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ECB monetary policy and catch-up inflation

In July, the ECB issued its first Strategic Review since 2003. The latest CfM-CEPR survey investigates one component of the announced policy shift: the new definition of price stability. Most members of the panel of experts on the European economy support the ECB explicitly allowing inflation to exceed its target for extended periods to make up for below-target inflation in the past. This 60% majority has divided views on the optimal alternative policies, with the largest share supporting average inflation targeting and some members supporting nominal GDP targeting or hybrid policies. 40% of the panel would prefer to maintain the current policy of traditional inflation targeting.

On 8 July 2021, the ECB issued its first Strategic Review since 2003.1 The new review systematises policy changes that have been adopted in the light of new economic challenges, such as slower productivity growth, globalisation, digitisation, climate change, the legacy of the 2008 financial crisis, and demographic changes. In addition to pursuing its traditional price stabilisation objectives, the ECB’s 2021 Strategic Review aims to tackle the broader issues of financial stability, balanced economic growth, competitive markets, employment, and environmental concerns. 

The latest CfM-CEPR survey2 investigates one component of the policy shift: the new definition of price stability. The Strategic Review makes explicit the ECB’s commitment to a symmetrical target around 2% inflation, as opposed to the perception that the ECB was to keep inflation consistently below 2%. There is existing evidence that the ECB has already followed such a policy, but the review formalises this reality (Bletzinger and Wieland 2017, Hartman and Smets 2019). However, the ECB has not gone as far as the Federal Reserve did in its strategic review of last year.3 The Fed has not only committed to a symmetrical target, but also to a policy of ‘catch-up’ inflation, whereby inflation may be allowed to exceed its target for a time, following extended periods of below-target inflation. Some commentators, such as Reichlin et al. (2021b) have urged the ECB to follow the lead of its US counterpart in allowing for a makeup element in its strategy. They write that such measures would help in “dealing with inflation shortfalls, to ensure that average inflation outcomes under its policy are in line with its numerical inflation objective”. Feld et al. (2021) take a different view, whereby the Fed’s approach may lack credibility because “market participants may speculate that once inflation reaches two percent, the Fed will refrain from further raising inflation. Additionally, some things remain unclear, such as the period over which the average should be at two percent. Moreover, if the inflation rate were to overshoot the target, it could be quite difficult to reverse that.”

A policy of ‘catch-up’ inflation can be viewed as a form of price-level targeting. Low periods of inflation put the price level below its trend and ‘catch-up’ policies help the price level revert to its trend, as would be the case with price-level targeting. Svenson (1999) lay down the intellectual foundations for this policy. Svenson’s influential research predicted that targeting the price level could lead to greater inflation stability than a policy of targeting inflation itself, when monetary policy is discretionary. Further, any inflation bias that might exist under discretion is replaced with a price-level bias that has lesser economic implications. Subsequent research has noted that Svenson’s conclusion depends on price-setting behaviour (Steinsson 2003, Gaspar et al. 2007), the information structure (Coenen and Wieland 2004, Ball et al. 2005), and the degree of price stickiness (Minford 2004), among other factors (see Ambler 2009 for a review).  Meh et al. (2010) study the distributional implications of price-level targeting and find that monetary policy redistributed wealth less aggressively compared to an inflation targeting regime.

However, as Nessén and Vestin (2005) show, average inflation targeting is not identical to price-level targeting. They formulate the conditions under which average inflation targeting outperforms both conventional inflation targeting and price level targeting (namely, when price setters are sufficiently ‘backward-looking’). Federal Reserve Bank of New York President John Williams (2021) defended average inflation targeting in a recent speech. A natural alternative is a hybrid model that allows for a combination of average inflation targeting and price level targeting (Batini and Yates 2003, Ceccetti and Kim 2005).  

Closely related is a policy of nominal GDP targeting. This policy aims to stabilise the path of nominal GDP leading to a countercyclical inflation target that allows inflation to be higher when GDP growth is slower. This policy too implies a form of catch-up inflation because it allows inflation to exceed and fall below its average rate at different points of the business cycle. Fackler and McMillin (2019) prefer nominal GDP targeting to both inflation and price-level targeting because the latter can be counterproductive in the face of supply shocks. In the case of a negative supply shock, an inflation-targeting central bank is forced to slow an already decelerating economy, because inflation exceeds its target. In contrast, nominal GDP targeting allows the central bank to let inflation increase because real GDP is declining. Sheedy (2014) highlights a further advantage of nominal GDP targeting: it redistributes wealth from creditors to debtors in recessions, a desirable risk-sharing feature when contracts are incomplete and nominal. A main critique of NGDP targeting is practical: data on inflation and public expectations thereof are more readily available in real time that data on nominal GDP and GDP faces frequent revisions. (See Beckworth 2019 for an extended discussion of nominal GDP targeting and Honkapohja and Mitra 2013 for its robustness properties. Hughes Hallet 2015 investigates the applicability of nominal GDP targeting for the ECB.)

