Opinion

Gabriel Makhlouf: What new ECB strategy means for us all

Policy targets inflation and bolsters ability to respond to economic shocks

The impact of Covid-19 is not the first – and won’t be the last – shock to affect the euro area.

Gabriel Makhlouf
Fri Jul 16 2021 - 01:00

Last week, my colleagues and I on the European Central Bank’s 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 pre-smartphone era. Our decisions will influence the price of goods and services across the EU and ensure more stable economic conditions for businesses and households.

The ECB and the 19 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: you will be able to buy less with the same amount of money in your pocket. 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) and businesses lose revenue, postpone investment and delay recruitment.

We need to avoid that. Stable prices matter. Positive, low and predictable inflation helps households and businesses plan their spending and investment and helps the economy grow and create 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 fluctuations without cutting jobs or wages.

Last week the governing council decided to target inflation at 2 per cent over the medium term. This new objective provides a clear target, replacing an ambiguous objective (which defined price stability as an annual increase in prices of below 2 per cent and specified an inflation aim of “below, but close to, 2 per cent”). We also made clear that 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).

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Risk of deflation

The reason for these changes is that, compared to when the last strategy was agreed in 2003, the risk of deflation has become more acute (for a number of reasons). And in such a disinflationary environment, we wanted to make clear that we would take action to resist inflation that was too low and respond to inflation below our target (as well as, of course, inflation that was above the target). Apart from lacking clarity, the previous objective (“below, but close to, 2 per cent”) was sometimes seen as a ceiling. Our new target makes clear that we will tolerate small deviations in either direction over short periods of time to ensure the smooth functioning of the economy.

Stable prices matter. Positive, low and predictable inflation helps households and businesses plan their spending

We’re also going to take into account the cost of owner-occupied housing in our analysis of inflation. This will better reflect people’s experience of price rises (as we heard when we consulted the public last year).

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 the actions of individual households and businesses), central banks can also play an important role. Last week, we committed to a comprehensive action plan and an ambitious roadmap to further incorporate climate change considerations into our policy framework, recognising that the transition to net-zero emissions has significant implications for the economy and price stability.

Price stability

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. Changes in interest rates, which pass through into the retail interest rates for households and firms, will continue to be the primary tool used to control inflation. But following years of very low rates, there are a range of other instruments that we will continue to use (including, for example, our asset purchase programme). We will return to these issues in 2025, when we conduct our next review.

In Ireland, thanks to the public health and community response, we can see light at the end of the tunnel

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 (or fluctuations) 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, 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. We believe we did that last week.

Gabriel Makhlouf is governor of the Central Bank

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