The European Central Bank (ECB)’s Monetary Policy Strategy Review (MPSR) conducted in 2020–2021 provides little certainty as to whether the next few years will be more inflationary than the past decade, when the Eurozone persistently undershot its inflation target. Since the outcome of the MPSR will depend on the average growth rate of M3, the question is whether the MPSR provided any clarity on this issue. Following directly from a similar review conducted by the US Federal Reserve in 2019–2020, we find that exercise was unhelpful in determining a path for the amount of money in the United States or the Eurozone. Moreover, international trends in monetary policy away from ‘economic and monetary analysis’ – the Bundesbank-based founding principles of the ECB – towards interest rate management or adjusting policy to ‘financial conditions’ are unhelpful for achieving any target for broad money (M3 in the Eurozone). The original ‘reference value’ for M3 is shown to have been too low, but the ECB’s new reliance on interest rates and ‘financial conditions’ alone without retaining a quantitative anchor as part of its dashboard is risky. The revised framework of a symmetric inflation target widens the ECB’s discretion while retaining its new policy tools without committing to any core principles, resulting in a high degree of uncertainty about future M3 growth and inflation.

Keywords: ECB, monetary policy, money supply, liquidity effect, Fisher effect, inflation  

1. Introduction

In the two decades since its creation, the European Central Bank (ECB) has carried out two reviews of its monetary strategy, one in 2003 and one in 2021. The first was conducted against a backdrop of relative stability in economic activity and inflation, and relatively normal interest rates. Its main focus was the emphasis to be placed on the two pillars that took centre stage in the early days of the ECB’s foundation: the economic analysis and the monetary analysis (Issing, 2004). Already by 2003 it was becoming clear that the 4.5 per cent ‘reference value’ for M3 was being exceeded without serious inflationary consequences. Unfortunately, the outcome of the review was that the two pillars – the economic analysis and the monetary analysis – were downgraded for modelling and analytical purposes, although they retained a nominal presence in the ECB President’s monthly presentation of policy (Issing, 2004).[1]

The second review of 2020–2021 was conducted against a much less stable economic and political backdrop. Following the Global Financial Crisis (GFC) in 2008–2009 and the Eurozone debt crisis of 2011–2012, Euro area monetary policy had experienced enormous challenges. In the immediate aftermath of the GFC, it was plagued with negative and sub-par M3 growth, weak nominal GDP growth, and near-deflationary conditions. This was followed by the Euro area debt crisis, which required the introduction of a series of ‘non-standard policies’, notably the Securities Markets Programme (SMP, May 2010–September 2012), long-term refinancing operations (LTROs, 2011), Outright Monetary Transactions (OMT, 2012), and the Asset Purchase Programme (APP, consisting of corporate, asset-backed, and public sector securities purchases from 2015). Finally, as if the early and middle years of the last decade were not problematic enough, the onset of the COVID-19 pandemic in 2020 has required the ECB to embrace a further series of non-standard measures including TLTROs (targeted long-term refinancing operations) and the PEPP (pandemic emergency purchase programme). All these have drastically changed the way the ECB operates, forcing the Governing Council to consider how it should best fulfil its mandate in a dramatically changed environment.

Note that none of these non-standard policies was introduced with the specific aim of raising the amount of money (as measured by the M3 growth rate). After Mario Draghi won the existential battle to preserve the euro (with his declaration of ‘whatever it takes’ in July 2012), policy shifted to belated adoption of quantitative easing (QE) in 2015, and M3 growth finally accelerated modestly. But money growth has become less and less of a focus for Governing Council members.

The purpose of the current article is to assess whether the conclusions of the 2020–2021 Monetary Policy Strategy Review (MPSR) provide an adequate basis for assuring long-term stability of broad money growth and hence prices and purchasing power in the Euro area. My assessment will be presented in the light of developing trends in central bank policy strategy, particularly in the US, as well as against the gradual divergence from the original medium-term anti-inflation framework devised for the Eurozone but steadily pushed aside in favour of shorter-term goals.

