The strategy review recently published by the ECB (ECB 2021) serves partly to systematise changes in policy that had already been adopted over the last few years, but it also announces the ECB’s intention to take on new challenges, such as incorporating climate factors in its monetary policy assessments or adapting the operational framework to take into account their impact on financial risks and price stability. On some issues – such as the future of the operational framework and fiscal-monetary interactions – there are no concrete proposals, although perhaps they will be discussed in the background analytical material that will be published in due course.
Some of these issues will – no doubt – be tackled in future reviews. Monetary policy strategies must evolve as economic circumstances do and, in the case of the euro area, when there are changes in its governance. Indeed, the ECB has announced that strategy reviews will be conducted on a regular basis. Rather than commenting on all aspects of the strategy review, in a new CEPR report we provide a framework for discussing both the changes to strategy proposed in the current review and the future evolution of the strategy (Reichlin et al. 2021).
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Starting with the part of the review which will have the most immediate effect on policy and which de facto explains what has already changed, we welcome the ECB’s new price stability target: a precise numerical value for the objective, to be applied symmetrically and with a medium-term orientation. These are characteristics that are widely supported by research as essential conditions for anchoring inflation expectations. The ECB has also clarified its intention to discount the more volatile components of headline inflation – such as energy prices – when taking monetary policy decisions. This avoids a repetition of past mistakes, when tightening decisions were unduly influenced by temporary spikes in energy prices.
The ECB’s clarification of the concept of forward guidance suggests the intention to stabilise inflation on average over the projection period (a sort of average inflation targeting with a forward window). Unlike the Federal Reserve, the ECB will not aim to compensate for under-shooting the target by over-shooting (a ‘make-up’ strategy), but will retain flexibility to deviate from the target nonetheless. For both central banks, the understanding and implementation of inflation has evolved to cope with the problem of anchoring inflation expectations when real interest rates are low and the zero lower bound may constrain monetary policy.
To understand the context of this discussion, Figures 1 and 2 illustrate the persistent decline of headline inflation since the financial crisis, the persistent decline of core inflation since the euro area debt crisis and the gap – since then – between the actual HICP index and the index that would have prevailed if inflation had been at the 1.9% (below but close to 2% as in the old strategy) since 2008.
Figure 1 HICP and core inflation rates in the euro area
Note: Shaded areas correspond to recessions as dated by the CEPR.
Source: Eurostat and authors’ calculations.
Figure 2 HICP price level in the euro area and the expected price level if an annual inflation rate of 1.9% had been achieved in the euro area since 2008
Note: Shaded areas correspond to recessions as dated by the CEPR.
Source: Eurostat and authors’ calculations.
The ECB’s new formulation of the price stability target is more transparent than the one at the Fed. Yet, in our report we argue that ‘make-up’ strategies have the potential to offer a clearer framework when dealing with trade-offs between primary and secondary objectives of monetary policy. By adjusting the length of the average inflation targeting window, make-up strategies – which include average inflation targeting, price-level targeting and nominal GDP targeting – provide a means to achieve the primary objective of price stability while pursuing secondary objectives such as financial and climate risk mitigation. This is particularly important if the monetary policy instruments have undesirable consequences. The ECB – as other central banks – has not attempted to provide a framework for defining the quantitative target in relation to changes in the structure of the economy. There is no reason why it should be 2% under all circumstances. In the report, we discuss this topic and offer suggestions for how to handle communication issues in case of future changes in the numerical target. In the years to come, central banks will have a lot to learn from the implementation of these new ideas. There is ample room for discretion in both the ECB’s target framework and that of the Fed, so the actual differences will have to be judged ex post.
Moving on to the operational framework, we anticipate that this strategy review will not be the end of the discussion. Our report highlights the need to build a shared understanding of the various new instruments that have been developed over the years (with some abuse of language, we can call them ‘balance sheet policies’). To confront the challenges of declining equilibrium real rates, occasional liquidity crises, and the financial market disruptions caused by recurrent flights to safety, the ECB has expanded its set of instruments. The practice of monetary policy is no longer just the steering of short-term interest rates. After more than ten years of experience characterised by multiple crises, the new tools in the toolbox should now be considered ‘normal’ and communicated as such.
