Frank Elderson: Proportioning policy action to the evidence
making the monetary policy strategy of the European Central Bank
concrete
Keynote speech by Mr Frank Elderson, Member of the Executive Board of the European Central
Bank and Vice-Chair of the Supervisory Board of the ECB, at The Institute of International &
European Affairs webinar, Frankfurt am Main, 24 March 2022.
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As no doubt all of you joining me here today, we at the European Central Bank look with horror at
the distressing reports from Ukraine. The human suffering and destruction we see in our part of
the world remains difficult to fathom. Our hearts and minds are with the people of Ukraine. With
those who are still in harm's way, and with those who have been forced to seek refuge
elsewhere, mainly in the European Union. These events are a stark reminder about what the
European Union stands for: peace in Europe, being united in diversity, shared principles and the
rule of law. The rule of law that also governs the institutions - including the ECB - that within their
mandate serve European citizens.
Today, I want to outline to you how the ECB will continue to contribute to this greater purpose by
delivering on the mandate bestowed upon us by the European treaties. The mandate to deliver
price stability in the euro area. You may be aware that last summer the ECB announced a new
monetary policy strategy after concluding a comprehensive review. A review in which we
engaged with a wide range of stakeholders, including European citizens, to learn lessons and
better understand the concerns of those we serve with respect to monetary policy and the
broader economy.
Understandably, one of the key elements of our new strategy which received a lot of attention
was the new, symmetric 2% inflation target over the medium term. This replaced our earlier
medium-term inflation aim of below, but close to 2%. Together with our new strategy, we also
published a roadmap outlining actions to incorporate climate change considerations in our
monetary policy. And I am very happy that this roadmap is drawing an equal amount of interest
and appreciation from among our stakeholders.
Today, however, I will focus on another specific element of our new strategy that tightly binds
together many of its constituent parts. A principal component that underpins the evidence-based
foundations of our monetary policy strategy. It is the compass that guides our actions when
taking monetary policy decisions. I am talking about the role of proportionality in our monetary
policy deliberations.
Bear with me these next twenty minutes and I will talk you through how, we as monetary
policymakers assess the proportionality of our policy actions, illustrated with experiences of
lawyers and construction workers, and how we apply this framework in the current
circumstances.
The legal principle of proportionality
As a trained lawyer, let me start by providing you with some legal background on proportionality.
To do so, I will take you back to 1882 when the Prussian Royal administrative court delivered
the Kreuzbergerkenntnis, or Kreuzberg judgement. This was a groundbreaking verdict that for
the first time explicitly established that a public authority - in this case the police - cannot pursue
the public good in full discretion without any limitations to the sacrifice of individuals and their
legal positions. The verdict annulled an ordinance issued by the police that banned owners of
land around the Kreuzberg war memorial in Berlin from constructing buildings above a certain
height, to keep the view of the monument clear. The court argued that with the ordinance, the
police had exceeded their mandate. To put it simply: the ruling made it clear that the police were
only responsible for public security, and not for safeguarding aesthetic interests.
The verdict signified an important step in the development of modern societies. Acknowledging
that their actions intrude on the lives of citizens, public sector authorities began limiting their
actions to what is strictly necessary to achieve the established objectives. Since then,
proportionality has evolved to become a fundamental principle in many legal systems. The
proportionality principle is a cornerstone of the institutional structure of the European Union, laid
down in Article 5 of the Treaty on the European Union. And all its institutions are bound by it in the
pursuit of their respective mandates. It requires them to carefully assess the necessity and
suitability of policy action to deliver on the mandate, while also considering whether this policy
action is less intrusive compared with other options for achieving the same goal. Needless to
say, this requirement also applies to the ECB.