The article is structured in three parts. To set the stage, section 2summarises the Fed’s 2019–2020 review, because the ECB’s review cannot be seen independently of the discussions and conclusions comprising the Fed’s review and the wider trends in central bank management strategies around the world. In some respects, the ECB review can be seen as a copycat exercise, starting and ending about a year after the Fed’s review. In the case of the ECB, the recent MPSR comes after a decade of major monetary policy challenges which, in my view, are best understood in the light of the shift in priorities from the original strong framework of the two pillars to a looser collection of ideas built around the management of interest rates. Section 3 therefore discusses some of the reasons why the strong original framework of the two pillars was maintained in name but not in substance, and how policy was conducted in practice following the downgrade of the two-pillar framework in 2003. Section 4 contains a brief theoretical explanation of why the current interest rate-dominated framework will likely founder. Section 5summarises the 2020–2021 MPSR and concludes that a return to a better formulated two-pillar framework would serve the people of the Eurozone better than the interest rate/financial conditions-led strategy which ECB policy has progressively adopted during the past decade.

2. The 2019–2020 review of the US Fed policy

The ECB’s 2020–2021 review took place against a background of the US Federal Reserve system having recently conducted the first-ever review of its policy in 2019–2020. The review took the Federal Reserve’s statutory mandate of full employment and price stability as given as well as the longer-run inflation objective of 2 per cent. The review process featured three key components (Board of Governors of the Federal Reserve System, n.d.):

  • A ‘Fed Listens’ initiative involving consultation with a broad range of people and groups across the country. This part of the exercise was aimed at reinforcing the Fed’s accountability by stressing diversity, inclusiveness, and openness to discussion with all groups. The ECB’s MPSR followed a similar format.
  • A more technical part of the review featured a flagship research conference hosted by the Federal Reserve Bank of Chicago. This brought policymakers together with leading academics and researchers to hear about research central to the framework review.
  • Finally, the Federal Open Market Committee (FOMC) discussed topics associated with the review at five consecutive FOMC meetings beginning in July 2019. This discussion was informed by analytical work by research staff across the Federal Reserve System and was reported in the minutes of those five meetings.

The results of the Fed’s review were announced on 27 August 2020 and rapidly earned the moniker ‘Flexible Average Inflation Targeting’. The key product of the review was a revised Statement on Longer-Run Goals and Monetary Policy Strategy, which lays out the goals for monetary policy, articulates the policy framework, and serves as the foundation for the Committee’s policy actions.

Among the more significant changes to the framework document were:

  • On full employment, the FOMC intends to pursue ‘maximum employment’ as a broad-based and inclusive goal. The Committee reported that its policy decision will be informed by its ‘assessments of the shortfalls of employment from its maximum level’. The motivation derives from the observation, mentioned several times in speeches by Fed governors and others, that lower income groups were benefiting significantly from employment and wage gains late in the cyclical expansion. The implied conclusion was that it was better to reach near-maximum employment as quickly as feasible after recovery so long as inflation was not triggered, rather than proceed with the kind of slow, ‘jobless’ recoveries that had characterised the three previous business cycle upturns (from March 1991, from November 2001, and from June 2009).
  • On price stability, the FOMC adjusted its strategy for achieving its longer-run inflation goal of 2 per cent by noting that it ‘seeks to achieve inflation that averages 2 percent over time’. To this end, the revised statement states that ‘following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time’. While it is highly unlikely that the Fed has this degree of control over the levers of policy and hence the inflation outcome, nevertheless, following a decade of undershooting on both employment and inflation targets, the Fed was adjusting its priorities to emphasise that it will try hard not to repeat the mistake of undershooting again. However, this worthy objective has already been torpedoed by the surge in consumer price inflation to over 7 per cent in late 2021 and early 2022 since the Fed will be compelled to spend 2023 and 2024 at least ensuring that inflation declines back towards its 2 per cent target zone, rather than maintaining an accommodative stance as they would prefer.

Ironically, the Fed came to these conclusions on maximum employment and 2 per cent average inflation just at the time – amid the pandemic – when broad money growth had been excessive, but the consequent inflation had not yet become evident. Therefore, the review concluded that central bank interest rates were more likely to be constrained by their effective lower bound than in the past. However, it has been clear for many months, in the light of the surge of inflation in 2021–2022, that the short-term outlook for policy rates must be for more rapid increases than central banks such as the Fed or the ECB were acknowledging back in 2020 or the first half of 2021. In other words, despite the elaborate façade of policy coherence that central banks have built up over the past two decades, the reality is that their interest rate- based policies have not controlled the mix of medium-term growth (or employment) and inflation anything like as closely as they may have claimed.