For this reason, the ECB could have gone beyond simply stating that the short-term interest rate remains the principal instrument while the others are staying in the toolbox for the moment. We discuss conditions under which the new tools are effective and we recommend summarising the monetary policy stance in terms of prices rather than quantities, and describe the intended policy impulse as the expected price effects onto the risk-free yield curve at all maturities.
Beyond that, we discuss the rationale for operations aimed at compressing risk premia in the credit and sovereign markets. For the latter, we argue that there are circumstances in which this is justified by the monetary policy objective when markets are segmented. But without a safe asset and a euro yield curve, targeting sovereign risk premia will always remain controversial since it has fiscal implications. This is discussed in a dedicated chapter.
Non-experts are often confused about the role of central banks’ balance sheets and whether their size matters for price stability. For an institution whose intellectual background is rooted in monetarism, it is appropriate that the review should contain a discussion on the size of the balance sheet. Our report stresses that, as long as the central bank satiates the demand for liquidity, there is no necessary relationship between the size of the balance sheet and the rate of inflation. The Friedman rule states that it is optimal to provide liquidity at satiation, as the ECB has done since the financial crisis: the balance sheet should at least be as large as necessary to satisfy the demand for liquidity. Beyond that, it may increase in order to implement credit policies (credit easing). Since the central bank is free to set the interest rate on reserves, it can respond to changing demand for liquidity at any given level of interest rates.
However, a large balance sheet and the policies associated with it imply that monetary policy has a much larger fiscal footprint than it had pre-2007. This has distributional consequences at the geographical level as well as potential risks which have to be managed. We argue that this calls for clarity on the rules for capitalisation of the national central banks and for risk management. The markets’ anticipation of potential losses and/or uncertainty about the implications of one national central bank finding itself with negative capital could harm the credibility of ECB monetary policy and lead to instability.
Our report discusses options for the rules on recapitalisation of national central banks. We consider that ‘constructive ambiguity’ over capitalisation and risk sharing was perhaps possible in a world of strict separation between monetary and fiscal policy. But this is not the world we live in today. In order to defend the ECB’s independence, this topic must be part of the conversation. Addressing it is important to preserve that credibility and trust in the system which is a condition for achieving macroeconomic stability. The ECB has not made any statement about this problem. We understand that this is beyond the scope of the strategy review because it involves a broader discussion on economic governance, but the ECB’s input in this debate would be desirable. As independent academics, we need to flag it as an important topic to tackle in the future.
On the other hand, the ECB’s strategy review does not shy away from talking about fiscal-monetary interactions. The review stresses that fiscal policy has an important role to play at the zero lower bound. This is consistent with ECB policy speeches in the last few years.
Any improvement in fiscal-monetary policy coordination in the monetary union will require some change in the governance structure; this agenda is clearly the responsibility of the national governments, not of the central bank itself. The ECB, however, has considerable experience and analytical expertise in these matters. This raises the question of whether institutional changes are needed to enable some fiscal-monetary policy coordination, without jeopardising the ECB’s independence and the concept of monetary dominance. We make the case for the establishment of a board, including representatives of both monetary and fiscal authorities, following the model of the European Systemic Risk Board. Its goal would be the analysis and oversight of fiscal-monetary policy interactions with a Union-wide perspective. It would provide a forum for discussion and would be charged with issuing occasional warnings to support the independent policy decisions of the ECB and the fiscal authorities.
The ECB will have to address new challenges in the future, and climate risk is probably the most pressing one. We welcome the emphasis that the ECB has given to this topic and provide an input to the development of analytical tools at the ECB to understand interactions between climate mitigation policies and inflation. We make the point that mitigation policies will involve trade-offs that will make the issue of developing a framework to link primary and secondary objectives more pressing. We also welcome the ECB’s commitment to a detailed two- to three-year roadmap on climate-related actions for monetary operations. We agree with the ECB that taking climate risk into account in monetary operations is mostly a question of good design and requires further work on disclosure, risk assessment, and standards.
ECB (2021), “The ECB’s monetary policy strategy statement”, 8 July.
Reichlin, L, K Adam, W J McKibbin, M McMahon, R Reis, G Ricco, and B Weder di Mauro (2021), The ECB strategy: The 2021 review and its future, CEPR Press.