Proportionality in policy deliberations
Thus, systematically assessing the proportionality of our monetary policy actions is exactly what
we set out to do - and made even more explicit in our new monetary policy strategy - when the
ECB Governing Council meets to discuss monetary policy every six to seven weeks. It is
important to note that the scope of the proportionality assessment of policy decision-making
bodies like the Governing Council differs from the scope of the judicial review that a court would
conduct when assessing the proportionality of public policy measures for the law. This was
carefully explained by European Court of Justice President Koen Lenaerts, at the ECB's recent
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annual legal conference. He outlined that when assessing proportionality, the Court applies a
judicial review limited to manifest errors. With this approach, the Court acknowledges that
institutions like the ECB enjoy a margin of assessment within the limits of their competences to
weigh technical considerations that go beyond the Court's own competence and expertise. At the
same time, the Court does require that institutions have in place a due process that ensures that
within their margin of assessment, all factors and circumstances of relevance at the time of a
policy decision are considered, including the impact of the action on other policies and the
existence of less intrusive means to achieve the set objective.
This is what the Governing Council's proportionality assessment needs to account for. And to
achieve that, our monetary policy strategy includes an integrated assessment framework to
support our deliberations on monetary policy options. This framework builds on two
interdependent analyses: the economic analysis and the monetary and financial analysis. The
economic analysis focuses on real and nominal economic developments which includes
economic activity, employment and price and wage developments. The monetary and financial
analysis examines monetary and financial indicators which includes lending by banks and
nonbanks, asset prices and financing conditions. The focus here is on monitoring how our monetary
policy decisions transmit throughout the financial system into the wider economy and assess
whether any impairments in that mechanism could be harmful to our price stability objective.
Moreover, the monetary and financial analysis allows us to monitor the possible risks to
mediumterm price stability from financial imbalances. These two strands of analyses do not stand in
isolation. Indeed, the important role of macro-financial linkages in economic, monetary and
financial developments requires that the interdependencies across the two analyses are fully
incorporated.
Each monetary policy decision by the Governing Council - even if it reconfirms decisions taken
in a previous meeting - builds on the evidence provided for by our integrated assessment
framework. This evidence informs our discussion on the monetary policy stance required to
ensure that economic, financial and monetary developments are consistent with maintaining
price stability. And it also supports our decisions on the choice, design and calibration of
instruments that deliver the required monetary policy stance. In this sense, our analytical
framework enables us to ensure that the blend of our policy instruments is proportionate to the
circumstances and challenges that we face in the pursuit of price stability.
Making the strategy concrete
Let me explain how this can be envisaged in practice with an analogy in construction that may
speak more to the minds of a general audience than concepts from the world of monetary
theorists and lawyers. Very much like price stability ensures a solid foundation to support a
wellfunctioning economy, in construction concrete is the bedrock of any structure: homes, office
buildings, bridges, wind and solar power stations, and so on. This bedrock is made up of four
simple ingredients: cement, gravel, sand and water. Every ingredient plays its part. Cement is
the key bonding agent that holds the concrete together. It is the gravel and sand that give it its
strength and structural integrity. The water activates the bonding process and also makes the
concrete malleable and allows for flexible application.
The optimal concrete mix ratio depends highly on where the concrete will be used. Generally, the
amount of sand and gravel is important for strength and durability, whereas cement and water
add to workability. As one might expect, dry environments call for a relatively higher proportion of
water in the concrete mixture, while the opposite holds for moist surroundings. Exposure to
mechanical or chemical erosion also call for relatively less water to maintain durability.
Environments subject to freezing and thawing benefit from concrete that contains some air
pockets, determined by the proportion between gravel and sand. The builder mixing the concrete
surely needs to establish what likely conditions the concrete needs to withstand before deciding
on the optimal mix.
I have come to learn that this concept is known among economists as state and shock
dependence of the optimal policy response. And the optimal calibration of the monetary policy
compound to maintain price stability is equally dependent on the external factors that have an
impact on the economy. Our new strategy confirms that the key ECB interest rates play a
primary role in this compound, but it also explicitly accounts for the use of other instruments as
appropriate. In line with the central banks in other advanced economies, this includes
communicating the expected future path of interest rates - also known as forward guidance - as
well as asset purchases and the provision of longer-term refinancing operations to banks. The
Governing Council has made clear its commitment to deploying and withdrawing all these
instruments to respond flexibly to challenges in a proportionate manner, as we have
demonstrated in the past.
