The Treaty on the Functioning of the European Union assigns the European Central Bank (ECB) the primary mandate of maintaining price stability across the euro area. However, the Treaty itself leaves it to the ECB to determine both the exact definition of “price stability” and how to achieve it—what is known as the “monetary policy strategy”.
In 1998, the ECB defined price stability as an annual increase in the euro area Harmonised Index of Consumer Prices of below 2%. It later clarified in 2003 that, in pursuit of price stability, it would aim for inflation below, but close to, 2% over the medium term.
With this strategy, over the years the ECB has had to confront the worst economic crisis of recent decades, with an unprecedented risk of financial fragmentation in the euro area, as well as a global pandemic. The result was the implementation of an ultra-expansionary monetary policy marked by negative interest rates and an intensive asset purchase programme. An extremely accommodative stance that, ultimately, can be deemed a qualified success, as it enabled the economic recovery and put deflationary pressures behind us, albeit at the cost of reducing the profitability of euro area banking institutions.
On 7 July 2021, the ECB’s Governing Council approved its new monetary policy strategy, through which the institution sought to bring greater clarity to its decisions via three basic notions: the establishment of a symmetric 2% inflation target, a medium-term orientation, and the recognition that the effective lower bound operates as a constraint (ECB, 2021). This approach was set out in a complex environment that coincided with the end of the pandemic and the exit from the crisis at a time when, from a more structural perspective, it was not evident that the deflationary pressures associated with demographic trends, globalisation or the digitalisation of the economy had been curtailed. In this context, it is easier to understand why the Governing Council considered negative and positive deviations of inflation from the stated target to be equally undesirable.
Following the announcement of this strategic review, the economic situation took an unexpected turn for the market and for the institutions themselves, with a broad-based increase in the pace of price growth. It seemed to be a response to several causes that were initially considered temporary, as they were linked to the reactivation of the economy after the pandemic and to bottlenecks in global supply chains. However, with Russia’s invasion of Ukraine and tensions in energy markets, inflation has proved more intense and persistent, to which the ECB has had to respond decisively under the parameters of its new strategy. An unforeseen reality that the institution has confronted by beginning a phase of interest rate normalisation after thirteen years of an accommodative policy to keep inflation expectations anchored at 2%.
This challenge is even more complex because the ECB, in addition to fighting inflation as set out in its mandate, must ensure financial stability in an area made up of countries with different fiscal situations and trajectories, meaning that the tightening of monetary conditions should not contribute to financial fragmentation among euro area countries. This makes the design of monetary policy more difficult, and so under the new strategy the analytical framework is expanded with a deeper economic analysis, as well as a macroprudential analysis that can balance the effectiveness of monetary policy with the economic situation, the stance of fiscal policy, public and private indebtedness, and the country’s financial stability. Moreover, as the ECB President noted, this complex operating framework must be able to safeguard a financial sector that ensures the flow of credit needed to sustain solid economic growth (Lagarde, 2022).
Lastly, the importance that the new strategy assigns to the guidance and flexibility of monetary policy is reflected in the relevance of climate change over the medium and long term. There are sufficient reasons to argue that rising global temperatures could have a significant impact on financial stability through a set of physical or transition risks, as the former Governor of the Bank of England set out in a seminal speech on the ‘Tragedy of the Horizon‘ (Carney, 2015). Likewise, there is a degree of consensus regarding the inflationary impact of the transition to a decarbonised economy. Whatever the reason, it seems entirely justified for the ECB to adapt its macroeconomic models in order to assess the short-, medium- and long-term implications of climate change for the transmission mechanisms of monetary policy and price stability. In the same way, it is reasonable for it to integrate the climate risk assessment framework into its expectations and supervisory policies.
However, moving into the fight against climate change from its role as a supervisory authority and adopting the objectives set out in the Paris Agreement could put both its independence and its credibility at risk. The ECB’s independence could be called into question because its decisions will have an asymmetric effect on the economy that could, eventually, clash with public policies and incentives designed by democratically elected governments (Fernández Villaverde, 2022). Likewise, the difficulty of committing to the fulfilment of two objectives, even if they may be interrelated, with monetary policy as the sole lever of action could cast doubt on the institution’s credibility if the desired targets are not achieved.
Even so, in addition to integrating the adverse effects of climate change into macroeconomic models, developing new indicators and extending supervisory responsibility to ensure that financial institutions properly provision for the climate risks associated with their loan portfolios and investment assets, the ECB has committed to aligning the Eurosystem balance sheet with the goal of net zero emissions by 2050. This entails introducing environmental sustainability disclosure requirements while also requiring the management of the collateral framework and corporate asset purchases in favour of those companies with a lower emissions impact. These circumstances will also require greater pressure against greenwashing. In any case, the relationship between monetary policy and climate change places the ECB in a situation that is as delicate as it is complex, which it will have to manage with prudence and proportionality, based on the support provided by the Network for Greening the Financial System (NGFS). This relationship will work more effectively if the institution works hand in hand with the banking industry, which, for its part, is seeking to anticipate the complex regulatory framework set out by the EU while contributing to the development of a more balanced and decarbonised economy.
In short, since the ECB set out its monetary policy framework in 2003, the world has undergone complex transformations that made a review of its strategy necessary. The effort to provide clarity and help convey precise, unambiguous messages, and to instil a flexible and adaptable medium-term orientation, represents a fundamental change from the way monetary policy has been implemented since then. In the short and medium term, the challenge of this new formulation will be to demonstrate its strength in keeping inflation expectations anchored and preventing second-round effects. Over the longer term, the challenge of this new framework will be to promote economic growth and align the stability of the financial system and price increases with the EU’s decarbonisation objectives in an environment of digital transformation and low productivity growth.
Juan Carlos Delrieu, economist and Director of Sustainability at the Spanish Banking Association
