Monetary policy strategy
The Maastricht Treaty stipulates that the primary objective of the monetary policy conducted by the ECB Governing Council is maintaining price stability. The Governing Council has defined a strategy which comprises a quantified definition of price stability and two pillars: an economic analysis and a monetary analysis.
The primary objective of monetary policy
The Maastricht Treaty confers on the Eurosystem the responsibility of maintaining price stability in the euro area. Indeed, the signatory Member States are convinced that a monetary policy which safeguards the internal value of the currency is the best way of encouraging an improvement in the economic prospects and a rise in the standard of living. In the past, deflation and inflation have proved to be damaging: they destroy the information contained within the price system, have an unseen effect on the value of contracts and savings, generate increased uncertainty and therefore hamper the efficient allocation of resources, investment and growth.
The definition of price stability
The ECB Governing Council has published a quantitative definition of price stability in order to provide a stable point of reference for price expectations and to make it easier for the public to assess its actions. Price stability is defined as an annual increase of less than 2 p.c. in the harmonised index of consumer prices (HICP) for the euro area. It has to be maintained in the medium term. The Governing Council made it clear that it would maintain that increase close to 2 p.c.
A gradual increase in the consumer price index is regarded as an indication that prices are stable overall, since the index is influenced by "measurement errors" due mainly to changes in spending patterns and the improvement in the quality of goods and services. The objective of an increase in the HICP offers a margin to allow for deflation risks.
The Eurosystem cannot be held responsible for short-term shocks, such as a price increase resulting from a rise in commodity prices on the international market, but it can be held to account for the trend in prices. Since its policy is geared to the medium term, it can also react gradually and cautiously to certain unexpected forms of economic disruption.
The two pillars of the strategy
The Eurosystem does not have direct control over prices, which are influenced only after a long process via the operation of the monetary policy instruments. That is why the Eurosystem should not respond to observed changes in the consumer price index but should anticipate predictable developments which may threaten price stability in the future. Such action is based on a detailed analysis of all available information in the form of two "pillars": economic analysis and monetary analysis.
- 1. The purpose of the economic analysis is to identify the risks for price stability in the short and medium term. It is based on the assessment of a large number of variables: price index figures, cost index figures (including labour costs), exchange rates, cyclical indicators, data on fiscal policy, indicators relating to the financial markets (such as long-term interest rates), etc. The ECB Governing Council also takes account of the macroeconomic forecasts published at regular intervals by the Eurosystem.
- 2. The monetary analysis makes it possible for the short-term indicators obtained on the basis of the economic analysis to be tested for the medium and long term. The monetary analysis takes account of indicators such as the broad monetary aggregate M3, its constituents - from the most liquid ones, such as M1 (notes and coins, sight deposits and electronic purses) to less liquid types such as savings deposits and term deposits and instruments that are negotiable in the short term - and its counterparts such as loans to enterprises and private persons.
The other objectives of monetary policy
The Maastricht Treaty stipulates that, without prejudice to the objective of price stability, the Eurosystem shall support the general economic policies in the Union with a view to contributing to the achievement of objectives such as growth, employment, and economic and social cohesion. The restriction expressed in the words “without prejudice to" unambiguously states the primary objective set for the Eurosystem. Creating a stable environment is the best way to promote growth and employment, although those aims also require other economic policy measures.
Moreover, it often happens that intervention necessary for preserving price stability is also beneficial for other objectives, such as the stabilisation of economic activity and the financial sector. Thus, the risks for price stability are often associated with cyclical fluctuations: if those risks are tending to diminish, in view of a decline in activity, the Eurosystem will cut interest rates, and that will bolster demand.
The treaty also stipulates that the exchange rate policy must not endanger price stability. There is now no official agreement governing exchange rates between the euro and currencies outside the Union. Furthermore, since the euro area constitutes a sizeable economy in which foreign trade accounts for only around 15 p.c. of the total demand for goods and services, the euro exchange rate does not perform a prominent role in the monetary policy strategy of the Eurosystem, but comes under the second “pillar” of that strategy. The repercussions of exchange rate fluctuations on internal prices are, however, taken into account in the economic analysis.