By Andreas Charalambous and Omiros Pissarides
During 2020, the European Central Bank (ECB) undertook a strategic review of its policy framework. Such a review requires an in-depth evaluation while constituting best practice for private and public entities.
Without any doubt, the role of central banks is crucial for national economies and markets. Traditionally, central banks focused on impacting inflation expectations and indirectly preserving macroeconomic stability as a necessary precondition for enabling steady growth. The main tools at their disposal were the setting of key interest rates, the control of money supply and the provision of liquidity to the banking system (effectively acting as ‘lenders of last resort’).
Recently, particularly after the financial crisis of 2008, the role of central banks was expanded substantially. A characteristic example is the ECB, which, in an attempt to fight deflation, did not hesitate in moving into negative interest rate territory and proceeding with sizeable asset purchases, including those of sovereign bonds, over a long period of time, attempting to lead inflation towards its announced target, notably ‘close to but below 2 per cent’. This policy approach received wide publicity, following the well-known statement ‘’whatever it takes’’ from then-ECB president Mario Draghi. It is generally acknowledged that this saved the eurozone. It has become even more entrenched over the last year, in the context of the policies adopted by the ECB to help counter the pandemic.
The recent strategic review of the ECB reinforces its expanded role. Inflation remained the main target which has been set at 2 per cent, instead of the hitherto target of ‘close to but below 2 per cent’ and it will be interpreted in a symmetric manner, reflecting the emphasis on fighting excessive inflation and, in parallel, deflation. Moreover, the reformed analytical framework focuses on the evolution of core inflation and the medium-term outlook and not on short-term fluctuations. Additionally, price developments in the housing market will be incorporated in this overall analytical framework.
A noteworthy additional dimension relates to climate change, whereby the ECB expressed its willingness to take into account the impact of climate change, particularly in the context of its supervisory mandate.
The above do not constitute revolutionary reforms. However, in practical terms, the new policy framework will allow for more flexibility in the formulation of monetary policy and an increasingly patient approach towards temporary upward inflation pressures.
The reaction of market participants has been favourable. Despite the recent increase of inflation, especially in the US but also in the EU, the sovereign and equity markets continue to function smoothly, while liquidity conditions remain supportive.
The so-called traditional economists have expressed reservations against the new ECB policy framework, pointing to risks of future inflation pressures as well as increases in private and public indebtedness. Other economists believe that the ECB should have adopted more radical and far-reaching reforms. What may prove to be a sound way forward is a combination of continuing accommodative monetary policies and in parallel the formulation of an effective exit strategy to be pursued when overall conditions have normalised.
Andreas Charalambous is an economist and former director of the Ministry of Finance. Omiros Pissarides is the managing director of PricewaterhouseCoopers Investment Services