2.1 European Central Bank began normalising its monetary policy in 2022
Surging inflation prompted the European Central Bank (ECB) to begin monetary policy normalisation. The ECB tightened its monetary policy in stages during the year, raising its key interest rates and recalibrating its monetary policy purchase programmes. In 2022, the ECB also transitioned from issuing forward guidance to taking policy rate decisions meeting by meeting on the basis of incoming data.
Monetary policy responds to changing inflation outlook in 2022
Before 2022, interest rates were exceptionally low and the ECB’s key policy rates were negative. Interest rates were low because the outlook for inflation was weak: inflation was projected to remain persistently below the ECB’s inflation target.
The global economic crisis caused by the COVID-19 pandemic resulted in a heightened risk of deflation. Central banks responded to the economic crisis by introducing a very accommodative monetary policy stance and, at the lower bound of interest rates, stimulating the economy through asset purchases and longer-term refinancing operations.
As the COVID-19 pandemic subsided, the rise in inflation in 2022 was stronger and more persistent than had been projected. Inflation surged worldwide (Chart 2). Post-pandemic market-based inflation expectations rose significantly in both the United States and the euro area.
In the euro area, the surge in inflation has been attributable to a combination of increased global demand following the pandemic, a strong upward trend in import prices and pandemic-related supply disruptions. Because the euro area is dependent on energy imports, the surge in energy prices caused by Russia’s invasion of Ukraine pushed up inflation more in the euro area in 2022 than in the United States.
Central banks responded to the high level of inflation by tightening their monetary policy. The ECB launched a gradual normalisation of its monetary policy, meaning that it began raising its key interest rates and phasing out non-standard monetary policy measures.
Using monetary policy to bring inflation down to the medium-term price stability objective is not a quick process, however. Monetary policy will influence the medium-term outlook for inflation and the way in which wages and inflation expectations are affected by the supply disruptions that are putting pressure on costs.
Policy rates are the main tool in monetary policy normalisation
Monetary policy normalisation means that key interest rates – or policy rates – are once again becoming the main tool for setting monetary policy. At the same time, asset purchases and other non-standard monetary policy measures are gradually being ended. Normalisation will lead to a tightening of financing conditions, which will reduce inflationary pressures in the economy.
In the euro area, the process of monetary policy normalisation started in December 2021, when the ECB Governing Council decided on a set of principles for tightening its monetary policy. Net asset purchases would be reduced gradually. Policy rates in the euro area would be raised only after the termination of net asset purchases.
The ECB communicated cautiousness over its interest rate policy. Euro area interest rates had been exceptionally close to the effective lower bound for a prolonged period, leaving little room for lowering nominal interest rates further (see Recent economic crises have modified the Bank of Finland’s market operations). The aim was to avoid a premature tightening of monetary policy after the pandemic.
With inflation rising faster and more persistently than expected, the ECB Governing Council has raised the key ECB interest rates at an exceptionally quick pace since its monetary policy meeting in July 2022. Between July and December, the ECB deposit facility rate was raised from -0.5% to 2%, a cumulative hike of 2.5 percentage points. The Governing Council has also signalled that further interest rate rises will be required in the near future.
The interest rate increases ended a seven-year period of negative interest rates in the euro area. At the same time, the ECB Governing Council has transitioned from issuing forward guidance to taking decisions on policy rates meeting by meeting and based on incoming data.
The pace of monetary policy tightening is determined according to the inflation outlook and inflation expectations, with the objective of bringing inflation down to the target of 2% over the medium term. Market rates, such as the 12-month Euribor rate, have increased on the back of higher policy rates (Chart 3).
ECB also ended its net asset purchases
In July 2022, the ECB ended its net purchases of assets. However, it continued to reinvest, in full, the principal payments from maturing securities held in its portfolio. In December 2022, the ECB Governing Council decided that from March 2023 onwards, it would begin gradually reducing the amount of these reinvestments.
Following the discontinuation of net asset purchases and longer-term refinancing operations, the ECB’s balance sheet has no longer been growing. The balance sheet currently stands at about EUR 8 trillion, equivalent to about 65% of euro area GDP. The asset purchase programmes account for about EUR 5 trillion of the ECB balance sheet (Chart 4).
A special characteristic of the euro area’s monetary policy is the diversity of growth figures among the euro area national economies. This could, in the extreme, lead to a differentiation of financial markets in the euro area and prevent the appropriate transmission of the monetary policy stance to market rates and lending rates. Besides the effects of monetary policy normalisation, the general uncertainty associated with the economic environment and the sustainability of public debt has contributed to a rise in the long-term yields on euro area government bonds.
If unwarranted or disorderly market dynamics were to pose a serious threat to the transmission of monetary policy across the different countries of the euro area, the Governing Council has at its disposal a number of tools to safeguard the transmission mechanism such that it can ensure it delivers on the ECB’s price stability mandate. One such tool is flexibility in the portfolio reinvestments of maturing securities purchased under the pandemic emergency purchase programme (PEPP). In July, the Governing Council approved the new Transmission Protection Instrument (TPI) to further secure the transmission of monetary policy.
Effective transmission of monetary policy in all circumstances will support the normalisation of monetary policy and achievement of the inflation target over the medium term. To achieve price stability in the euro area, it is essential that the ECB operates independently in determining its monetary policy stance and that countries’ debt-servicing capacity is at a sustainable level.