review in relation to a) the medium-term orientation of monetary policy, b) the monetary policy instruments, c) the new integrated analytical framework, d) the enhanced regular proportionality assessment and e) communication.

The medium-term orientation of monetary policy confirmed

The two per cent symmetric inflation (medium-term) target marks an important change to the ECB’s monetary policy strategy.

At the same time, the review led the Governing Council to confirm elements of the existing strategy, such as its medium-term orientation. First, the medium-term orientation allows to account for uncertainties in the monetary transmission process. While the euro area is continuously subject to shocks that affect prices and inflation, it is widely acknowledged that changes monetary policy only affect price developments with a significant, yet uncertain and variable time lag. Since keeping inflation at its targeted level at all times is impossible, monetary policy needs to act in a forward-looking manner and can only maintain price stability over longer periods of time.

Second, the medium-term orientation, the review confirmed, allows the Governing Council to respond flexibly to economic shocks. The optimal monetary policy response depends on the specific nature, size and persistence of shocks affecting the economy. For some types of shocks (e.g. demand shocks that affect economic activity and prices in the same direction), a swift monetary policy response is often adequate. Other types of shocks (e.g. cost-push shocks such as a sudden increase in oil prices) may temporarily move output and prices in different directions. In such cases, aggressive monetary policy action aiming to bring inflation back to target “in no time” could bear substantial costs (e.g. in the form of higher unemployment owing to a tightening of monetary policy with the aim to curb the immediate price impact of higher oil prices).

With a view to retain flexibility with regard to the exact time frame, the Governing Council does not define (and previously has not done so) the medium term with reference to a predetermined horizon. The horizon at which the Governing Council aims to align inflation sustainably with the inflation target depends on the shock(s) affecting price developments. Depending on the type and magnitude of the shock(s), the policy-relevant horizon may therefore deviate from the standard horizon of the ECB/Eurosystem staff macroeconomic projections (i.e. two to three years).[2]

Third, without prejudice to the primary objective of price stability, the medium-term orientation allows the Governing Council to cater in its monetary policy decisions for other relevant considerations, such as employment, financial stability and climate change.

Article 127(1) of the Treaty on the Functioning of the European Union (TFEU) states that the primary objective of the European System of Central Banks is to maintain price stability. But without prejudice to the objective of price stability, the ESCB shall also support the general economic policies in the European Union with a view to contributing to the achievement of the objectives of the EU as laid down in Article 3 of the Treaty on European Union (TEU).[3] Other relevant considerations will be necessary for maintaining price stability over the medium term. Balanced growth, full employment and price stability, for instance, are largely consistent objectives. Financial stability is a precondition for price stability and vice versa. Physical and transition risks related to climate change have implications for both price stability and financial stability. When taking these considerations into account the Governing Council bases its assessment on the relevance of these considerations for the primary objective of price stability and its ability to support the general economic policies in the EU.

Monetary policy instruments of the Eurosystem

As discussed above, all else being equal, the declining equilibrium real interest rates constrain the room for standard policy rate cuts following a disinflationary shock. As discussed in one of the previous blog articles on unconventional monetary policy tools, central banks are limited in how deep in the negative territory they can cut policy rates by the effective lower bound on nominal interest rates. Not only as deposit rates decline, the negative nominal yield will at some point exceed the cost of storing physical cash, but commercial banks could also increase their lending rates and thereby choke off the desired expansionary impulse (“reversal rate”).[4]If not addressed by other tools, the limited policy space could lead to persistent downward deviations of inflation from the central bank’s target and eventually economic agents might revise their inflation expectations below the target.

Over the past decade the Governing Council deployed new monetary policy tools that helped to mitigate the limitations generated by the lower bound (see also the earlier blog articles on unconventional monetary policy instruments adopted before 2020 and the exceptional response to the exceptional Covid-19 pandemic). Broadly speaking, these tools include negative interest rates, forward guidance, large-scale asset purchases and longer-term refinancing operations. As episodes during which the effective lower bound becomes binding may also emerge in the future, the Governing Council will consider all policy instruments, if proportionate and as needed, in the pursuit of its inflation target. While the primary monetary policy instrument are the key policy rates (described in an earlier article on conventional monetary policy tools), the new tools will remain an integral part of the ECB’s toolkit.

The Governing Council recognizes that the commitment to a symmetric inflation target requires especially forceful or persistent monetary policy action when the economy is close to the effective lower bound, in order to avoid negative deviations from the inflation target becoming entrenched. As described above, such response is considered to be needed to support the anchoring of longer-term inflation expectations at the inflation objective of two per cent, which contributes to maintaining price stability over the medium term. Such a forceful or persistent response, when appropriate and based on a careful proportionality analysis, may also imply a transitory period in which inflation is moderately above target (and, hence, outside the price stability definition announced in 1998).

