The ECB’s Monetary Policy Strategy

Last Monday, Christine Lagarde announced the conclusions of the ECB Governing Council’s review of its monetary policy strategy.  The announcement – and updated Monetary Policy Strategy Statement – was the outcome of a period of reflection on the robustness of our framework since the last review and our assessment of its fitness to meet our mandate of price stability over the next five years.

Like all households and businesses, policym­akers find themselves in a time of considerable uncertainty. We are witnessing major structural shifts relating to the stalling, and partial reversal, of global economic integration. We are experiencing the emergence of artificial intelligence tools, which could have broad effects on the way our economies operate. And we continue to face familiar transitions such as the impact of an ageing population and ongoing digitalisation, and changes to our climate. There are many overlapping forces at play. In such times, trust in policymaking institutions is of vital importance.

Many of these structural changes will have substantial implications for inflation or the rate at which prices rise over time. Importantly, the scale of these changes will make inflation more volatile. This makes it more likely we will see larger shocks affecting inflation, in either direction, than we experienced in the two decades before the pandemic.

It is the responsibility of the Governing Council to deliver price stability in the euro area. We interpret price stability as a symmetric target of 2 per cent inflation in the medium-run. It is essential, therefore, that we have a strategy that is robust to today’s uncertain world.

The previous review of our monetary policy strategy concluded in mid-2021 and was focused on lessons learned from a period in which inflation had been too low. But shortly after its conclusion, we experienced an inflation surge, with the overall rate of price inflation in Ireland peaking at just under 10 per cent in the summer of 2022. Very similar patterns were observed across euro area economies. This was initially caused by supply bottlenecks as economies reopened after Covid-19, and energy price increases in the wake of the Russian invasion of Ukraine.

Though the macroeconomic and financial environment has changed, the updated strategy is decidedly not a total revamp. The fact that we took a conscious decision not to overhaul our strategy reflects the fact that the previous version had real strength that helped us deal with the strong inflationary pressures we faced. In particular, the clear symmetric target of 2 per cent we introduced in 2021 helped anchor long-term inflation expectations, even as inflation rates themselves accelerated.

When inflation expectations are anchored at target, it is hard for inflation to become embedded, as price-setters tend to make decisions based on their expectations of future prices. Further, with anchored inflation expectations, it becomes easier to engineer a so-called “soft-landing”, where disinflation occurs without large increases in unemployment. We did not see the large increases in unemployment in Europe that we saw during the inflationary period of the 1970s. Well-anchored inflation expectations, helped by our clear target, are an important reason for this.

It is also important, however, to fully recognise that, though the rate of price increases has fallen, the period of elevated inflation put a great deal of strain on Irish households. The price level of goods has risen, with incomes only catching up with a delay. Central Bank of Ireland, as part of the European System of Central Banks, is committed to price stability. Price stability is in fact our primary objective, and something we take very seriously. We understand that maintaining the public’s trust requires us to deliver on our mandate effectively.

We on the Governing Council focus on the rate of price inflation, rather than the price level, because a small, positive inflation buffer is helpful to avoid persistent, aggregate price decreases or “deflation”.  The small, positive inflation buffer means that prices will rise gradually and predictably over time (as will wages, which are effectively the price of labour). The buffer protects us from deflation, which is a particularly hard problem for monetary policymakers to deal with. The fact that low inflation can become entrenched is why we spent so much of the previous review of our strategy discussing what to do when inflation is below target.

However, while the key features of the strategy remain in place, we have made some changes. For example, we have made it clearer that we do not only respond forcefully or persistently when inflation is too low. We have gained greater understanding of the way large upside inflation shocks can potentially become self-sustaining, as prices and wages begin to reset more rapidly. We have therefore taken the opportunity to emphasise that, while low inflation can be hard to deal with, of course we are also vigilant regarding the risks of high inflation. 

How we deal with uncertainty

An important overall learning point is that we on the Governing Council have been forced to think harder about how we deal with uncertainty. The role of uncertainty was relevant during the pandemic, and inflation surge periods, and it remains very relevant today.

As part of our response to elevated uncertainty, we have focused on “agility” in our updated strategy. What does agility mean for us?  To be agile means to be sensitive at all times to the consequences of large shocks. There may be times, for example, when the shocks that hit us are sufficiently large, that they change the typical relationships between economic variables. During such times, we must act quickly, and we may also have to revise our outlook and policies quickly.

To give a specific example, forward guidance regarding future interest rates can be an effective tool when we run out of room to cut rates further (since there is a limit to how low rates can go). However, it is important not to box ourselves in when uncertainty is high and, on reflection, that was a weakness in our previous approach. Forward guidance remains part of our toolkit but we will have to be more agile in how we use it.

Elevated uncertainty also implies a need to de-emphasise our central forecasts, which describe what our staff consider the most likely outcome, when communicating our policies. For example, previously, the forward guidance we gave was often linked to the baseline from the macroeconomic forecasting exercises prepared by staff. However, beyond the most likely outcome, we also need to consider carefully the balance of risks when communicating. In our updated strategy, we have placed a new emphasis on scenario analysis. Scenarios are useful because they allow us to talk about uncertainty in a specific, rather than a general way. By simulating and considering potential scenarios, we can better communicate how we will respond if eventualities materialise that are not part of our central projection.

The importance of communication

The importance of communication itself is also made clear in the updated strategy, as it was in the previous version. Communication with the wider community is essential for ensuring public trust in our actions.

In the spirit of transparency, we have made clearer in the updated strategy that when we deploy unconventional monetary policy tools, we do so with distinct rationales. We may deploy them when interest rates are close to their lower bound, or to preserve the smooth functioning of monetary policy transmission.  We have emphasised again our commitment to evaluating the proportionality of our decisions, and their potential side effects.

Importantly, we acknowledge in our latest review that we expect inflation to be subject to shocks pushing it more strongly away from target, in either direction. It is important for us to communicate this now, to help us explain our actions when we see larger shocks.

In an environment where large shocks affecting inflation are more likely, we will have to ensure we work especially hard to earn and maintain the trust of the wider public. Communicating our outlook and strategy is clearly part of this, and I am a strong believer that regular reviews of strategies and frameworks are important to ensure they remain fit for the future.  Our next monetary policy meeting, and our first under our refreshed strategy, will be on 24 July. The next review of the strategy itself is scheduled for 2030.

Gabriel Makhlouf