The ECB strategy review

Article #34 by Christopher Mallia - Published Monthly

On 23 January 2020, the European Central Bank (ECB) formally launched a wide-ranging review of its monetary policy strategy for the first time since the last review was undertaken back in 2003. The strategy review, which is expected to be completed by the end of this year, will evaluate everything that forms part of the Bank’s comprehensive framework used in achieving its mandate of price stability. This follows a similar decision, back in November 2018, by the US Federal Reserve to conduct a review of its own monetary policy strategy which it is expected to be completed by the end of the first half of 2020.

So how does the ECB conduct monetary policy under its current strategy? Firstly, the ECB had adopted a quantitative definition of price stability – inflation rates below, but close to, 2 percent over the medium term. The quantification of the price stability target serves three purposes: (i) it makes the monetary policy decision process more transparent; (ii) the ECB can be more easily held accountable and (iii) it offers guidance to the general public. Furthermore, the medium-term timeframe is also an important consideration as it is impossible for any central bank to keep inflation always at a specific point or bring it back to a desired level within a very short period of time. Therefore, it gives the ECB the flexibility required to respond in an appropriate manner.

The other aspect of the ECB’s current strategy is the two-pillar approach used to analyse economic developments. The first pillar is the economic analysis whereby the ECB “assesses the short-to-medium-term determinants of price developments” such as gross domestic product and labour market conditions. Moreover, based on the data available and developments across eurozone nations, the ECB also prepares economic projections which also form an integral part of any monetary policy decision. The second pillar is the monetary analysis comprising “a detailed analysis of monetary and credit developments with a view to assessing their implications for future inflation and economic growth”. The ECB website explains that such a two-pillar system also provides a cross-check mechanism of its analyses.

Besides the importance of periodically reviewing any strategy by any institution, the ECB, under the leadership of the recently appointed President Ms Christine Lagarde, felt it necessary to undertake this review for a number of reasons. Firstly, since the 2003 strategic review, both the euro area and the global economy have undergone profound structural changes including the 2008/09 financial crisis, changing demographics, various geopolitical developments and the increasing protectionist measures in global trade that were mostly evident over the past two years. Furthermore, monetary policy responses in recent years have driven interest rates into unprecedented low and negative levels. This could hinder the effectiveness of monetary policy going forward and could give rise to harmful side-effects such as elevated debt levels particularly across corporates, higher risk taking in search of a higher yield, excessive mispricing particularly in bond markets and the real-estate sector as well as creating income inequality.

Moreover, at the time of the 2003 review, the ECB challenge was to counter rising levels of inflation whereas nowadays the main task of the ECB is to address low inflation. Also, the ECB needs to assess how other issues such as environmental sustainability, rapid digitalisation, further globalisation and evolving financial structures should be considered and tackled, if at all, in its monetary policy decisions.

Furthermore, as indicated in the press release issued by the ECB on 23 January 2020 and subsequently emphasised by the ECB President Ms Christine Lagarde on more than one occasion, the ECB will also review the way it communicates with the public at large in order to enable the general public to better understand the workings of the ECB as good communication enhances the ECB’s credibility and will likely make the ECB’s monetary policy actions more effective.

Therefore, the strategy review will be very wide ranging as it will evaluate existing tools and procedures, the effectiveness of past monetary policy decisions and also consider alternative methods that best suit the eurozone economy going forward. In this respect, the ECB President Ms Christine Lagarde noted in her statement to the Committee on Economic and Monetary Affairs of the European Parliament on 6 February 2020 the strategy review “…will be a thorough and intense process.” Moreover, the whole process is being undertaken with an open mind as the ECB engages with all stakeholders.

Naturally, this exercise has spurred a lot of opinions on what the best course of action for the ECB should be and has also generated speculation on the ultimate outcome. One of the main considerations is whether the ECB should change its quantitative definition of price stability. This topic is creating huge debate as the ECB is the only central bank amongst developed countries that adopted an asymmetric target of inflation – “below, but close to”. Given the state of the eurozone economy in recent years, various analysts are also questioning whether the quantum (2 percent) is still appropriate.

Moreover, unlike the Bank of England or the Bank of Japan, the ECB has the added task of transmitting its monetary policy into 19 countries which tend to be have different economic situations and hence the economic data for the whole of the eurozone, including the inflation reading, might not reflect the reality in each and every country.

The ECB has not yet issued any further press releases regarding the strategy review as it undertakes this exercise. Ms Lagarde has also been very careful not to publicly air her own views in this regard in order not to influence the review process and also not hinder any future consensus building efforts which she will likely need to undertake to reach an agreement on the new way forward.

In the meantime, the ECB will continue to operate within the current framework that will determine the monetary policy decisions throughout 2020. Ms Lagarde, on various occasions including during the traditional press conference following the ECB Governing Council meeting held on 23 January 2020, clearly stated that during 2020, the ECB will not be standing idle. In fact, Ms Lagarde emphasised that the ECB Governing Council will continue to assess incoming data as described above and policy changes will be made throughout this year if deemed necessary.

Moreover, although Ms Lagarde acknowledged the importance of such a review, she reiterated that to achieve the best outcome for European citizens, monetary policy decisions should be supported by fiscal measures and hence called on European governments to do their own part.

This article simply gives an overview of what the ECB has an embarked upon. Nonetheless, this is a huge task for the ECB as not only the exercise is daunting in itself but the newly adopted framework will be the basis of future monetary policy decisions that will significantly influence economic developments across the eurozone going forward.

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