Central banks were often established in the past with the aim of bringing stability in the aftermath of historic episodes. The Bank of England was established during the sovereign debt crisis of 1690, when the government was unable to obtain funding in the market. The Federal Reserve was created after a series of panics that had rocked the US banking system in the late 19th and early 20th century. The euro was introduced 20 years ago in response to repeated episodes of exchange-rate instability and the need to secure the Single Market against competitive devaluations. The ECB was established as the keystone of the new Economic and Monetary Union (EMU). The first decade of the Monetary Union was characterised by calm macroeconomic conditions, with limited volatility and steady economic growth. The second decade, however, has seen profound shifts in the prevailing environment – including both financial and sovereign debt crises – and our monetary policy strategy has had to adapt with it. I would like to discuss why this evolution came about and how it was achieved – and what the past twenty years can tell us about the ECB’s monetary policy in the future.
The ECB’s mandate is given by the Treaty as price stability. In 1998, the Governing Council defined price stability as inflation within a range of 0-2% over the medium term, which constitutes the ECB’s objective. Then, in 2003, the Governing Council clarified that, within this range, it would aim at a focal point of below, but close to, 2%, which remains our medium-term aim to this day. This was a formulation that differed from the standard inflation-targeting framework of the time, which was typically based around a point target for inflation. But there were sound reasons why this definition was put in place.
In common with central banks across the world, the ECB faced a macroeconomic environment before the crisis that was predominantly defined by low volatility and moderate shocks, with the distribution of shocks to inflation almost exclusively to the upside. In the euro area, HICP energy prices rose by 80% between January 1999 and September 2008. Under these conditions, establishing a strong reaction function against high inflation was seen as crucial to anchor inflation expectations. Emphasising an aim of “below, but close to, 2%” was seen to imply a stronger commitment than a standard inflation-targeting regime.
But monetary policy in the euro area also faced a special challenge. The ECB was a new central bank operating in a very heterogeneous monetary union, which created a particular imperative to establish inflation credibility. Establishing a commitment to controlling inflation was seen as critical to cement lower inflation expectations across the euro area – especially as moderate inflation was a relatively new phenomenon in several Member States.
Over the two decades up to 1999, inflation had averaged above 3% in 10 of the 12 original members. The decline in inflation in many countries in the run-up to EMU was in large part due to expectations of joining, as well as to a number of extraordinary actions taken by national authorities to meet the convergence criteria. From 1989-99, long-term inflation expectations had fallen from a range of between 2.5-4.5% in the four largest euro area economies to below 2% across the board. It was now the task of the new central bank to lock in this moderate-inflation environment – and it did so successfully. Over the next decade, inflation expectations internalised the ECB’s commitment to keep inflation down and remained below 2%.
But this process of building inflation credibility had implications for the ECB’s reaction function. As a matter of accounting, stabilising headline inflation largely caused by its volatile components must mean that core inflationadjusts downwards. Rolling cross-correlations between energy inflation and core inflation show that an episode of high energy inflation between 1999 and 2007 was accompanied by a period of rapidly softening core inflation. As a result, between January 1999 and September 2008 headline inflation in the euro area averaged 2.35%, while core inflation averaged 1.7% and exceeded 2% less than 15% of the time.
Central banks in other advanced economies faced similar challenges and adopted similar strategies. But differences in mandates – and length of track records in fighting inflation – led to differences in how much energy price pass-through to headline inflation others were comfortable accommodating. For example, energy prices in the US CPI rose by 160% over the same period and headline inflation averaged 2.9%. The Federal Reserve reacted less to headline inflation, and core CPI inflation averaged 2.2%.
The upshot was that the euro area entered the crisis having succeeded in establishing its anti-inflation credentials, but with underlying inflation dynamics that were perhaps relatively weaker. This was not immediately apparent, as inflation stayed at fairly elevated levels for more than four years after the Lehman crash. Monetary policy responded decisively to the global financial crisis and disinflationary threats seemed to pass quickly.
But in hindsight it seems reasonable to conclude that the inflation process was vulnerable to a shift in the environment – which is what transpired from around mid-2012 onwards.
At this point, headline inflation in the euro area began what was, in retrospect, a prolonged downward drift, and core inflation fell by almost a percentage point from mid-2012 to early 2014. There are two factors that help explain the switch to a disinflationary trend.
First, the distribution of shocks to inflation moved strongly to the downside and the amplitude of the shocks increased. Supply-side shocks gradually dissipated over the years following the Lehman crash and the sovereign debt crisis. Negative demand shocks, driven at different times by domestic demand and external demand, instead became the dominant source of macroeconomic fluctuations in the euro area. ECB analysis shows that negative demand shocks have weighed on euro-area inflation by more than 1 percentage point on average since the start of the crisis. In the previous ten years, their effect was neutral overall, with periods of both upward and downward pressure.
The second factor was a change in the macroeconomic policy mix. While in the first phase of the crisis fiscal and monetary policy had eased in tandem – with fiscal policy loosening by a total of about 3% of potential GDP between 2008 and 2010 – thereafter the stance of monetary and fiscal policy decoupled. The euro area fiscal stance turned contractionary in response to the sovereign debt crisis, tightening by around 4 percentage points of potential GDP until 2013 – years the euro area was mostly in recession.
This editorial was published with permission of The European Central Bank, Speech by Mario Draghi, President of the ECB, ECB Forum on Central Banking, Sintra, 18 June 2019