The ECB concluded its last monetary policy strategy review and adopted a new strategy in 2021, just before the unprecedented surge in inflation. Three years and three crises later, this column takes stock of how well the revised strategy functioned in a high-inflation environment. The redefined inflation target helped achieve the ECB goal to tame inflation over the medium term. Given the continuous evolution of the global environment, including geopolitics, the ECB should regularly review its monetary policy framework, supported by a thorough analysis of the forces that drive inflation dynamics over time.
The past few years have been challenging for economic policymakers. The ECB concluded its last monetary policy strategy review – and adopted a new strategy – in July 2021, just prior to the unprecedented surge in inflation (ECB 2021a).
At that time, we were still at the end of a long decade of exceptionally low inflation, and most of our work and analysis concentrated on improving our policymaking in those conditions of ‘lowflation’. Now, over three years and three crises later, it is time to take stock of how well the revised strategy has functioned in a high-inflation environment and consider how to further develop the strategy in the emerging new – or perhaps old – normal.
Revised strategy passed a tough test
The most important decision following the 2021 strategy review was to set a symmetric inflation target of 2% over the medium term. The symmetry means that both negative and positive deviations from the target are treated as equally undesirable. We – the ECB’s Governing Council – also underlined the medium-term orientation for reaching the target. These decisions about the inflation target were set out in the ECB’s monetary policy strategy statement (ECB 2021b).
Prior to the review, our price stability definition (“below, but close to, 2%”) was perceived as asymmetric, effectively setting a 2% ceiling for inflation. 1 This asymmetry very likely contributed to lowering inflation expectations and thereby inflation itself, with potentially adverse implications for growth and the conducting of monetary policy. Since then, the revised symmetric inflation target appears to have been effective in influencing long-term inflation expectations and helping anchor them solidly to the 2% inflation target.
When we published our revised symmetric target in July 2021, the operating environment for monetary policy was just starting to change dramatically. First, the COVID-19 pandemic and then Russia’s unjustified and brutal war in Ukraine caused supply shocks. These shocks pushed the euro area inflation rate (measured using the Harmonised Index of Consumer Prices, HICP) above 2.5% in autumn 2021 – the first time it reached that level in nine years – and then all the way up to 10.6% in October 2022. This can be seen in Figure 1, which illustrates three distinct periods of inflation experienced in the euro area since 1999.
Figure 1 Three periods of inflation in the euro area, 1999–2023
Source: Eurostat.
32426@HICP+averages2
Euro area inflation averaged 8.4% in 2022 and 5.5% in 2023. The ECB ended quantitative easing and increased its policy rates rapidly by a total of 450 basis points between July 2022 and September 2023, bringing the deposit facility rate to 4%. In line with our revised strategy, our goal was to tame inflation over the medium term by preventing high inflation from leading to elevated inflation expectations and potentially to a wage-price spiral. In my view, this goal has been, by and large, achieved.
Thanks to the normalisation of energy prices and the determined and very consistent monetary policy tightening, euro area HICP inflation has come down close to our target, and in October 2024, it was precisely at 2.0%. Even though service and wage inflation are still elevated, core inflation has declined, and inflation expectations have fallen and are re-anchored. Significant progress has been made in bringing inflation down to target, and inflation is projected to reach the target sustainably in 2025.
Against this backdrop, we reduced our policy rates for the first time in June 2024 and reduced them further in September and October, given that disinflation continues to be well on track.
The redefined inflation target has provided a clear anchor for inflation expectations and enough flexibility both in terms of the temporal definition and the instruments used. This has helped us bring inflation close to its target from very high levels without unduly restricting growth and employment. Thus, in my view, the inflation target itself does not need reconsideration. To put it another way, ‘don’t fix it if it ain’t broke’.
But we do need a better understanding of the inflation dynamics of the past few years and of the secular trends affecting monetary policy going forward. These trends include the central role of geopolitics, the transformation of the labour market, and other structural drivers of the natural rate of interest.
It is essential that we analyse the large and persistent supply shocks that the euro area encountered in the past few years and how well the monetary policy response has worked in the context of such shocks. But we must also have an open debate on the role of demand shocks, including monetary and fiscal policies. The jury is still out concerning the relative importance of their contribution to the period of high inflation.
The same goes for the period of low inflation before the pandemic and the exit from it. Did we come out of the liquidity trap as a result of our own policy actions, or was it due primarily to the pandemic-related supply shocks and the strong fiscal stimulus?
A further key question is whether we should react to supply shocks in a different way than in the past few years. To what extent can we, as a central bank, stabilise the economy if supply-side shocks are prevalent?
Geopolitics is shaping the operating environment – along with other secular trends
One thing that has fundamentally changed since our last strategy review is the geopolitical landscape. Russia’s illegal, brutal war in Ukraine and the war in the Middle East will continue to affect Europe’s economic policies and outlook in the years ahead.
