The ECB’s new monetary policy strategy – a small important step in the right direction

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In July of this year, the European Central Bank published the results of its monetary policy strategy review. Since the previous strategy dated back to 2003, an adjustment was imperative. The new monetary policy strategy takes into account developments since the financial crisis and incorporates many of the monetary policy innovations that the ECB had already introduced in practice in response to the various monetary policy challenges since 2007.  A large part of the innovations were expected and also led to few reactions in the financial markets. The two most important modifications probably concern the inflation target and the thematization of the influence of climate change on monetary policy.

The previous target of an inflation rate “close to, but below, 2 percent” was adjusted to a symmetric 2 percent target in the medium term. Short-term deviations to the downside or upside are accepted, provided they are classified as temporary. This clearly states that under- and overshooting are equally undesirable. This is important, for example, in the current phase of economic recovery and temporary inflationary pressure; the modified strategy ensures that the ECB does not have to put the brakes on monetary policy prematurely. This is probably a way to avoid past mistakes. For example, after the financial and economic crisis subsided, the ECB probably began to make monetary policy less expansionary too early, thus putting the brakes on the economic recovery.

The ECB’s modified monetary policy strategy is moving in a similar direction to the strategy of the U.S. Federal Reserve, which was adjusted in August 2020. The latter is now pursuing an average inflation target of two percent, with a temporary undershooting of the inflation target to be compensated for by a moderate overshooting thereafter.  The ECB chose a less clear-cut approach by merely stating that the inflation target should be achieved in the medium term. The ECB thus remains somewhat more flexible than the U.S. Federal Reserve in the way it deals with temporary deviations from the inflation target. As with the Fed, however, the ECB is also unclear about the width of the tolerance band around the two percent target. However, the new ECB strategy avoids one source of uncertainty. For example, in the Fed’s new monetary policy strategy, it is not clear to which period, for example, past undershooting refers and how aggressively it should be compensated thereafter to achieve the average inflation target.

A second important element of the ECB’s adjusted monetary policy strategy is the explicit mention of climate change and its importance for monetary policy. In its new strategy, the ECB acknowledges that climate change and the transition to a more sustainable economy may affect inflation, economic growth, or the transmission of monetary policy. In any case, climate change or, for example, the design of a CO2 emissions trading scheme directly affects the risk profile of assets on the Eurosystem’s balance sheet.

The ECB has announced that it will review its monetary policy strategy more frequently in the future. This will provide the opportunity to correct possible weaknesses in the new strategy at an early stage and to react to new developments. 

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