Three observations relevant to the ECB review are worthwhile at this stage. Firstly, the FOMC’s preferred instrument is interest rate adjustment. (The Bank of England has also made similar statements in recent months.) Secondly, due to the proximity of interest rates to the so-called effective lower bound (ELB), the FOMC stands ready to resort to balance sheet expansion whenever it might be deemed necessary, complementing such policies with forward guidance. A return to orthodox interest rate policies by the Fed and other central banks is clearly preferred but cannot be guaranteed. Thirdly, although unstated in its review, it is a fact that the Fed abandoned any attempt at managing – or even referencing – the quantity of money from the 1990s onwards, with the result that the inclusion of traditional monetary measures or similar quantitative criteria for judging the stance of monetary policy was not even considered in the recent Fed review.

The lack of any reference to a broad money supply aggregate means that the Fed does not have such variables anywhere on their ‘dashboard’ of key indicators, and the huge growth of money during the early part of the pandemic was ignored by the FOMC. Yet despite many claims about global factors such as supply chain disruptions or energy prices causing the inflation, the true reason for the surge in economic growth and inflation was the egregious increase in the broadly measured stock of money in the US since the onset of the pandemic in March 2020. By contrast, the much lower relative rates of broad money growth in China, Japan, and Switzerland over the two years 2020–2021 explain why inflation in those economies has remained much lower. This is despite these economies experiencing the same type of supply chain disruptions and similar energy price increases (see Greenwood & Hanke, 2021). The conclusion is that the Fed’s reliance on interest rate-based policies, as advocated in its review, is not a good formula for ensuring low and stable money growth in the future.

3. The 2003 Strategy Review and the ECB’s shift from the two pillars to interest rate management

Numerous contemporary papers and subsequent memoirs lay out the original philosophy adopted by the ECB at the start of the Eurozone. Confidence in the two-pillar framework derived from the long success of the Bundesbank in managing monetary policy for Germany in the post-war years after its formal creation in 1957. When the euro was formally introduced in January 1999, the expectation was that the new central bank for the Euro area, endowed with full independence from political direction and provided with the same operating philosophy, would operate on the same principles that the Bundesbank had followed so successfully for the previous four decades.

As mentioned in the introduction, the Eurozone’s chosen reference rate for M3 growth was 4.5 per cent, but it was not given the status of an intermediate target. Otmar Issing, previously chief economist at the Bundesbank and subsequently the first chief economist of the ECB, explained the ambivalence towards relying on the signal from M3 in a Mais Lecture (2004). He first expressed the desirability of including such information but then admitted that it had not been possible to include monetary aggregates into central bank modelling and therefore the Governing Council would, in a practical manner, look at everything affecting the inflation outlook.

Last but not least, inflation forecast targeting neglects the information stemming from monetary developments. Up to now it has not proved possible to integrate the monetary side into the inflation forecast in a satisfactory manner. Whether this will ever be possible in a convincing way – not least on account of the different horizons involved – remains a matter of conjecture. At any rate, the Governing Council is adhering to its stance of considering all important indicators and of according monetary factors a prominent position in its assessment of the risks to price developments and thus in its monetary policy. (Issing, 2004: 5)

In effect he was saying that ‘for good reason the ECB has chosen a strategy which does not focus exclusively on either a single indicator or a single analytical tool – be it money or an inflation forecast’.

The curiosity I wish to explore here is the difference between the chosen reference rate of 4.5 per cent for M3 and the reference rate that would have been appropriate for the newly created monetary union. To calculate the appropriate money growth rates for each economy I have used the Cambridge version of the equation of exchange (MxV = PxY), taking logs of both sides of the equation and differentiating with respect to time, which enables the data to be expressed in rate of change form (thus, m+v = p+y). The data in Table 1, where all the variables are shown as average rates of change over one year, strongly suggest that, for the four largest economies of the monetary union, the appropriate money growth rate – given the common 2 per cent inflation target, the different real GDP growth rates, and the annual change in desired money balances – would have been significantly higher than 4.5 per cent. On a simple average basis, a better rate would have been 5.2 per cent, although this ignores the fact that Italy had been a relatively high-inflation economy and therefore Italian velocity did not exhibit the normal downward trend shown in other economies. Omitting Italy, the appropriate reference rate for M3 would have been 6.0 per cent.

