Review of the ECB’s monetary policy strategy: what changes can we expect?

2021-09-23

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Comments by Tomas Reichenbachas, Principal Economist of the Monetary Policy Division of the Bank of Lithuania

In updating the strategy, the ECB worked closely with the national central banks of the euro area countries, including the Bank of Lithuania, which together form the Eurosystem. The ECB's monetary policy strategy was last reviewed in 2003.

Global economy, including that of the euro area, has undergone significant changes since 2003. Population ageing, a slowdown in the growth rates of labour productivity and the continuing effects of the 2008-2009 global financial crisis have significantly reduced interest rates and, at the same time, the ability of the ECB and other central banks to support the recovery of economies merely by reducing policy interest rates. Rising average life expectancy in developed countries is driving people to save more and more for old age. In turn, rising savings are lowering interest rates.

Other examples of structural change are the digitalisation and globalisation of the economy. For the smooth conduct of monetary policy, it is particularly important how and why different prices change, and the way prices are set has changed considerably over the years. A significant increase in e-commerce makes it easier for people to compare the prices of different products and to buy goods from around the world, which promotes price competition. E-commerce was still a completely new area in 2003, and now it is the daily routine of many people. This can easily be illustrated by statistics: Amazon's sales amounted to just over USD 1 billion in 2003, while in 2020 they reached just over USD 67 billion.

For all these reasons, the ECB's monetary policy strategy has been reviewed and will be reviewed on a regular basis in the future (the next review is scheduled for 2025). The key results of the review published in July this year are the following: 1. A symmetric 2% inflation target over the medium term has been adopted; 2. A consistent improvement of the harmonised index of consumer prices was recommended to better reflect housing-related consumption costs; 3. an ambitious climate action plan has been adopted.

What are the implications of each of these developments, which will indirectly affect millions of Europeans?

Updated inflation target

While the population often sees any price increase as a negative phenomenon, the economy can only function properly if prices are rising gradually. This can be illustrated by one example: imagine that prices of consumer goods are falling. Let's say, it is known that a TV set (or another product) will cost less after a month. Then, why would you buy this product today? Is it possible to wait? Although this would seem to be a logical solution for every individual, it can be very detrimental at the level of the economy as a whole. If the population as a whole buys less goods - waiting for them to become cheaper - this will affect the companies producing them, which will reduce production, which in turn will force them to reduce the number of employees and the income of those employees. Falling income will further reduce demand for goods and make it more difficult for businesses and households to repay their debts. This can lead to a deflationary spiral of the economy, with not only lower prices but also lower demand for goods and lower real income of the employees, as well as the rising numbers of bankruptcies and unemployed people. However, excessive inflation is also harmful. A rapid rise in the prices of goods may provide an overly strong incentive to buy goods already now, which will overheat the economy and encourage businesses and consumers to make unjustified choices. For these reasons, it is essential to strike the right balance, with prices increasing, but only gradually.

Against this background, the ECB's analysis shows that the approved symmetric inflation target of 2% over the medium term is appropriate to ensure healthy economic growth. The new definition is clearer than the previous wording, which aimed at annual price increases that are "below, but close to, 2%". The newly formulated target is symmetric, meaning that any deviation to either side is equally undesirable. Both too slow and too fast price increases are detrimental to the economy.

Inclusion of owner-occupied housing costs

Currently, inflation measurements include trends in the prices of consumer goods and services, but do not consider fluctuations in the prices of investment goods (such as shares, bonds, gold, etc.). There is a conceptual issue here as to whether housing should be seen as a unit of investment or of consumption. Historically, the prices of owner-occupied housing have not been included in the standard inflation indicators used by the ECB. However, this is a particularly important 'commodity' for the population, as rising real estate prices have a significant impact on access to housing. This issue has often been voiced to central banks by the population in several euro area countries, including Lithuania.

The ECB's analysis has shown that the inclusion of costs of owner-occupied housing in inflation measurements would better reflect the inflation rate relevant to households. The ECB therefore asked the European Commission to develop as soon as possible a new indicator (or complement an existing one) to measure inflation, which would include the purchase prices of new housing and other related costs. As this would take several years, during the transitional period, the ECB will also take account of various synthetic indicators based on developments in housing prices.

Addressing climate change

Getting a grip on climate change is likely to become one of the biggest challenges of this century, which will also affect price stability. For this reason, the ECB committed itself to an ambitious action plan on climate change.

While governments and parliaments are directly responsible for actions combating climate change, the ECB also recognises the need to further integrate climate change issues into its fields of activity. Under the adopted action plan, commitment has been made to expand the analytical capacity for climate change, as well as to include, as much as possible, climate change considerations in monetary policy operations.

The ECB's monetary policy strategy is the key document on which the monetary policy decisions of the Eurosystem, which includes the Bank of Lithuania, must be based, so these changes will sooner or later reach many of us.

Perhaps most importantly, this time the decisions to modify the strategy have been taken in consultation with all the interested groups of society. Lithuanian institutions and organisations had the opportunity to express their position during the ECB Listens event organised by the Bank of Lithuania. We hope that this will lead to a more integrated, flexible and more resilient monetary union, of which we are part.

The main objective of the ECB, which is to maintain price stability in the euro area, remains unchanged. Without prejudice to the objective of price stability, the Eurosystem supported and will continue to support the EU's broad economic policies with a view to achieving balanced economic growth, employment for all and social progress, protecting the environment and improving its quality.

The views expressed herein are solely those of the authors and do not necessarily reflect the views of the Bank of Lithuania or the Eurosystem.

Economic analysis and projections, Monetary policy