The September 2021 CfM-CEPR survey asks about the desirability of catch-up inflation and the best ways to implement such a policy. The first question asks whether the ECB should follow the Fed’s example and allow for catch-up inflation. The question is framed in terms of catch-up inflation for periods of below average inflation, but should be understood as also applying to lower-than-average inflation following periods of excess inflation.

Question 1: To what extent do you agree with the following statement: “The European Central Bank should systematically allow for inflation to exceed its target to compensate for periods of below target inflation.” 


Thirty-seven panel members answered this question. Fifty-nine per cent either agreed or strongly agreed with the statement displayed above. Jumana Salaheen (CRU Group), considers previous and current policies insufficient for the ECB to achieve its goals: “The ECB move to a symmetric inflation target [was] underwhelming. Since the ECB was founded in 1998, annual HICP inflation has averaged 1.6%... Moving to a 2% symmetric target does not feel like a big enough change to shift inflation expectations, which is ultimately what the ECB is trying to do. Introducing an average inflation target would be a bit more ambitious and would signal the desire for meaningful change.” In a similar vein, John Van Reenen (London School of Economics) argues that the “ECB has clearly undershot its target for too long causing a deflationary bias in Europe and generating too low a growth rate.” Patrick Minford, who supports a policy of NGDP targeting in response to the second question below, views average inflation targeting as a close substitute: “Average 'catch-up' inflation targeting, together with an output gap response in practice gets close to Nominal GDP targeting. So I think moving towards this will be beneficial.”

Thirty-five per cent either disagreed or strongly disagreed with the question’s statement. Volker Wieland (Goethe University Frankfurt) states that “make-up strategies including price-level targeting perform well in model-based evaluations under rational expectations and full credibility. The ECB has leeway to allow over- and undershoots of inflation. To promise credibly to provide a make-up for past inflation below target is difficult, however, and subject to lack of credibility and uncertainty. Furthermore, a symmetric price level targeting that makes up for past overshoots as well as undershoots of inflation is quite a challenge to deliver. It would make it necessary to purposely tighten policy to keep inflation below the target rate of 2% to reach the price level target path consistent with a 2% trend. A purely asymmetric policy catch-up policy could overdo it and induce an upward bias.” Costas Milas (University of Liverpool) highlighted that lacking a clear definition of average inflation targeting, this policy would risk unanchoring of inflation expectations. Likewise, Robert Kollmann (Université Libre de Bruxelles) believes that “the proposed ‘catch-up’ rule for inflation is too fuzzy, as the rule does not stipulate how long and by how much inflation would be allowed to exceed its target, after a period of low inflation. This lack of clarity would (further) undermine the credibility of the ECB. The ECB needs simple, transparent and credible rules! The ECB is rightly concerned about the persistent decline in the equilibrium interest rate and the resulting increase in the risk of hitting the interest rate effective lower bound. This concern calls for a permanent increase in the target inflation rate to, say, 2.5% or 3%.”  

Fabrizio Coricelli (University of Siena and Paris School of Economics) warns against applying crisis-time targets to regular times. He argues that “prolonged periods of below-target inflation, as observed after the Global financial crisis, may reveal an instrument problem rather than a target problem. The question is why central banks were unable to boost inflation through massive increase in money supply? In such circumstances, announcing that inflation would be allowed to overshoot the target is unlikely to have effects on inflation expectations.” David Miles (Imperial College London) supports Coricelli’s claim, writing that “any monetary policy committee would be right to be very wary of actively wanting inflation to be 4% for two years after it had been close to 0 percent for two years.” Panicos Demetriades (University of Leicester) points towards potential political repercussions of the idea, which, in his view, fails to account for them: “Whatever the economic merits of this idea, they are detached from political realities, writes Demetriades. Average inflation targeting is likely to be perceived as abandonment of price stability by the ECB. The ECB has already been under fierce political attack in Germany for its accommodative monetary policy.”

The second question asks for the type of policy that should be adopted. 

Question 2: Which of the following policies is the most desirable to meet the ECBs objective to achieve its mandate of ‘price stability’ as you understand this term.



Thirty-seven panel members answered this question. Forty per cent support the status quo of inflation targeting, while the remaining 60% support alternatives, which include average inflation targeting, nominal GDP targeting, and hybrid policies. Jorge Braga de Macedo (Nova School of Business and Economics, Lisbon), argues in favour of Average Inflation Targeting, saying that given the status quo, this policy is “the least complicated to adjust to”, although “other policies targeting the ‘price level’ or ‘nominal GDP’ or a ‘hybrid’ [policy] may be more appealing in theory.” In contrast, Patrick Minford (Cardiff Business School) supports NGDP targeting, underlining that it “creates a powerful stabilising influence from monetary policy. I found this gave the highest welfare under conditions of fixed price stickiness, based on simulations on US data [in my 2016 paper].” Finally, some respondents argued in favour of hybrid policies. Simon Wren-Lewis (University of Oxford) writes that “because of the interest rate lower bound, there are good reasons to aim for a price level catch up policy after recessions. There is nothing equivalent after booms, when you want bygones to bygones. So an asymmetric policy makes sense, where a price level catch up is used after lower bound recessions, but otherwise we have inflation targeting.” 

