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. Monetary policy deliberations are based on an integrated analytical framework which comprises two analyses: economic analysis and monetary and financial 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 publishes 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 increase of 2 p.c. in the harmonised index of consumer prices (HICP) for the euro area in the medium term. That new definition was introduced only recently when the Eurosystem completed the appraisal of its monetary policy strategy at the beginning of July 2021. While the price stability objective was until recently defined as “an annual increase in the HICP below but close to 2% in the medium term”, the current definition is deliberately symmetrical: negative and positive deviations from that objective are both considered equally undesirable. 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.
An integrated analytical framework
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, making use of an integrated analytical framework comprising different analyses: economic analysis and monetary and financial analysis.
- 1. The economic analysis concerns real and nominal economic developments. It centres on analysis of short-term variations in economic growth, employment and inflation, assessment of the factors behind the shocks affecting the euro area’s economy, the projections produced by the Eurosystem and the ECB staff for the main medium-term macroeconomic variables, and an overall assessment of the risks to economic growth and price stability. The emphasis is on regular analysis of structural trends and their implications for inflation, potential output and the real equilibrium interest rate, the role and importance of heterogeneities and non-linearities, and the use of new available granular data, including surveys of expectations such as the new consumer expectations survey.
- 2. The focus of the monetary and financial analysis has changed considerably since the 2003 assessment, in response to the challenges arising during and after the global financial crisis. The monetary and financial analysis accords a key role to examining the monetary and financial indicators, with the emphasis on the functioning of the monetary policy transmission mechanism, particularly via credit, bank lending, risk taking and asset prices. These assessments facilitate the identification of any changes in transmission (linked, for example to structural factors such as an increase in non-bank financial intermediation) or barriers to transmission due, for example to market fragmentation or tensions. The monetary and financial analysis also permits a more systematic assessment of the long-term accumulation of vulnerabilities and financial imbalances and their potential implications for the residual risks to activity and inflation. In addition, it assesses the extent to which the macroprudential measures attenuate any risks to financial stability which are relevant from the point of view of monetary policy. The monetary and financial analysis thus recognises that financial stability is a pre-condition for price stability. The integrated analytical framework aims to take account of the information derived from monetary and credit aggregates as well. Inclusion of that information and the other variables used to evaluate the functioning of the monetary and financial transmission reflects the relevance of those indicators for assessing the accumulation of vulnerabilities and risks to price stability. In addition, a detailed assessment of the interaction between monetary policy and financial stability is scheduled to take place at regular intervals as part of the monetary and financial analysis, and will be examined at the Governing Council’s monetary policy meetings on the basis of the Financial Stability Review and other relevant documents.
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, economic and social cohesion, and improvements to environmental quality. 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.