The Bank of Finland is participating in the reform work underpinning the European Central Bank's monetary policy strategy review. The comprehensive review will examine the definition of price stability and the monetary policy toolkit as well as changes in the economic environment which have impacted on monetary policy.

On 23 January 2020, the Governing Council of the European Central Bank (ECB) launched a review of its monetary policy strategy. At the time, the process was expected to be concluded by the end of 2020.

However, due to the crisis caused by the COVID-19 pandemic, the timetable for the strategy review has been extended by six months. It is now expected to be completed by the middle of 2021.

The strategy review is being conducted on the principles of thorough analysis and open minds. It will look at the quantitative formulation of price stability and the inflation target, the monetary policy toolkit, the effects and side-effects of monetary policy, and communication practices.

It will also assess what digitalisation, financial stability, globalisation, and climate change mean for the conduct for monetary policy going forward.

The work is being carried out across a number of committees and working groups belonging to the European System of Central Banks. There are ten workstreams focusing on specific areas of the strategy review, each with at least one representative from the Bank of Finland.

The tools of monetary policy have changed

The economic environment has changed significantly since the ECB last revised its monetary policy strategy, in 2003.

Declining productivity growth, an ageing population and the legacy of the financial crisis have led to a secular decline in real interest rates.

This is hampering the ability of central banks to respond to negative surprises in the economy. When interest rates are near zero, there are limited options for lowering them further.

The monetary policy toolkit has also changed significantly as new instruments have been added. The COVID-19 pandemic has created new tensions for monetary policy, especially as economies have rapidly increased their levels of national debt.

The Eurosystem is listening to the views of the public in its strategy review

Listening to the views of the public and stakeholders is a central element of the monetary policy strategy review.

The ECB and the euro area national central banks have been holding dialogues with, among others, the European Parliament and national parliaments, the academic community, researchers and analysts, civil society organisations, local communities and citizens.

The Bank of Finland, for its part, held three domestic listening events in relation to the strategy review and held a webinar on international monetary policy (Finnish) in November 2020.

The listening events were aimed at climate and environmental leaders, students, and representatives from different sectors of the economy, including finance, labour unions and interest groups representing business and trade.

The webinar on international monetary policy was aimed at researchers and monetary policy professionals. Bank of Finland Governor Olli Rehn chaired the events.

The listening events thoroughly explored how changes in the operating environment for central banks have impacted on monetary policy. Participants expected central banks to take an active role in preventing both climate change and increasing inequality.

Other topics of interest in the discussion events were household and general government debt, the low interest rate environment and the limitations encountered by monetary policy, and the decline in economic growth caused by the pandemic and its aftermath.

Should the inflation target be changed?

Price stability was defined as the primary objective of the European Central Bank already in the Maastricht Treaty.

In addition to price stability, the ECB is tasked with supporting the other economic policy objectives of the EU, as long as price stability is not jeopardised. This mandate is not subject to change under the strategy review. Instead, the goal is to discover how changes in the economic environment have impacted on monetary policy.

The ECB's strategy review in 2003 led to the current formulation of price stability, which is defined as a rate of inflation below, but close to 2% over the medium term.

The ECB's two-step definition is ambiguous and leaves room for varying interpretations, both inside and outside the Governing Council.

The definition is also asymmetric. It can be interpreted as meaning that inflation can, temporarily at least, slow towards zero but has a strict upper bound of 2%.

The ECB's inflation target can be viewed as being tighter than the respective targets of other central banks, as they often simply define an inflation rate of 2% as their target.

A clearly asymmetric definition of price stability does well in situations where the central bank must grapple with the risk of inflation overshooting its target.

However, in an environment of downward price pressures, an asymmetric definition can lead to a risk of undershooting inflation, falling far short of a 2% average.

What sort of definition of price stability, then, is most appropriate for an environment of low inflation and a low natural rate of interest? One viable alternative would be a symmetric and unambiguous inflation target. This would do away with any of the aforementioned problems.

Structural changes in the economy are contributing to low inflation

The ECB's strategy review is needed more than ever due to the prolonged period of low inflation and the damage to the economy wrought by the COVID-19 pandemic.

Yet the strategy review has also been prompted by changes in the structures of the economy. These include a suspected change in the relationship between inflation and employment, i.e. a change in the Phillips curve, and a decline in the general level of interest rates or, more technically speaking, a lower equilibrium real interest rate (or natural rate) where savings and investment are balanced in the economy.

First, even if the economy had very low levels of unemployment, it has been estimated that this would not generate as much inflationary pressure as before. That is, the Phillips curve might be significantly flatter than in the past, lowering the risk of high inflation.

Second, monetary policy has been constrained by the long-standing decline in interest rates. There is little available space for interest rate cuts if interest rates are already at zero or even in negative territory, even though this constraint has been mitigated with non-standard measures of monetary policy.

Third, the underlying fundamentals of the economy have changed since the global financial crisis. Inflation is being depressed by a number of long-term trends, including population ageing, increased aggregate saving, and slower productivity growth.

Fourth, climate change, ongoing globalisation, rapid digitalisation and the structural transformation of the financial sector following the global financial crisis are phenomena being observed all over the world. These might hold unpredictable consequences for the dynamics of the economy and for monetary policy. All of the aforementioned changes in the structures of the economy and their respective impacts on monetary policy are being assessed in the ECB’s strategy review.

The strategy review is also drawing on the experiences of other major central banks

The Federal Reserve System (the Fed, the US central bank) and the Bank of Canada have also reviewed their monetary policy strategies recently by taking stock of the changes in the economic environment.

At the core of the Fed's new strategy is ‘a flexible form of average inflation targeting’. This means that the central bank may allow inflation to overshoot its target if it has long persisted below target.

The goal here is to influence inflation expectations that have long remained too low. The employment rate will similarly be allowed to rise above normal levels for long periods of time without the central bank expecting it to lead to higher inflation.

The strategies of other central banks will inevitably have an impact on the operating environment of the European Central Bank — the ECB does not operate in a vacuum.

It is also notable that the Federal Reserve System announced its intention to undertake a comprehensive public review of its monetary policy strategy, tools, and communication practices roughly every 5 years, and to make adjustments as appropriate.

Support from other policy areas is also needed

The strategy review will draw on the research and expert work conducted daily at the ECB and the national central banks of the Eurosystem.

By holding the aforementioned listening events, the Eurosystem also wishes to leverage the views of euro area residents and different types of stakeholders.

The Bank of Finland wishes to better understand people’s expectations and concerns so that it may find the best way to fulfil its mandate of price stability and support economic policy more generally.

However, monetary policy will not be able to provide a solution for every problem, even once the ECB concludes its strategy review. Economic growth needs to be supported by other policy areas and cannot rest on an accommodative monetary policy alone.

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The European Central Bank's monetary policy and its preparation in 2020