 Data RangepyvAppropriate M3 (= p+y-v)
West Germany1970–199822.9(-1.8)6.7% p.a.
France1971–200022.7(-0.9)5.6% p.a.
Italy1971–199822.5(+1.7)2.8% p.a.
Spain1971–200022.7(-0.9)5.6% p.a.
Average Av (ex-Italy)1971–1998 1970–20002 22.7 2.8(-0.5) (-1.2)5.2% p.a. 6.0% p.a.
Table 1. Calculation of appropriate growth rate for Eurozone M3 based on pre-1999 data (Data from Refinitiv; author’s calculations)

If we now consider what happened subsequent to the launch of the monetary union, the results again suggest that a higher reference rate for M3 would have been appropriate, not only for the four largest economies but also for the Euro area as a whole.

 Data RangepyvAppropriate M3 (= p+y-v)
Unified Germany1999–202121.3(-2.1)5.4% p.a.
France2000–202121.3(-3.1)6.4% p.a.  
Italy1999–202120.5(-2.8)5.3% p.a.
Spain1999–202121.8(-1.9)5.7% p.a.
Eurozone1999–202121.3(-2.6)5.9% p.a.
Table 2. Calculation of appropriate growth rate for Eurozone M3 based on data after 1999 (Data from Refinitiv; author’s calculations)

In all Euro area countries the real GDP growth rates slowed in the two decades after 1999, and in the Italian case it did so quite strikingly, from 2.5 per cent per annum to. to 0.5 per cent per annum. However, more than offsetting the declines in real GDP growth, the demand to hold money balances (the inverse of income velocity) increased substantially. This is the kind of result that perhaps should have been expected from creating a monetary union whose prime purpose was to keep inflation low and stable. On a simple average basis, the combination of lower real GDP growth but increased demand for money balances plus the 2 per cent inflation target in these four leading economies translates into an appropriate rate of growth of M3 of 5.7 per cent per annum. It should be noted, however, that this ignores the probability that smaller, faster-growing economies of the Euro area would almost certainly have raised this average even further in two ways – not only through their higher growth rate, but also because lower-income economies tend to see a faster rise in desired money balances relative to income (or a faster decline in velocity).

This naturally leads one to wonder, given that the M3 growth rate considerably exceeded the 4.5 per cent reference rate in the early years – averaging 8.4 per cent growth in 2001 and 6.7 per cent per annum for the five years 1999–2003, without generating inflation significantly above 2 per cent – whether one of the reasons for downgrading the monetary pillar in the 2003 review was that it had been set at too low a rate which was already obsolete by 2003 (European Central Bank, 1998).

In addition to problems with the M3 reference value, the other major factor to consider in the ECB’s shift away from the two pillars since 2003 is the prevailing intellectual climate surrounding monetary economics. In addition to its continued use of Phillips curves, the output gap, and other Keynesian tools of long standing, the economics profession had started to make extensive use of the so-called Taylor rule (1993), a device linking central bank interest rates to the level of the output gap (or in some versions the degree of tightness in the labour market) and the extent of overshoot or undershoot in inflation. The essence of this idea is that there is a monotonic relationship between central bank nominal policy rates on the one hand and the stance of monetary policy on the other: tighter policy requires higher rates, easier policy requires lower rates.

Although the Taylor rule concept is directly contrary to the teachings of Irving Fisher (in the sense that it assumes changes in nominal interest rates precede changes in inflation, whereas, whereas Fisher showed that the opposite was true) and in conflict with Milton Friedman’s aphorism that monetary policy is not about interest rates but about the growth of the quantity of money, it nevertheless attracted widespread professional attention. For example, modifications of the Taylor rule have been used to calculate theoretical negative central bank interest rates under QE.

Together with the Phillips curve and a dynamic IS curve (that is, one that incorporates expectations), the Taylor rule has featured in New Keynesian models to analyse monetary policy, culminating in the Clarida, Galí, and Gertler three equation model (1999). The subsequent two decades have seen further development, but although these ideas dominate academic analysis of monetary policy they do not perform well empirically.

