Introduction

Institutions dedicated to serving the public good must look to the past to learn from experience; and look to the future to prepare, as best they can, for the trials that might lie ahead. The 20th anniversary of Economic and Monetary Union (EMU) offers an opportunity to apply such a perspective to the monetary policy of the European Central Bank (ECB): to evaluate its accomplishments and to learn the lessons that can improve the conduct of its policy in the future....

Strategy in Action

The policy framework of the European Central Bank (ECB) attracted both bouquets and brickbats in the pre-crisis era. This chapter aims to assess those arguments with hindsight: was policy successful in delivering the objective or was it instead ‘inattentive’, as some critics at the time claimed? We argue that the euro area economy faced a series of inflationary supply shocks and the policy framework was helpful in those conditions. The perceived asymmetry of the inflation objective—with a hard ‘ceiling’ at 2%—allowed automatic adjustments in underlying conditions, including inflation expectations, to do a large part of the stabilization job. However, we show that this self-stabilizing mechanism also admits a second regime: if the economy enters a situation where negative demand shocks dominate, the ‘ceiling’ ceases to bind and act as a stabilizer, leading inflation to drift downwards. We contend that the ECB may have entered such a regime after the financial crisis.

The Foundations

The design of the European Central Bank (ECB) reflected a decades-long evolution of academic thinking and real-world experience concerning the optimal practice of central banking. In this chapter, we aim to unpack these influences and explain how they motivated both the drafters of the ECB’s statute and the economists in the national central banks who set the ECB up. We concentrate on the ideas that were dominant at the turn of the last century and the principles that were seen to constitute ‘good’ monetary governance, including the notion that monetary policy should focus primarily on price stability. We show how these principles were not only echoed in the EU Treaty, but also ‘hard-coded’ into the policy framework that, by the second half of the 1990s, had come to prominence in academic and policy circles: inflation targeting and its counterpart in econometrics, the New Keynesian model.

The Crisis

This chapter offers a comprehensive account of the European Central Bank’s (ECB) actions in the early phases of the financial crisis. We show how, despite stubborn inflation pressures, the ECB responded effectively to post-Lehman shock, inter alia by quantifying the effect of moving to ‘fixed rate with full allotment’ lending in regular and longer-term operations. We nonetheless demonstrate that the potency of this response was partially constrained by the ECB’s ‘passive’ approach to liquidity provision—which hinged on demand from banks—and the ‘separation principle’ between interest rate decisions and liquidity operations. We lay out how these principles began to dissolve with the launch of the ECB’s first bond-buying programmes—the Securities Market Programme in 2010 and the Outright Monetary Transactions programme in 2012—and quantify the effects of these measures. In particular, we document the sequence of events that led up to President Draghi’s famous ‘whatever it takes’ announcement.

The Second Regime

That the euro area economy had switched over into the second regime described in Chapter 3 became more evident in the last phase of the crisis. In this chapter, we describe the landscape facing the ECB in 2013 and 2014, with disinflationary demand shocks replacing inflationary cost-push shocks as the dominant force in the economy. With conventional policy unavailable, we outline the series of unconventional policies launched by the European Central Bank (ECB) to avert a multi-year depression and the deflation scenario that would have accompanied it. We chart the evolution from a policy of ‘separation’ to one of ‘combination’, with different policies seen as mutually reinforcing in fighting deflation risks. We illuminate how the ECB responded to key obstacles such as breaking through the zero lower bound (ZLB) on interest rates and implementing liquidity policies in a deleveraging banking sector.

The ECB Strategy and Its Critics

While the EU Treaty established the European Central Bank’s (ECB) primary objective as price stability, defining price stability was left to the ECB’s Governing Council (GC). This chapter shows how the GC chose to formulate an objective that subtly but consciously differed from the standard inflation targeting framework of the time. Rather than expressing a preference for a particular rate of inflation, a ‘target’ that could be changed if circumstances changed, it opted to qualify price stability unconditionally as an inflation rate below 2%. We explain some of the factors behind this decision and describe the process whereby, already in 2003, the ECB’s monetary policy strategy came to be reviewed. The internal debates that informed the ECB’s characteristic ‘below but close to 2%’ objective and ‘two pillar’ strategy are discussed. The chapter also focuses on the ECB’s early critics.

A Combined Arms Strategy

The culmination of the European Central Bank’s (ECB) policy evolution was the ‘combined arms strategy’ that started taking shape in 2014–2015. In this chapter, we review how four unconventional measures—negative interest rates, asset purchases, targeted lending operations, and forward guidance—were progressively combined into a unified policy package. We recount the sequence of ‘recalibrations’ of these tools that took place between December 2015 and June 2018 and the internal debates that informed them. We then conduct an impact analysis where we seek to isolate and examine the contribution of the policy package to financial conditions and macroeconomic outcomes. The novelty of our analysis lies both in its methodological approach and in its diagnostics, which allows us to disentangle the respective contribution of each instrument and assess counterfactual scenarios in which they were not combined. We end by considering some of the side effects of our unconventional policies with a focus on the banking sector.