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The Governing Council of the ECB has to influence the level of short-term interest rates to ensure that price stability is maintained over the medium term.
To do so, the Governing Council needs
- to interpret economic developments,
- to analyse their implications for future risks to price stability, and
- to take into account how its policy decisions are transmitted to the economy.
The central bank constantly faces a high level of uncertainty regarding
- the nature and size of economic shocks. An economy is permanently subject to largely unforeseeable economic shocks, such as oil price changes or technological innovations. These can affect the economy in different ways. The appropriate monetary policy for maintaining price stability depends on the circumstances. For example, the appropriate monetary policy response to an oil price increase will be different from that required in the case of a decrease in demand. Yet another response will be necessary depending on whether the oil price increase is expected to be temporary or long-lasting.
- the existence and strength of the relationships that link macroeconomic variables;
- the transmission mechanism of its policy impulses to the economy.
The ECB's principles
To deal with this uncertainty, the ECB's strategy aims to
- preserve the functioning of the transmission mechanism. The proper functioning of the money market is central to the transmission of the ECB’s policy rates. Dysfunctional money markets can weaken the capacity of monetary policy to influence the outlook for price stability through interest rate adjustments alone. The great financial crisis has demonstrated that the orderly transmission of monetary policy can be hampered when massive financial turbulences occur. In order to keep the transmission mechanism fully operational and to ensure the maintenance of price stability over the medium term, a central bank may need to introduce non-standard policy measures, i.e. liquidity interventions aimed at facilitating the transmission of the interest rate policy and enhancing the flows of credit to the broad economy.
- be forward-looking. Owing to the lags in the transmission process, changes in monetary policy today will only affect the price level after several quarters or years. This means that central banks need to ascertain what policy stance is needed today in order to maintain price stability in the future, after the transmission lags unwind.
- focus on the medium term. Monetary policy should have a medium-term orientation in order to avoid the introduction of unnecessary volatility into the real economy. The transmission lags make it impossible in the short run for monetary policy to offset unanticipated shocks to the price level (for example, those caused by changes in international commodity prices). Some short-term volatility in inflation rates is therefore unavoidable. In addition, the transmission process is complex and there is always a large element of uncertainty about the effects of monetary policy. About the medium-term orientation.
- firmly anchor inflation expectations. Monetary policy is considerably more effective if it firmly anchors inflation expectations. In this respect, it is crucial that the central bank specifies its goal, sticks to a consistent and systematic method for conducting monetary policy, and communicates its decisions and actions clearly and openly.
- be broadly based. Like any other central bank the ECB faces considerable uncertainty about the reliability of economic indicators, the structure of the euro area economy and the monetary policy transmission mechanism, among other things. A successful monetary policy therefore has to be broadly based, taking into account all relevant information and using several approaches and models in order to understand the factors driving economic developments.