Monetary policy during normal times

During normal times inflation-targeting central banks, including the ECB, the Bank of England and the Fed, use interest rates to respond to macroeconomic shocks that push inflation above or below target. Central banks react to positive inflation shocks by raising official rates and to negative shocks by cutting official rates. The standard transmission channels of monetary policy include (a) expectations; (b) money market interest rates, which, in turn, affect bank lending rates; (c) asset prices; (d) money and credit; and (e) the exchange rate. All five of these channels influence supply and demand in goods and labour markets, which determine both domestic and import prices. A schematic illustration of the transmission mechanism, as viewed by the ECB, is provided in Figure 4.1.

The primary objective of the ECB, established by the Treaty on the Functioning of the European Union, is price stability. Although the treaty does not give a precise definition of price stability, the Governing Council defines it as “a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2%”. The Governing Council has, in addition, clarified that it aims to maintain inflation rates “below, but close to, 2% over the medium term”. The main idea behind putting a figure on price stability is that it makes monetary policy more transparent. There are several reasons for aiming at below, but close to, 2 per cent, some of which are technical, but the main one is that it provides an adequate margin to reduce the risk of deflation. Central banks fear deflation more than inflation; this is because there are limits to how much interest rates can be cut when inflation is negative. Specifically, negative interest rates on savings can be disruptive to the financial system, because they encourage firms and households to hold cash or real assets instead of bank deposits. Negative interest rates can, therefore, lead to financial disintermediation – a reduction in savings held by the financial system, which can be severely detrimental to the financing of small and medium enterprises, as well as households.