Expanding central banks mandates without undermining price stability
Financements
The ancient Greek philosopher Heraclitus once said “everything changes, and nothing stays”. For the world of central banks, things have changed — a lot. Before the outbreak of “the Great Inflation” in the 1970s, hardly anyone paid any attention to the words of central bankers. Today, monetary policy decisions can shape and shake financial markets.
Things have changed in central banking in other important ways.
In the aftermath of the Great Inflation, most central banks have adopted price stability as the primary objective of monetary policy, and the number of political independent central banks has risen sharply. The European Central Bank (ECB) is a central bank that is both independent and bound by legislative measures to achieve price stability.
In the aftermath of the Global Financial Crisis, many central banks’ mandates have been augmented with financial stability objectives and some were given sole or co-responsibility for macroprudential tasks. In the euro area, the direct supervision of significant banks was entrusted to the ECB in close cooperation with the national authorities (Single Supervisory Mechanism).
My focus today will be on the Eurosystem. Our primary objective of price stability is mandated by the Treaty on the Functioning of the EU. The focus on price stability is the result of the awareness of the damage that can be caused by deviations from price stability.
How we deliver on this objective is defined by our monetary policy strategy. Our specific target is symmetric: we aim for 2% inflation over the medium term. This formulation was introduced in 2021. By making the numerical target explicit it has provided a stable reference point that is easy for the public to understand. It has improved wage and price setting, strengthening the anchoring of inflation expectations.
From the time of its inception in 1999 until the early 2020s, the ECB achieved an annual inflation rate that was, on average, slightly below 2%, earning significant credibility. As a result, long-term inflation expectations remained firmly anchored throughout the recent inflation surge and we were able to tighten gradually and bring inflation back down to 2% while, at the same time, achieving a soft landing.
Why 2% and why not 0% inflation? Because a buffer above zero provides monetary policy with space for interest rate cuts in the event of adverse developments and with a safety margin against the risk of deflation. Downward nominal rigidities and measurement bias also warrant an inflation buffer.
Several academics and policymakers have called for raising the target above 2%. Such proposals have to be carefully weighed against potential risks to central bank credibility. Frequent adjustments to the target could lead market participants to anticipate further changes in the future, eroding confidence and creating risks of de-anchoring of inflation expectations.
The medium-term orientation acknowledges the fact that monetary policy transmits through long and variable lags, and provides the flexibility to respond to price pressures in a gradual way without resorting to drastic measures that could undermine economic activity and employment. At the same time, our strategy safeguards the smooth transmission of monetary policy across all sectors and countries.
Central banks do not operate in a vacuum. In the euro area, we must navigate a complex environment shaped by fragmented capital markets, geopolitical tensions, the urgency of climate risks and a pressing need to address the productivity gap vis-a-vis other major economic areas.
The primary responsibility for addressing these challenges, of course, lies with governments and legislators in Europe. The role of monetary policy is to provide an anchor of stability, securing a fundamental requirement for sustainable growth thereby fostering confidence, spurring investment and job creation.
During the past year, the remaining layers of monetary policy restriction have been gradually removed. This easing in financing conditions will be key to supporting investment by making capital more accessible and affordable, in an environment of very high uncertainty.
Our renewed strategy reaffirms the continued importance of climate in our policy agenda. But we are also pressing for progress in other areas. relating to European integration, by finalizing the Banking Union and advancing the Capital Markets Union, while a fully fledged Savings and Investment Union is essential to improve how our financial system channels savings into productive investment.
A more complete union will also allow the euro to take on an expanded role as an international currency – sharing in the benefits associated with that role and providing Europe with more responsibility on a global stage that has become fractured by uncertainty.
Effective macroeconomic stabilisation requires fiscal policy and monetary policy to complement each other. A vital lesson from the euro area debt crisis is that when fiscal and monetary policies are aligned, but with a clear distinction of the respective roles, responsibilities and mandates, they can reinforce each other. A permanent central fiscal capacity – a shared framework for managing public finances – would be a turning point, enabling coordinated investment and shared responsibility for growth-enhancing initiatives. The Recovery and Resilience Facility could serve as a blueprint for the future – including the creation of a common European safe asset, to deepen financial integration and resilience.
In turbulent and fluid times, central banks need to constantly reassess their monetary policy strategies in order to deliver on their mandate, while ensuring that they remain credible. Here I touched on some of the issues arising in the context of that discussion, which provide important lessons and, at the same time, highlight the way forward – to a more efficient euro area architecture.