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Abstract

Lower neutral rates of interest have eroded the policy space necessary to fight recessions. Against this backdrop, several central banks are re-assessing how their strategy and tools can be refined to best achieve their goals. The European Central Bank (ECB) should be no exception. Its strategy review should focus on redefining the inflation objective and on developing contingency plans for using its statutory authority creatively to achieve its mandate.

Executive Summary

• Lower neutral rates of interest have eroded the monetary policy space to fight the next recession for central banks around the world. Against this backdrop, several of them are reviewing their strategy and framework to see if they can be improved.
• In the euro area, the typical process of interest rate normalisation that takes place during a recovery has not even started, so the ECB has even less scope than other central banks to cut policy rates.
• The ECB is, however, well placed to improve its strategy and framework, especially given the high degree of discretion that it enjoys compared to other central banks when it comes to introducing new policy instruments.
• The paper recommends that the ECB start a broad review of its strategy along the lines of those happening in Canada and Sweden. In particular, the ECB should not follow the Federal Reserve in its decision to exclude a redefinition of its inflation objective from the review.
• The paper views (1) the redefinition of the price stability objective and (2) establishing contingency plans for using new instruments as the two most urgent elements on which the review should focus.
• The ECB should redefine price stability as a year-on-year increase in the Harmonised Index of Consumer Prices for the euro area close to 3 percent. By providing a higher starting point for bond yields across the yield curve, a higher inflation target could provide a total increase in policy scope that is equivalent to a 300 basis points cut in the policy rate.
• The ECB should not only detail how the parameters governing the use of its current instruments could be modified to provide more stimulus but also explore adding new instruments to its toolkit such as equity purchases and outright cash transfers to households.

Introduction

Monetary policy reviews are used to assess whether, and in what possible ways, a central bank's strategy, tools, and communication practices can be refined to achieve and maintain its goals as consistently and robustly as possible (Clarida 2019). The Federal Reserve System (Fed) and the Bank of Canada (BoC) initiated monetary policy reviews in 2018. European Central Bank (ECB) President Christine Lagarde signalled in September that she would be open to doing the same for the euro area.

This paper discusses the motivation for performing a monetary policy review at the ECB and what such a review should look like. It also provides background and policy recommendations for some elements of the ECB's monetary policy strategy. We focus these recommendations on two urgent elements: (1) the redefinition of price stability and (2) the need for additional monetary instruments. Other elements, such as the two-pillar analysis or the communications framework, could be improved at the margin. But they are far less important and should not detract from the requisite focus on these most urgent challenges.