For its part the Governing Council of the ECB has not wanted to adopt either a corrected two-pillar philosophy for the Eurozone economy or the prevalent New Keynesian orthodoxy. Its approach in the years preceding the recent review has remained pragmatic, paying lip service to the original two pillars but not actually adjusting policy to conform to the implicit recommendations of either monetarist or New Keynesian schools. Thus the monthly press conferences of the President of the ECB following the meeting of the Governing Council almost invariably contained the following three sentences (or something very close to them):

  1. ‘Let me now explain our assessment in greater detail, starting with the economic analysis …’ [emphasis here and below in the original].
  2. ‘Turning to the monetary analysis, the annual growth rate of broad money (M3) …’
  3. ‘To sum up, a cross-check of the outcome of the economic analysis with the signals coming from the monetary analysis confirmed …’

This formulaic presentation appeared to remain true to the original two-pillar design, in part no doubt to placate the conservative, anti-inflation interests on the Governing Council. In practice, however, the wide deviation of monetary growth on either side of the appropriate M3 growth rate – for example, the double-digit growth of M3 in 2007–2008 followed by the collapse to year-on-year declines between October 2009 and May 2011 – showed either that the Governing Council did not pay much attention to such deviations from the original reference value, or that the Governing Council felt unable to adjust the monetary growth rates in the short to medium term, even if it had the intention to do so.

Since the announcement of the new monetary policy strategy on 8 July 2021, this formula for presenting Governing Council discussions and decisions has been abandoned. Instead, after some introductory remarks, the President’s speech now contains the following sections: Economic Activity, Inflation, Risk Assessment, Financial and Monetary Conditions, and a Conclusion. It is noteworthy that since July 2021 the section on Financial and Monetary Conditions has included regular mention of financing conditions, market interest rates, and bank lending as well as bank balance sheets and profitability, but the narrative has been entirely qualitative, with no specific numbers being mentioned in this section. Reporting on the amount of money (as measured by M3) in the President’s remarks has been dropped entirely.

4. Theoretical and empirical objections to an interest rate-based strategy

At this point it is worthwhile to spell out briefly why purely interest rate-based strategies for managing monetary policy are liable to be unsound. In any diagram of supply and demand in economics there are two axes: typically, a horizontal quantity axis and a vertical price axis, as in the quantity of wheat and the price of wheat. When it comes to money, however, this convention is routinely broken. On the vertical axis teachers and students alike usually show interest rates. This occurs even in widely taught concepts such as IS-LM curves, or in the Keynesian liquidity preference diagram. The problem is that interest rates are not the price of money – they are the price of renting or borrowing money for a specific period, that is, the price of credit per unit of time. The price of money, however, is its opportunity cost – what a certain number of units can purchase, best expressed as the inverse of the price level, or as an exchange rate for another currency.

The problem with these diagrams is that the experience of the world is the exact opposite of what is shown in the supply/demand diagrams. According to the liquidity preference diagram, if the quantity of money is increased, interest rates decline. Yet if we ask, ‘In which countries of the world are interest rates lowest?’, the answer will be economies such as Japan or Switzerland or the Eurozone. But this is not because they have been increasing the quantity of money rapidly. On the contrary, these economies have been holding down the growth of money. They have low interest rates because there is negligible inflation and economic growth is weak.

Similarly, if one asks the question, ‘In which countries of the world are interest rates highest?’, the answer will be economies such as Venezuela or Argentina or Turkey. But this is not because they have been holding down the quantity of money. On the contrary, these economies have been increasing the quantity of money rapidly. They have high interest rates because they have inflation.

These phenomena are essentially what Irving Fisher showed: high interest rates tend to reflect a strong economy and high or rising inflation expectations. Conversely, low interest rates tend to reflect a weak economy and low or falling inflation expectations. Later Milton Friedman showed that interest rates go through a two-stage cycle during a business cycle upswing and the opposite two-stage cycle during a business cycle downswing. Initially interest rates tend to fall temporarily during a monetary acceleration, but then as the economy strengthens, as the demand for credit rises and inflation expectations rise, interest rates will tend to rise. Conversely, in a downturn, initially interest rates tend to rise temporarily during a monetary deceleration, but then as the economy weakens, as the demand for credit falls and inflation expectations decline, interest rates will tend to fall. A short-term liquidity effect in one direction is followed by a longer-term inflation (Fisher) effect in the opposite direction. In short, policymakers cannot rely on the level of interest rates to judge the state of the economy or the stance of monetary policy.

Translated into a policy prescription for the ECB, this means that a monetary policy strategy that is led by interest rates alone without regular reference to the growth of the quantity of money can easily become unanchored – much as we have seen with the US Federal Reserve’s monetary policy during the pandemic, when the desire to ensure low rates and smoothly functioning credit markets resulted in an increase in the quantity of US M2 in excess of 40 per cent in less than two years. By abandoning the two-pillar strategy, as the ECB did in the 2020–2021 review of its strategy, this is the risk the ECB is taking.