The changes that are taking place in the world economy, from trade wars to supply chain diversions, are likely to increase inflation volatility. Moreover, they are already shaping the new equilibrium of the euro area economy that will emerge after the current interest rate cycle. This brings us to the question of the level of the long-term real natural rate of interest, r*, or the equilibrium interest rate. This has been much discussed among central bankers in various forums, such as at the Bank for International Settlements and the IMF.
There are arguments supporting the view that the natural rate is rising – as a result of the huge investment needs due to the green transition, artificial intelligence and defence spending – but there are also arguments for the view that it is declining – due to weak productivity growth combined with population ageing and geoeconomic fragmentation. The true trajectory of the natural rate is still unclear for now and requires considerable further research.
Going forward: Determinants of labour input and its productivity
In my view, one of the key analytical issues of the ECB’s next strategy review should be the transformation of the labour market, not least since it is closely linked to the marked slowdown in productivity growth.
In recent years, euro area employment growth has been robust, and the unemployment rate has been at a record low, currently 6.3%. However, the number of hours worked has increased at a significantly lower rate than the number of people in employment. This means that the euro area labour input – when measured as total hours worked – has not developed particularly favourably.
We need to gain a better understanding of how demographics will shape labour market trends in the future. We should, I believe, also analyse how, during the past few years, large and exceptional shocks originating from the labour market have shaped the short-term dynamics of wages and prices. In addition to the sharp decrease in average hours that has led to an increase in the demand for labour, immigration has increased the supply of labour and helped to constrain wage pressures in the euro area. Taking these shocks into account makes the developments in the labour market of the past few years look much less mysterious than is often claimed.
Overall, the strategy review needs to be supported by a thorough analysis of the forces that drive inflation dynamics over time. As policymakers, we need to base our decisions on both economic theory and empirical evidence, and remain open to fresh thinking.
As an example, let me mention two different interpretations of the impact of global megatrends on the natural interest rate and future inflation. Based on an empirical analysis employing historical data on Europe, Jordà et al. (2022) argue that pandemics, like COVID-19, have long-lasting negative effects on the natural rate, reflecting a lack of essential investment, an increased desire to save, or both.
On the other hand, Goodhart and Pradhan (2020) reach the opposite conclusion. They argue that global population ageing and worsening dependency ratios around the world, not least in China, will lead to increased inflation pressures through multiple channels. Such channels include labour shortages driving up the bargaining power of labour relative to capital, deflationary pressures being dampened by the growing share of the non-productive population, and increased healthcare expenditure needs (Goodhart and Pradhan 2020; see also Juselius and Takáts 2021).
My view, based on comparative historical analysis, is closer to that of Jordà et al. Nevertheless, I found Goodhart and Pradhan’s argumentation refreshing. Whether or not their predictions will hit the mark is another issue. But it is important that critical questions are raised and backed by analysis, and that we look afresh at widely held assumptions regarding future developments.
Indeed, the continuous evolution of our operating environment – not to mention potential reversals in some global megatrends – is a compelling reason for the ECB to regularly review its monetary policy framework. This enables us to recognise the impacts of key structural developments on the operating environment and allows us to regularly revisit our strategy as appropriate so that monetary policy can remain fit for purpose.
Disinflation and the still robust wage growth are supporting real disposable incomes and paving the way for a consumption-led recovery in the euro area. Our Achilles heel, though, is the low level of productive investment – which we badly need.
When it comes to productive investment, the distinction between structural and cyclical is never crystal clear, black and white. It is true that the current clouds of geopolitics and intra-European uncertainty are weighing on the European economy in the form of confidence-damaging effects. Nevertheless, if I may paraphrase a certain giant of economics, John Maynard Keynes: in the long run, we are all retired. But in the meantime, we need more productive investment.
In other words, even though the euro area’s longer-term growth and competitiveness challenges cannot be solved using monetary policy, an easing in financial conditions will bring welcome relief to households and companies in the short term, and should support investment, which in turn is needed to increase longer-term productivity.
Europe must therefore pursue stronger productivity growth, not least since its populations are ageing, the green transition requires massive investment, public debts and deficits are large, and defence spending needs to be substantially raised. This is essentially the message in the long-awaited report on EU competitiveness by the former ECB president, Mario Draghi, which was published in September 2024. The Draghi Report is a wake-up call to all Europeans and a clear-eyed and honest, even brutal, diagnosis of the reasons behind Europe’s weak growth and weak competitiveness.
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Uncertainties and exceptional price dynamics have challenged our policymaking in the past few years. The silver lining is that we have gained a lot of understanding about the appropriate policy responses in these circumstances. This understanding should be pooled and deepened in the upcoming ECB strategy review.
For me, the experiences of recent years have, above all, highlighted the crucial role of inflation expectations in the making of monetary policy. Likewise, they have underscored the importance of a firm commitment to a medium-term inflation target in line with our strategy.
Going forward, the monetary policy strategy should be designed in a way that is robust in the face of uncertainty about the future state of the world. It should be flexible enough to work well in different environments and react to new and unknown shocks. Thus, while we have made major advances in the science of economics relevant to monetary policy, there is still room for judgement – that is, for the art of monetary policy.
Source : VOXeu