In our proportionality assessment we are also mindful that monetary policy measures have an
impact on the broader economy and economic policies. In fact, the Treaty requires us to support
- subject to such support not undermining our efforts to maintaining price stability - the general
economic policies in the European Union with a view to contributing to the achievement of the
EU's objectives. These objectives include balanced economic growth, a highly competitive social
market economy aimed at full employment and social progress, and a high level of protection
and improvement of the quality of the environment. In this context, whenever we identify different
sets of instruments that are equally conducive to price stability, we will choose the configuration
that best supports those general economic policies of the EU. Or, to use the example of the
concrete mix: when there are multiple blends that are equally conducive to preserving structural
integrity, the one that is most supportive to environmental sustainability is clearly mandated from
a proportionality perspective.
Current outlook for the euro area economy
The framework that I have outlined provides the lens through which we assess the proportionate
monetary policy response also to recent developments. We update our outlook for growth and
inflation by closely monitoring all relevant incoming data and analysing them with our
state-of-theart modelling toolkit, building on the knowledge and expertise of both ECB and Eurosystem staff.
Now, even with all this analytical infrastructure in place, the current exceptional uncertainty
means that we need to be humble about how accurately we can predict the future state of the
economy. It is difficult to assess the exact quantitative impact of the tragic developments that
began unfolding just as we were casting off the impact of two years of another unforeseeable
event with dramatic consequences - the COVID-19 pandemic. That being said, the new ECB
staff projections that were prepared for our monetary policy meeting two weeks ago and included
two complementary scenarios to cater for the uncertainty paint a clear picture of what qualitative
impact to expect.
The analysis confirms that the present circumstances represent new headwinds to growth,
emerging at a time when previous, pandemic-induced, headwinds were finally waning. In
particular, there are two important channels through which the war weighs on the euro area
economic outlook: negative confidence effects, which have an impact on both international trade
and on financial markets, and high energy prices. This is reflected in a downward adjustment of
growth in the baseline of the latest staff projections. At the same time, it should be noted that the
outlook that prevailed before the Russian invasion was quite favourable, showing the euro area
economy emerging from the pandemic on solid footing. This implies that in our updated baseline
outlook, and also in more adverse and severe scenarios for the impact of the war, stagnation is
not foreseen.
While we are facing downward pressures on growth, inflation has continued to surprise on the
upside. After having fallen sharply in the first months of the pandemic, it started rebounding
around one year ago and has increased above our 2% target since last summer reaching 5.9%
last month. The strength and the persistence in the rebound of inflation has consistently
surprised many analysts and professional forecasters, including us. Unexpectedly high energy
costs contributed most to these surprises, yet we do also see that price rises have become
more broad-based. Even if global oil prices do not increase any further and stabilise at high
levels, we currently expect inflation to be above our 2% target well into 2023, before settling
around target in 2024. We are aware that the current spell of high inflation has a consequential
impact on many citizens' personal livelihoods in a time in which both economic and a broader
sense of uncertainty have again taken hold. Let me reiterate: our commitment to medium-term
price stability is unwavering.
With inflation stubbornly above our target for so long, some concerns have been raised about the
risk of "second-round effects", which could make high inflation even more persistent. These
effects describe a situation where high inflation feeds into higher wages, implying increased
costs for businesses, which would lead to higher inflation still. Our current inflation projection
accounts for some increase in wages building on historical regularities of pass-through from
inflation to wages and further spillback mechanisms. And at present we are not yet observing
stronger second-round effects than projected. At the same time, we are mindful that some
ingredients for potential stronger effects are in place. Slowing growth and high inflation put
pressure on households' real disposable income that they may seek to recover through higher
wages in an economy in which labour market shortages and other supply side bottlenecks are
lingering. Thus, the interplay between inflation and wage growth - with an important role for
inflation expectations - is something that we will carefully continue to monitor in the period ahead.
