The primary goal of the Eurosystem’s monetary policy is to maintain price stability. However, central banks cannot steer the price level directly, but only by influencing other economic variables, which in turn have an impact on inflation. The process by which this influence has an impact is referred to as the monetary policy transmission mechanism. Essentially, it consists in the impact of short-term interest rates on the real economy, which in turn has a lagged effect on inflation.
Monetary policy decisions are thus taken with future inflation in mind and require a framework to support these decisions. The monetary policy strategy provides this framework; it structures all information relevant to monetary policymaking to assist the Governing Council of the ECB in passing interest rate decisions. At the same time, the strategy is also supposed to help clearly communicate the Eurosystem’s interest rate decisions to the general public.
To this end, the monetary policy strategy of the Eurosystem is made up of three parts. The key element is the quantitative definition of price stability, which aims at inflation rates of below, but close to, 2% over the medium term. The other parts of the strategy consist of what is referred to as the two pillars. One pillar, the "economic analysis," contains those indicators which provide information about the short- to medium-term factors determining price developments. The other pillar, the "monetary analysis," contains what is referred to as monetary indicators; these serve as a means of cross-checking, from a medium- to long-term perspective, the short- to medium-term indications from the economic analysis.
The Monetary Policy Strategy of the Eurosystem
Monetary Policy Strategy – an Introduction
Detailed Information about the Monetary Policy Strategy
The challenge the ECB faces in view of the mechanism that governs the transmission of monetary policy may be formulated as follows: The Governing Council must influence conditions on the money market and hence the level of short-term interest rates to ensure that price stability is maintained over the medium term. Yet in the decision-making process, the Eurosystem is continuously confronted with a high degree of uncertainty, both about the type of economic shocks and about the interaction between economic variables. Against this backdrop, it is possible to identify several important characteristics of successful monetary policy. Monetary policy will be more effective if it firmly anchors inflation expectations. To this end, the Eurosystem is called on to specify its objective, to develop and apply a consistent and systematic approach to reaching this objective, and to engage in direct and open communications.
Such a strategy is key to attaining a high degree of credibility, which is a prerequisite for influencing market participants’ expectations. Owing to the lags inherent in the transmission process, changes in monetary policy today will not affect the price level until after a number of quarters or even years. This means that central banks need to ascertain what policy stance is needed today in order to maintain price stability in the future, after the transmission lags unwind. In this sense, monetary policy must be forward-looking. As the transmission lags make it impossible in the short run for monetary policy simply to offset unanticipated shocks to the price level (for example, those caused by changes in international commodity prices), some short-term volatility in inflation rates cannot be avoided. In addition, owing to the complexity of the transmission process, there is always a large element of uncertainty surrounding the effects of monetary policy. For the above reasons, monetary policy should have a medium-term orientation to avoid excessive activism and unnecessary volatility in the real economy.
Finally, like any other central bank, the Eurosystem is confronted with considerable uncertainties surrounding e.g. the reliability of economic indicators, economic structures and the monetary policy transmission mechanism. A successful monetary policy therefore has to be broadly based, taking into account all relevant information to identify the factors driving economic developments and not relying on a single model of the economy.
The Governing Council has announced a monetary policy strategy to ensure that a consistent and systematic approach to monetary policy decisions is available. This monetary policy strategy follows the above-mentioned basic principles, allowing it to meet the challenges the Eurosystem faces. The monetary policy strategy is intended to provide a comprehensive framework within which decisions on the appropriate level of short-term interest rates can be taken.
The main elements of the Governing Council’s monetary policy strategy is its quantitative definition of price stability. In addition, the design of the strategy ensures that, in forming its overall judgment of the risks to price stabiity, the Governing Council does not overlook important information concerning future price trends. At the same time, the strategy provides a framework for explaining monetary policy decisions to the public in a clear and transparent manner.
The Eurosystem’s approach to organizing, evaluating and cross-checking the information relevant for assessing the risks to price stability is based on two analytical perspectives referred to as the “two pillars.”
One perspective, "economic analysis," focuses on the assessment of short- to medium-term factors determining price developments, with a special view to the real economy and financing conditions. It takes account of the fact that price developments over these time horizons are largely influenced by the interplay of supply and demand in goods, services and factor markets.
The other perspective, "monetary analysis," focuses on a longer time horizon, utilizing the long-term relationship between money and prices. Monetary analysis serves mainly as a means of cross-checking, from a medium- to long-term perspective, the short- to medium-term indications for monetary policy from the economic analysis.
With a view to arriving at a balanced overall assessment of the risks to price stability, the two-pillar approach aims at ensuring that complementary perspectives are applied, that no relevant information is lost and that information gained is adequately cross-checked.