Expressed more robustly, given an inflation target and knowing the real GDP growth potential and the trend of money holding in the economy (the inverse of velocity), we can specify an optimum or appropriate monetary growth rate (for broad money) for any economy. By contrast, there is no equivalent for the short-term policy rate of a central bank – notwithstanding the huge literature on r* (the real interest rate that should pertain when an economy is in equilibrium, meaning that unemployment is at the natural rate and inflation is at the target rate). Depending on the state of the economy and inflation expectations, 6 per cent broad money growth may initially require the central bank’s main policy rate to be 0 per cent, 2 per cent, 4 per cent, or 8 per cent, and even then, it may require further adjustment. This is the essence of the argument here – priority should be given to money growth, not to interest rates. But sadly, or unwisely, the ECB appears to have taken M3 off its dashboard.

5. The ECB’s 2020–2021 Monetary Policy Strategy Review and prospects for the future

In January 2020, the ECB announced a Monetary Policy Strategy Review with the aim of ‘making sure our monetary policy strategy is fit for purpose, both today and in the future’. Since the 2003 review, the ECB had stressed that declining economic growth linked to slower productivity growth and demographic factors implied lower ‘equilibrium real interest rates’ (ECB, 2021a, 2021b). In turn, this had reduced the scope for the ECB to achieve its inflation mandate by relying on changes in policy interest rates alone. This interest rate-driven framework has dominated monetary policy in the Euro area – and elsewhere – for the past two decades, with any changes in monetary aggregates at best a secondary consideration, but more often largely ignored. In the ECB’s case I showed how the President’s regular press statement after each meeting of the Governing Council paid lip service to the growth of monetary aggregates. With this backdrop in mind, the ECB sought – on the basis of consultations with private financial institutions, governments, and private citizens – to consider whether it could develop a new approach to monetary policy in the face of persistently below-target inflation.

When the ECB’s new strategy was announced on 8 July 2021, the reactions both in the financial markets and in the financial media were relatively muted, suggesting that there were no significant or substantive changes in the way the ECB will conduct monetary policy in the future. Initially a 12-point summary of the ECB’s review was released, and later, a more complete ‘Overview of the ECB’s Monetary Policy Strategy’ was published. Item 9 of the 12-point release provides a convenient summary of some of the key issues relating the old, two-pillar framework to the proposed, new decision-making and operating procedures of the ECB in the future:

9. The Governing Council bases its monetary policy decisions, including the evaluation of the proportionality of its decisions and potential side effects, on an integrated assessment of all relevant factors. This assessment builds on two interdependent analyses: the economic analysis and the monetary and financial analysis. Within this framework, the economic analysis focuses on real and nominal economic developments, whereas the monetary and financial analysis examines monetary and financial indicators, with a focus on the operation of the monetary transmission mechanism and the possible risks to medium-term price stability from financial imbalances and monetary factors. The pervasive role of macro-financial linkages in economic, monetary and financial developments requires that the interdependencies across the two analyses are fully incorporated. This framework reflects the changes that the ECB’s economic analysis and monetary analysis have undergone since 2003, the importance of monitoring the transmission mechanism in calibrating monetary policy instruments and the recognition that financial stability is a precondition for price stability [emphasis added]. (European Central Bank, 2021b)

The wording of the above paragraph pays tribute to the former two-pillar formula while building in ‘financial indicators’ (to allow more attention to interest rates and yield spreads), ‘the monetary transmission mechanism’ (code for how interest rate and yield changes impact the wider Euro area financial system), ‘the possible risks to medium-term price stability from financial imbalances’, and ‘the recognition that financial stability is a precondition for price stability’. In short, the new formula insists – perhaps understandably from a political accountability perspective – that the members of the Governing Council will now look at everything in coming to their decisions on monetary policy and will not be bound by the strictures of the old, two-pillar framework. Crucially, they will be more concerned with shorter-term market considerations than medium-term inflation forecasts based on M3.

