- THE ECB BLOG
The new monetary policy strategy: implications for rate forward guidance
Philip R. Lane, Member of the Executive Board of the ECB
Frankfurt am Main, 19 August 2021
Today, I will explain the revision to the Governing Council’s rate forward guidance that we announced in our latest meeting. This should be viewed as a fundamental step in implementing our new monetary policy strategy, since it is essential that our approach to setting our policy rates is fully aligned with delivering our symmetric two per cent inflation target over the medium term.
Forward guidance on the path of interest rates is an effective tool to steer interest rate expectations. In particular, state-contingent formulations of forward guidance provide a powerful automatic stabilisation mechanism. In one direction, should the inflation outlook improve more than anticipated, the expected time horizon to the first increase in interest rates automatically shortens. In the other direction, if there were setbacks to the inflation outlook, the time to lift-off would automatically lengthen. In general, the systematic approach to monetary policy embedded in rate forward guidance has the capacity to boost inflation expectations and thereby strengthen inflation dynamics. In turn, stronger inflation dynamics are the key to eventual normalisation of policy rates.
The new monetary policy strategy
The new monetary policy strategy incorporates two innovations that warranted an update to our forward guidance on interest rates: first, the redefinition of our price stability objective as a symmetric two per cent inflation target over the medium term; and, second, a conditional commitment to take into account the implications of the effective lower bound when conducting policy in an environment of structurally-low nominal interest rates.
The two per cent inflation target is intended to provide a sufficient safety margin to protect the effectiveness of monetary policy in responding to disinflationary shocks. The symmetry of the inflation target means that the Governing Council considers negative and positive deviations of inflation from the target to be equally undesirable.
The conditional commitment to take into account the implications of the effective lower bound when conducting policy in an environment of structurally-low nominal interest rates reflects the asymmetric nature of the constraint imposed by the effective lower bound. While central banks can technically raise nominal interest rates without limits, there is only limited space to lower rates into negative territory, owing to the lower bound on cash. This limited ability to lower rates, if left unaddressed, will result in persistent downward deviations of inflation from the target, especially if the economy is repeatedly hit by disinflationary shocks. In turn, this could result in inflation expectations settling below the central bank’s target inflation rate.
To address the asymmetry of the effective lower bound constraint, the commitment to a symmetric inflation target requires especially forceful or persistent monetary policy action when the economy is close to the effective lower bound, to avoid negative deviations from the inflation target becoming entrenched. Proximity to the lower bound can arise either from a low equilibrium real interest rate or from large and persistent disinflationary shocks influencing the inflation expectations embedded in nominal interest rates, or from a combination of the two factors.
An especially forceful or persistent response to negative deviations is warranted by the need to support the anchoring of longer-term inflation expectations at two per cent, which helps to maintain price stability over the medium term. This implies that, faced with large adverse shocks, our policy response will include an especially forceful use of its monetary policy instruments. In addition, closer to the effective lower bound, it may also call for a more persistent use of these instruments. This may also imply a transitory period in which inflation is moderately above target.
Rate forward guidance
A commitment to maintain monetary accommodation on a persistent basis is essential in view of the effective lower bound constraint and the shortfall in the medium-term inflation outlook relative to the two per cent target.
Under the conditions we currently face, forward guidance reinforces the Governing Council’s commitment to attaining the inflation target by clarifying that our policy rates will be lifted only if the evidence is sufficiently robust to allow us to see with a high degree of confidence that the inflation rate will reach two per cent on a durable basis. In particular, our revised forward guidance spells out how our policy reaction will be especially persistent in conditions in which nominal interest rates have been close to their lower bound for some time and the outlook for inflation is still well below our target.
Specifically, our forward guidance now reads:
“In support of its symmetric two per cent inflation target and in line with its monetary policy strategy, the Governing Council expects the key ECB interest rates to remain at their present or lower levels until it sees inflation reaching two per cent well ahead of the end of its projection horizon and durably for the rest of the projection horizon, and it judges that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at two per cent over the medium term. This may also imply a transitory period in which inflation is moderately above target.”
Following the preamble that underscores that alignment with the newly-adopted strategy and in support of the symmetric two per cent inflation target, the forward guidance describes three key conditions that should be met before interest rates are raised:
The first condition “until we see inflation reaching two per cent well ahead of the end of our projection horizon” provides reassurance that the convergence of inflation towards the new target should be sufficiently advanced and mature at the time of policy rate lift off. Moreover, requiring the inflation target to be reached “well ahead of the end of the projection horizon” helps to hedge monetary policy against the risk of reacting to forecast errors, which tend to be larger at longer horizons.
The second condition that we expect inflation to reach two per cent not only well ahead of the end of the projection horizon but also “durably for the rest of the projection horizon” telegraphs that reaching the inflation target should be lasting and not just be the result of short-lived forces that lead to one-time increases in prices that are unlikely to lead to persistently higher year-over-year inflation.
The third condition “progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at two per cent over the medium term” signals that policy rates should not be lifted unless underlying inflation is also judged to have made satisfactory progress towards the target. This condition is based on the realised data and provides an extra safeguard against a policy tightening in the face of cost-push shocks that might elevate headline inflation temporarily but fade quickly.
It is important to keep in mind that “underlying inflation” is a broad concept and refers to the persistent component of inflation that filters out short-lived, reversible movements in the inflation rate and provides the best guide to the medium-term inflation developments. In view of the state-contingent nature of the forces shaping underlying inflation trends, underlying inflation is not proxied by any single indicator, and central banks routinely monitor a host of measures of underlying inflation. These measures typically range from simple exclusion measures that strip out certain volatile components of inflation to more complex statistical approaches that exploit the cross-sectional variation of all inflation components, and thereby also account for persistent effects of volatile inflation components. It follows that some judgement is required both in terms of the choice of indicators and the assessment of their signals, while at the same time, the analysis of realised underlying inflation adds discipline to the assessment of whether inflation is set to stabilise at the target over the medium term.