Similarly, in the pursuit of our mandate, we diligently monitor whether the prevailing financing
conditions remain consistent with inflation reaching our 2% objective in the medium term. The
Russian invasion of Ukraine and the subsequent financial sanctions have clearly caused
substantial volatility in financial markets. However, these factors have so far not caused severe
strains in money markets or liquidity shortages in the euro area banking system.
Shortly before the Russian invasion of Ukraine, ECB Banking Supervision published the results
of the 2021 cycle of the Supervisory Review and Evaluation Process (SREP). The findings of
that annual assessment indicate that significant institutions have maintained solid capital
positions, with most banks going beyond the levels dictated by capital requirements and
guidance. Of course, the 2021 SREP cycle did not envisage the current war in Ukraine nor the
sanctions on Russian counterparts that followed. Yet, the SREP results do reflect the general
resilience of Europe's banking sector, which should help avoid disruptions in financing conditions
as the economy and financial system are adjusting to the evolving circumstances. As regards
Russia, the ECB continues to monitor direct and indirect channels of impact on European banks,
but none have been disruptive so far.
Outlook for monetary policy
Let me now turn to how this assessment of the euro area economy outlook translates into the
outlook for monetary policy. It is a well-established practice in monetary policy that in times of
uncertainty prudent policy calls for gradualism, as was also alluded to in a speech last week by
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ECB President Christine Lagarde.This holds particularly true when we approach potential
turning points in the monetary policy cycle. In determining the appropriate degree of gradualism,
the Treaty gives us a compass - the principle of proportionality. A compass that points to price
stability and - in line with our monetary policy strategy - has its needle moved by the evidence.
Against this backdrop, already in December we announced our intention to end the net asset
purchases conducted under our pandemic emergency purchase programme (PEPP), which in
our recent meeting we confirmed we would do at the end of this month. Moreover, in light of the
revised inflation outlook, we have assessed that net asset purchases under our other purchase
programme can be discontinued in the third quarter if the incoming data confirm that the
medium-term inflation outlook will not weaken after net asset purchases. This strengthens our
policy optionality by removing obstacles for potential policy rate normalisation beyond the horizon
of our asset purchases. Any adjustments to the key ECB interest rates will take place some time
after the end of our net asset purchases and will be gradual and based on the incoming data.
Both the timing and the pace will be proportionate to the evolution of the inflation outlook in
relation to our price stability objective.
If the evolution of the inflation outlook supported by incoming data allows a further normalisation
of monetary policy, we stand ready to adjust our instruments accordingly. Meanwhile, we will
continue to fully reinvest the maturing securities acquired in the context of our asset purchase
programmes past the date on which we start raising the key ECB interest rates. Whenever we
face renewed pandemic-related threats of market fragmentation that are a risk to price stability,
the reinvestments that we undertake under the PEPP can be adjusted flexibly across time, asset
classes and jurisdictions to counter those threats. Moreover, we can design and deploy new
instruments to counter any threats to price stability that may emerge as we move along the path
of policy normalisation.
Conclusion
Let me conclude. The Scottish philosopher David Hume once said that a wise person
proportions their beliefs to the evidence. Likewise, I think the evidence should proportion a wise
person's actions. This is as true for a wise monetary policymaker pursuing price stability as it is
for a wise judge delivering a sound verdict, or a wise construction worker securing structural
integrity. In our case, it is our evidence-based monetary policy strategy that enables us to do
exactly this. And by paving the way for gradual normalisation with significant policy optionality to
account for uncertainty, we are putting it into practice. We will proportion our actions to the
evidence. That way, our commitment to maintain medium-term price stability remains rock-solid.
Lagarde, C. (2022), "Monetary policy in an uncertain world", speech at "The ECB and Its Watchers XXII"
conference, Frankfurt am Main, 17 March.