Forty per cent expressed support towards the status quo, arguing for continued inflation targeting. Jagjit Chadha (National Institute of Economic and Social Research) writes that “a clear point target of 2% or perhaps 2.5% seems pretty much consistent with price stability. We can adopt a margin of error or range and ask the ECB's President to explain deviations of more than 1% on either side and outline the reason for the miss and when we will return back to target range.” Others argue that alternatives are either infeasible or too unclear. Costas Milas states that “any other policy [that inflation targeting] is arguably (much) more difficult to understand, let alone explain to market participants and the public.” Similarly, Volker Wieland writes that “while symmetric price level targeting is better based on model evaluations, I am still sceptical it can be implemented effectively.” He supports traditional inflation targeting and suggests that “a good way to implement a make-up strategy is to use a Taylor rule with make-up factor in communication.” 

References and further reading

Ball, L, N G Mankiw and R and Reis (2005), “Monetary policy for inattentive economies”, Journal of Monetary Economics 52: 703– 725.

Batini, N and T Yates (2003), “Hybrid inflation and price-level targeting”, Journal of Money, Credit and Banking 35: 283– 300.

Bletzinger, T and V Wieland (2017), “Lower for longer: The Case of the ECB”, Economic Letters, 159. 

Cecchetti, S G and J Kim (2005), “Inflation targeting, price-path targeting, and output variability”, in B S Bernanke and M Woodford (eds), The Inflation-targeting Debate, University of Chicago Press.

Coenen, G and V W Wieland (2004), “Exchange-Rate Policy and the Zero Bound on Nominal Interest Rates”, American Economic Review 94(2): 80-84.

Fackler, J and W D McMillin (2019), “An Evaluation of Nominal GDP versus Price-Level Targeting”, Policy Brief, Mercatus Centre, George Mason University.

Gaspar, V, F, Smets and D Vestin (2007), “Is time ripe for price level path stability?”, European Central Bank Working Paper No. 818.

Haldane, A G and C K Salmon (1995), “Three issues on inflation targets: some United Kingdom evidence”, in A G Haldane (ed.), Targeting Inflation, Bank of England.

Harmann, P and F Smets, (2019), “The first twenty years of the European Central Bank: Monetary Policy,” ECB Working Paper No. 2219. 

Hatcher, M and P Minford (2014), “Inflation targeting vs price-level targeting: A new survey of theory and empirics”,, 1 May.

Honkapohja, S and K Mitra (2013), “Targeting Nominal GDP or Prices: Expectation Dynamics and the Interest Rate Lower Bound”, Federal Reserve Band of San Francisco, 22 April.

Hughes Hallet, A et al. (2015), “Is nominal GDP targeting a suitable tool for ECB monetary policy? Monetary Dialogue 23 September 2015”, European Parliament, 23 September.  

Kostanyan, A and D Laxton (2020), “Time to change the Bank of Canada’s mandate”, mimeo.

Masolo, R M and F Monti (2021), “Ambiguity, Monetary Policy and Trend Inflation”, Journal of the European Economic Assocciation 19(2).

Meh, C A, J-V Ríos-Rull Y Yaz Terajima (2010), “Aggregate and welfare effects of redistribution of wealth under inflation and price-level targeting”, Journal of Monetary Economics 57(6): 637-652.

Minford, P (2004), “Monetary policy – should it move onto a price level target?”, A.W. Phillips Memorial Lecture to the New Zealand Association of Economists, July.

Minford, P and D Peel (2003), “Optimal monetary policy: is price-level targeting the next step”, Scottish Journal of Political Economy 50: 650– 667.

Minford, P, E Nowell and B Webb (2003), “Nominal contracting and monetary targets – drifting into indexation”, Economic Journal 113: 65– 100.

Nessén, M and D Vestin (2005), “Average inflation targeting”, Journal of Money, Credit and Banking 37: 837– 863.

Reichlin, L, K Adam, W J McKibbin, M McMahon, R Reis, G Ricco and B Weder di Mauro (2021a), “The ECB strategy: The 2021 review and its future”,, 1 September.

Reichlin, L, K Adam, W J McKibbin, M McMahon, R Reis, G Ricco, and B Weder di Mauro (2021b), The ECB strategy: The 2021 review and its future, CEPR Press.

Sheedy, K D (2014), “Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting”, Brookings Working Paper.

Steinsson, J (2003), “Optimal monetary policy in an economy with inflation persistence”, Journal of Monetary Economics 50: 1425– 1456.

Svensson, L E O (1999), “Price-level targeting versus inflation targeting: a free lunch”, Journal of Money, Credit, and Banking 31: 277– 295.

Vestin, D (2006), “Price-level targeting versus inflation targeting”, Journal of Monetary Economics 53: 1361– 1376.

Williams, J C (2021), “The Theory of Average Inflation Targeting”, remarks at Bank of Israel/CEPR Conference on “Inflation: Dynamics, Expectations, and Targeting”, 12 July.



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