Finally, the sentence that the forward guidance “may also imply a transitory period in which inflation is moderately above target” makes explicit that rate forward guidance that is committed to avoiding premature tightening may imply that inflation runs moderately above the target for a temporary period. However, such transitional dynamics are fully in line with delivering the two per cent inflation target in the medium term. The transitory property of such a phase is underpinned by the commitment to lift rates once we see inflation reach two per cent on a durable basis, conditional on this criterion being met well in advance of the end of the projection horizon and that realised progress in underlying inflation is sufficiently advanced to be consistent with inflation stabilising at two per cent over the medium term. More generally, the acknowledgement that the persistent policies that may be required to address the implications of the effective lower bound may imply such transitory phases in which inflation is moderately above target is included in paragraph 6 of the monetary policy strategy statement.
The opening sentence of paragraph 8 of our monetary policy strategy statement stipulates that “The ECB is committed to setting its monetary policy to ensure that inflation stabilises at its two per cent target in the medium term.” Through the strong set of conditions linking our policy rates to reaching the two per cent target, our new rate forward guidance is an elemental step in fulfilling this commitment. In addition to rate forward guidance, paragraph 8 also highlights the potential roles of asset purchases and longer-term refinancing operations, as appropriate, in addressing the effective lower bound constraint on policy rates. We stand ready to adjust all of our instruments, as appropriate, to ensure that inflation stabilises at our two per cent target over the medium term.
The revision to rate forward guidance constitutes just the first step in implementing our new strategy. The monetary policy strategy statement lays out the range of factors that will shape our monetary policy decisions in the coming months and years, with further context provided by the accompanying overview document. Accordingly, the new monetary policy strategy should be viewed as laying strong foundations for future decision-making, in the service of delivering our price stability objective.
- For empirical evidence on the macroeconomic effects of rate forward guidance in the euro area, see Andrade, P. and Ferroni, F. (2021), “Delphic and Odyssean monetary policy shocks: Evidence from the euro area”, Journal of Monetary Economics, Vol. 117, pp. 816-832; Coenen, G., Montes-Galdón, C. and Smets, F. (2020), “Effects of State-Dependent Forward Guidance, Large-Scale Asset Purchases and Fiscal Stimulus in a Low-Interest-Rate Environment”, Working Paper Series, No 2352, ECB, Frankfurt am Main; Jarociński, M. and Karadi, P. (2020), “Deconstructing monetary policy surprises: The role of information shocks”, American Economic Journal: Macroeconomics, Vol. 12, No 2, pp. 1-43; Kortela, T. and Nelimarkka, J. (2020), “The effects of conventional and unconventional monetary policy: identification through the yield curve”, Research Discussion Papers, No 3, Suomen Pankki – Finlands Bank; Rostagno, M., Altavilla, C., Carboni, C., Lemke, W., Motto, R. and Saint Guilhem, A. (2021), “Combining negative rates, forward guidance and asset purchases: identification and impacts of the ECB’s unconventional policies”, Working Paper Series, No 2564, ECB, Frankfurt am Main; and Zlobins, A. (2019), “Macroeconomic effects of the ECB’s forward guidance”, Working Paper Series, No 3, Latvijas Banka. For similar evidence on the United States, see Bundick, B. and Smith, A. L. (2020), “Should We Be Puzzled by Forward Guidance?”, Research Working Papers, No 20-01, Federal Reserve Bank of Kansas City; D'Amico, S. and King, T. (2015), “What Does Anticipated Monetary Policy Do?”, Working Papers, No 2015-10, Federal Reserve Bank of Chicago; Kim, K., Laubach, T. and Wei, M. (2020), “Macroeconomic Effects of Large-Scale Asset Purchases: New Evidence”, Finance and Economics Discussion Series, No 2020-047, Board of Governors of the Federal Reserve System, Washington, D.C.; Lakdawala, A. (2019), “Decomposing the effects of monetary policy using an external instruments SVAR”, Journal of Applied Econometrics, Vol. 34, Issue 6, pp. 934-950; and Lunsford, K.G., (2020), “Policy Language and Information Effects in the Early Days of Federal Reserve Forward Guidance”, American Economic Review, Vol. 110, No 9, pp. 2899-2934.
- For a discussion of the automatic stabilisation function of forward guidance see, for example, Lane, P.R. (2020) “The monetary policy toolbox: evidence from the euro area”, Keynote speech at the 2020 US Policy Forum, New York. Calendar-based formulations of forward guidance can also play a role by providing certainty that rates will not be lifted within a specified interval.
- For discussions of measures of underlying euro area inflation see, for example, European Central Bank (2018), “Measures of underlying inflation for the euro area”, Economic Bulletin, Issue 4; Nickel, C. and O’Brien, D., (2018), “The ECB's measures of underlying inflation for the euro area”, VoxEU.org, Centre for Economic Policy Research; Banbura, M. and Bobeica, E. (2020), “PCCI – a data-rich measure of underlying inflation in the euro area”, Statistics Paper Series, No 38, ECB, Frankfurt am Main.
- The common factor in these different measures of inflation is that these seek to distinguish, in quasi real time, the signal on medium-term inflationary pressures contained in the HICP inflation data from the noise of idiosyncratic factors. At the same time, the estimation can be performed at different levels of statistical complexity, ranging from the exclusion of some components of inflation on account of their volatility, to the estimation of complex statistical models exploiting cross-sectional variation in inflation components.
- See The ECB’s monetary policy strategy statement.
- See the ECB’s Overview of the monetary policy strategy.