Introduction
The European Central Bank (ECB) has embarked on what might be its most profound transformation since its creation in 1998. This shift from a strictly rule-based approach to greater discretion in setting monetary policy priorities acknowledges the reality of a world marked by external shocks. However, this change also brings significant risks.
The ECB’s New Strategy
At first glance, the changes in the ECB’s policy framework appear relatively modest. The medium-term inflation target remains at 2%, and the principle of symmetry, where rates above or below the target are equally undesirable, is maintained. The most significant change lies in how the ECB defines and fulfills its mandate.
While EU treaties establish that price stability is the sole objective of the ECB, policymakers have broad discretion to interpret this goal. The updated strategy sees the ECB evaluating the proportionality of its decisions by weighing policy benefits against potential economic and financial risks. Decisions will no longer be guided exclusively by “the most likely trajectory of inflation.” Instead, the ECB will operate as a risk manager.
This measure allows the ECB to refrain from implementing measures that, while necessary for maintaining price stability in the medium term, may have severe side effects or prove largely ineffective. Consequently, the inflation target may lose its primacy, and larger or prolonged deviations might be tolerated.
Christine Lagarde’s Perspective
In a speech introducing the new strategy, ECB President Christine Lagarde emphasized that such deviations would only be permitted if inflation expectations remained well-anchored. Lagarde argued that a “persistent” policy response could replace a “forceful” one. In other words, the ECB might favor gradual and sustained interest rate increases over sharp hikes.
However, this reasoning is fundamentally flawed because the two approaches differ in their effectiveness, especially during crises when trade-offs become more apparent and the cost of inaction increases. For instance, between 2015 and 2019, then Bundesbank President Jens Weidmann repeatedly criticized the ECB’s large-scale bond purchases, which drove German sovereign bond yields into negative territory, destabilized financial markets, and increased pressure on financial institutions.
Global Economic Realities
The revised ECB strategy reflects the realities of a global economy marked by frequent disruptions, from financial and debt crises to pandemics, geopolitical conflicts, energy price hikes, and environmental disasters. In today’s world, it’s unrealistic to expect central banks to maintain price stability at all times using conventional tools, especially when doing so risks significant collateral damage and undermines public trust.
In this context, the ECB’s new strategy seems timely and prudent, providing policymakers with the necessary flexibility to navigate a challenging economic landscape. However, questions remain: At what point do side effects justify deviating from the price stability objective? Which economic factors will policymakers consider when making these decisions? Will attention be limited to stability, employment, and growth, or will it extend to issues like inequality, innovation, and European integration?
Lessons from the U.S. Federal Reserve
The U.S. Federal Reserve offers valuable insights into addressing these questions. With a dual mandate, the Fed can balance its two primary objectives: maintaining price stability and achieving maximum employment. In contrast, the ECB formally adheres to a single objective. However, the new ECB strategy effectively broadens its mandate, potentially allowing a wider range of considerations to prevail over the inflation target when necessary.
Risks and Challenges
Loss of Credibility
The effectiveness of a central bank depends not only on its tools but also on its ability to anchor inflation expectations. If the ECB’s actions appear erratic, confidence in its commitment to price stability may wane. To preserve trust, policymakers must define and communicate the principles guiding their decisions, setting limits on their discretion.
Marcel Fratzscher, former high-ranking official at the ECB, is president of the DIW Berlin expert group and professor of Macroeconomics and Finance at Humboldt University in Berlin.
Communication and Consensus Risks
Increased flexibility heightens the risk of communication breakdown and market uncertainty. The ECB’s Governing Council, a political body dominated by national central bank governors, already struggles to convey a unified message due to its members’ representation of their home countries’ interests and preferences.
As policymakers begin to consider factors beyond price stability, disagreements are more likely to arise, complicating consensus. Lack of coherence in messages could create uncertainty about the ECB’s policy direction and contribute to market volatility.
Independence at Risk
The ECB risks losing some of its de facto independence. A more flexible strategy could open the door to increased political pressure. For example, governments might push for a more accommodative monetary policy to create fiscal space or accept higher debt levels. This dynamic could lead to a form of fiscal dominance, with broad implications for the ECB’s autonomy and long-term credibility.
Conclusion
The ECB’s new strategy is an audacious and necessary step acknowledging the realities of a multipolar, crisis-prone world. However, it must clearly articulate how it will assess potential trade-offs, under what conditions it might deviate from traditional policy responses, and how it plans to ensure that greater discretion doesn’t undermine its effectiveness. By combining strategic flexibility with increased transparency and clear communication, the ECB can protect its independence and meet growing demands in an increasingly unstable global economy. Its credibility—and influence—depend on it.
