Gabriel Makhlouf: European Central Bank's New Strategy
Blog by Mr Gabriel Makhlouf, Governor of the Central Bank of Ireland, 16 July 2021.
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Last week, my colleagues and I on the European Central Banks's (ECB) Governing Council
completed a review of our monetary policy strategy , the first since 2003. We wanted to make
sure our strategy is fit for purpose in a world that has changed significantly since the
presmartphone era. Our decisions will influence the price of goods and services and ensure more
stable economic conditions for businesses and households.
The ECB and the nineteen national central banks represented at the Governing Council are part
of the Eurosystem. Our job is to maintain price stability, ensuring that price changes within the
broader economy don't move either too high or too low. If prices increase (inflation) too quickly, it
is harder for businesses and consumers to plan. And while a decline in prices (deflation) might
seem attractive, it can have very serious implications for the economy (and ultimately the wider
community): consumers postpone their purchases (in the hope that prices will fall further),
businesses lose revenue, postpone investment and delay recruitment.
Stable prices matter. Positive, low and predictable inflation helps households and businesses
plan their spending and investment, helps the economy grow and creates employment. We want
prices that grow at a stable and sufficiently positive rate to ensure the economy does not slip into
deflation and to enable businesses to adjust to economic shocks without cutting jobs or wages.
For my part, there are five outcomes from the review that are worth emphasising.
First, we decided to target inflation at 2 per cent over the medium-term (similar to central banks
in other advanced economies). Our analysis shows that a 2 per cent target helps to stabilise the
average level of inflation at this level over the long run; inflation is less volatile and so more
predictable for businesses and consumers alike. Targeting inflation at 2 per cent also provides
an important buffer against the threat of deflation and allows for the smoother adjustment of
economic imbalances that may arise across euro area countries (and avoids individual countries
experiencing persistently negative price growth). In addition, as nominal wages in the euro area
tend not to adjust downwards, a 2 per cent inflation target allows for real wage adjustments and
avoids severe increases in unemployment during economic downturns. At the same time, a 2
per cent target seeks to mitigate the welfare costs of higher inflation, which become increasingly
more costly as the level of the inflation target rises. This new objective provides a clear target,
replacing what had become an ambiguous and unclear objective (which defined price stability as
an annual increase in prices of below 2 percent and specified an inflation aim of "below, but close
to, 2 per cent").
We have also made clear that the 2 per cent target is symmetric: it is equally undesirable to have
inflation that is too high above or too far below 2 per cent (recognising that economies are
changing constantly and that inflation will not be 2 per cent precisely all of the time).
The main reason for these changes is that, compared to when the last strategy was agreed in
2003, disinflationary pressures have become more acute. The need for a clearer target had
become self-evident and a perception that the "close to but below" objective was asymmetric
may have contributed to the decline in inflation expectations and the persistence of low inflation
over the last decade. In such a disinflationary environment, we want to make clear that we will
take forceful action to respond to inflation below our target (as well as, of course, inflation that
was above the target). We will tolerate small deviations in either direction over short, transitory,
periods to ensure the smooth functioning of the economy. (Unlike the US Federal Reserve, we
decided against adopting "average inflation targeting". Although we are both central banks, our
mandates are different and, overall, we decided that our new target was simple, clear and easy
to communicate, and more appropriate for the ECB.)
Second, we decided that we will take account of the cost of owner-occupied housing when
assessing price pressures. This would better reflect people's experience of inflation (as we
heard when we consulted the public last year). We also laid out a roadmap for how to include
these costs in our target measure of inflation. Ultimately, this is a decision for the European
Statistical System but, in the meantime, we will use standalone data on housing costs to inform
our monetary policy assessments.
Third, climate change has been a key issue in our review. While governments have the primary
responsibility to act and mitigate the effects of climate change (after, of course, the actions of
individual households and businesses), central banks can also play an important role. Last week
we committed to an action plan that further incorporates climate change considerations into our
policy framework, recognising that the transition to net zero emissions has significant
implications for the economy and for price stability.
Fourth, we decided to make a step change in our communications, in particular with the public.
It's important that the citizens of the euro area understand our decisions and better, more
targeted, communications - including regular outreach events - will help us do that.
Finally, we also decided to commit to periodic reviews of our monetary policy strategy and to
conduct the next one in 2025. We don't want to wait for another 18 years!
The changes I have outlined - including our inflation target, the measure we use, and the
transition to net zero - will guide us over the coming years, and ultimately help maintain price
stability across the euro area.
So will the new strategy lead to immediate change in the daily lives of businesses and
consumers? No. In the very short run, people may not notice a change. But the new strategy will
improve our ability to respond to economic shocks that threaten price stability and the economy.
Our policy decisions will now be taken in line with our new strategy, but they will also continue to
depend on economic activity, and, in the near-term, the lifting of the health restrictions introduced
to manage the pandemic and the
pace at which the government decides to withdraw the significant supports it has put in place.
Across the euro area, the economy is gradually reopening as vaccination coverage continues to
expand. In Ireland, thanks to the public health and community response, we can see light at the
end of the tunnel. We expect the Irish economy to recover strongly in the second half of the year
but uncertainty regarding the evolution of the pandemic remains.
Of course, the impact of COVID-19 is not the first, and won't be the last, shock to affect the euro
area. As monetary policymakers, we at the Governing Council need to be aware of risks on the
horizon, and ensure that our policy tools are ready when needed to minimise the fallout of
downturns on households and businesses. I believe we did that last week.
*This blog is adapted from Governor Mahlouf's earlier op-ed in the Irish Times .