The new integrated analytical framework

The analytical framework refers to the type of analyses of the risks to price stability that underpin the monetary policy decisions of the Governing Council, including the regular proportionality assessment covering the effectiveness, efficiency and side effects of all monetary policy measures. Since its inception, the Eurosystem organised the analytical framework into two pillars: the economic analysis identifying short to medium-term risks to price stability and monetary analysis assessing medium to long-term trends in inflation in view of the close relationship between money and prices over extended horizons. So far, the results from the two analyses were cross-checked against each other to obtain an overall judgement on the risks to price stability.

Going forward, the Governing Council will build its monetary policy assessment and decisions on two specialised areas, i.e. the “economic analysis” and the “monetary and financial analysis”.

The integrated analytical framework accounts for inherent links between economic and monetary and financial analysis. The new framework replaces the previous two-pillar framework and the cross-checking of the information coming from the two analyses is discontinued.

The economic analysis in the new framework focuses on real and nominal economic developments. It covers analyses of developments in economic growth, employment and inflation; the assessment of shocks that hit the euro area economy, staff projections of key macroeconomic variables and a broad-ranging evaluation of risks to economic growth and price stability. Particular attention is also given to the analysis of structural trends and their implications for monetary policy.

The monetary and financial analysis focuses on the operation of the monetary policy transmission mechanism and the possible risks to medium-term price stability from financial imbalances. The analysis of the monetary policy transmission aims to identify potential changes in transmission (such as increasing role of non-bank financial intermediation) or impairments in transmission that could make monetary policy less efficient. Furthermore, the monetary and financial analysis evaluates the longer-term build-up of financial vulnerabilities and imbalances and their possible implications for the tail risks to output and inflation. It thus recognises that financial stability is a precondition for price stability. Last but not least, the information from monetary and credit aggregates is used to assess the functioning of the monetary and financial transmission given their relevance for identifying risks to price stability.

Enhanced regular proportionality assessment

In making monetary policy decisions the Governing Council systematically assesses the proportionality of its measures. The proportionality assessment incorporates an analysis of the benefits (in terms of the monetary transmission process and in terms of the impact on inflation/price stability), and the possible negative side effects (i.e. unintended effects on the real economy and on the financial system) of monetary policy measures, their interactions and their balance over time. The proportionality assessment applies to all monetary policy instruments, but is of particular importance for instruments other than standard policy rates. The outcome of the proportionality assessment may affect both the intensity with which measures are employed and their design/modalities.

Communication of monetary policy decisions

The importance of monetary policy communication increased over the last two decades and in particular when central banks adopted non-standard monetary policy measures. Monetary policy communication turned into an important policy tool itself as evidenced by the active use of “forward guidance” by central banks.[5] Well-designed communication with markets and public is key central bank accountability, builds credibility and trust and can increase effectiveness of monetary policy.

The Governing Council will adjust its communication on monetary policy decisions by enhancing the information provided to make it accessible to various audiences. The main communication products will remain: (i) the press release, (ii) the (revised) introductory statement, renamed “monetary policy statement”, (iii) the Economic Bulletin and (iv) the monetary policy accounts.

The monetary policy statement of the Governing Council will reflect the new analytical framework outlined above and will be built around an integrated narrative motivating each monetary policy decision drawing on results of the economic and monetary and financial analyses.

The Economic Bulletin will feature more analyses of monetary and financial issues and regular updates on the proportionality assessment of Eurosystem’s monetary policy measures.

The strategy review benefited from the input from European citizens received through various Eurosystem’s “listening” events organised by the ECB and the Eurosystem’s national central banks including Banque centrale du Luxembourg (click here for an overview of the events organised by Banque centrale du Luxembourg) The Governing Council intends to maintain the interactions with the public including both “listening” and “explaining” dimensions with a view to improve the public’s understanding of Eurosystem’s monetary policy and its implications.

Finally, with a view to ensure the ECB’s monetary policy strategy remains fit for purpose, going forward, the Governing Council intends to periodically assess the appropriateness of its strategy, with the next assessment expected in 2025.

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[1] The first part of this series focused on the motivation behind the 2020/21 strategy review as well as the inflation target as a key outcome of the review. The second article reviewed the outcomes of the review in relation to a) the Harmonised index of consumer prices (HICP) as the appropriate price measure for monetary policy purposes, b) the role of owner-occupied housing costs and c) climate change.

[2] Eurosystem staff projections, produced jointly by ECB and euro area NCB experts, are published in June and in December of each calendar year. ECB staff projections are published in March and in September of each year. Macroeconomic projections play an important role in the economic analysis (see section “The new integrated analytical framework” further below).

[3] The objectives of the EU include, among other things, the sustainable development of Europe based on balanced economic growth and price stability, and a highly competitive social market economy, aiming at full employment and social progress. Moreover, the ESCB shall also contribute to the smooth conduct of policies pursued by competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system. Furthermore, the Eurosystem shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources.

[4] See also the blog article “Unconventional monetary policy tools adopted before 2020”.

[5] Forward guidance provides information about the intentions of the central bank thus reducing uncertainty about the future.

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