Part 4 of the ECB’s Overview document (2021a) is headed ‘ECB’s Integrated Analytical Framework’ and makes the case for further downgrading the role of monetary aggregates in future analysis. The claim is made that ‘[t]he monetary analysis has shifted from its main role of detecting risks to price stability over medium to longer-term horizons towards a stronger emphasis on providing information for assessing monetary policy transmission’. The authors justify this change with three arguments: (1) a weakening of the empirical link between monetary aggregates and inflation – a claim that could surely be challenged; (2) impairments in monetary policy transmission during the global financial crisis; and (3) the broadening of the ECB’s monetary policy toolkit.

After stating that ‘the new framework will replace the previous two-pillar framework and discontinue the cross-checking of the information derived from the monetary analysis with the information from the economic analysis’, there is a judicious amount of back-pedalling. Although ‘the integrated analytical framework will continue to consider the information from monetary and credit aggregates’, the emphasis will move to various parts of the transmission mechanism such as ‘the credit, bank lending, risk-taking and asset pricing channels’. The claim is that ‘such assessments facilitate the identification of possible changes in transmission (for example related to structural factors such as the rise in non-bank financial intermediation) or impairments in transmission, for example owing to fragmentation or market stress’. 

In summary, based on its review, the ECB has shifted further away from the Bundesbank tradition of focus on monetary factors as the primary driver of inflation towards the prevailing consensus of interest rate-led monetary policy among major central banks. That consensus largely discounts the lagged relationships between broad money aggregates (such as M3 in the Eurozone) and their impact on asset prices, spending, and inflation in favour of an analysis that relies more on the short-term transmission of monetary policy via interest rates, other ‘macro-financial linkages’, and their effects on the stability of the financial system. As we have seen with the Fed’s recent experience, success in ensuring price stability based on this modus operandi is far from guaranteed.

6. Conclusion

The majority of the proposals from the ECB’s Monetary Policy Strategy Review are cosmetic at best and mainly serve to entrench the new paradigm of interest rate-based central bank policies adopted across advanced economies. There are three key concepts:

  1. A 2 per cent average or symmetric inflation targeting mandate related to the Fed’s flexible average inflation targeting scheme.
  2. Further movement away from reliance on monetary aggregates towards reliance on discretionary judgements about the appropriate level of interest rates or financial conditions, supposedly with a view to monitoring the transmission of monetary policy.
  3. A stress on inflation expectations rather than actual inflation or money and credit growth as the ultimate guide to monetary conditions (that is, whether monetary growth is too slow or too rapid).

Whether this combination of policies will produce a better record of stable money growth and steady inflation in future seems highly unlikely. More probably, once the current episode of inflation has been brought under control, balance sheet ratios and capital requirements imposed on commercial banks by Basel III and other regulations will again lead to sub-par growth of bank balance sheets and hence deposit money or M3. In turn, this will bring low inflation and low rates, followed by another crisis which will require the ECB to create money directly from its balance sheet using non-standard measures instead of relying on the commercial banks.

If the ECB wishes to raise inflation sustainably to the 2 per cent target, it will need to raise the average growth rate of the broad money supply (M3), perhaps to 6–7 per cent per annum. The ECB could easily achieve this by adjusting its QE asset purchase programme to include non-bank counterparties, or by reducing capital and liquidity requirements imposed on the commercial banking sector. In the absence of such reforms, the new MPSR paradigm summarised by the three concepts above will have little material effect on the growth in money and bank credit, meaning any extended impact on inflation will also be minimal.


Board of Governors of the Federal Reserve System, Review of Monetary Policy Strategy, Tools, and Communications, https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications.htm.

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Greenwood, J. & Hanke, S. H. (2021). ‘On Monetary Growth and Inflation in Leading Economies, 2021–2022: Relative Prices and the Overall Price Level’, paper presented at University of Buckingham, IIMR Conference, December.

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[1] The economic analysis focuses mainly on the assessment of current economic and financial developments from the perspective of the interplay between supply and demand in the goods, services, and factor markets. The monetary analysis serves as a means of cross-checking, from a medium- to long-term perspective, the short- to medium-term indications arising from the economic analysis. In October 1998 the Governing Council assigned a prominent role to money in recognition of the fact that, in the medium to long run, monetary growth and inflation are closely related. This provides the Governing Council with key information at time horizons stretching beyond those usually adopted for the construction of central bank inflation projections. The prominent role assigned to money in the ECB’s strategy is signalled by the announcement of a reference value for monetary growth. However, the monetary analysis seeks to provide a comprehensive survey of the liquidity situation, thereby going far beyond an assessment of monetary growth in relation to the reference value.


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