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The ECB’s monetary policy strategy Back  
The European Central Bank recently made its first interest move since 2003 when it raised interest rates by 25 basis points. Here we examine the two pillars of the ECB’s monetary policy strategy - economic analysis and monetary analysis.
Economic analysis: The economic analysis focuses on the assessment of current economic and financial developments and the implied short to medium-term risks to price stability. It analyses all factors which are helpful in assessing the dynamics of real activity and the likely development of prices in terms of the interplay between supply and demand in the goods, services and labour markets. The economic analysis also pays due attention to the need to identify the nature of shocks hitting the economy, their effects on cost and pricing behaviour and the short to medium-term prospects for their propagation. To take appropriate decisions, the Governing Council needs to have a comprehensive understanding of the prevailing economic situation and be aware of the specific nature and magnitude of economic disturbances which threaten price stability.

The ECB regularly reviews developments in overall output, demand and labour market conditions, a broad range of price and cost indicators, fiscal policy, and the balance of payments for the euro area. Developments in financial market indicators and asset prices are also closely monitored. Movements in asset prices may affect price developments via income and wealth effects. For example, as equity prices rise, share-owning households become wealthier and may choose to spend more on consumption. This adds to consumer demand and may fuel domestic inflationary pressures. Conversely, should equity prices fall, households may reduce consumption.

Asset prices and financial yields can also be used to derive information about expectations in the financial markets, including expected future price developments. For example, when buying and selling bonds, financial market participants implicitly express expectations about future developments in interest rates and prices. Using a variety of techniques, the ECB can analyse financial prices to extract the markets’ implicit expectations for future developments.

Developments in the exchange rate are also carefully assessed for their implications for price stability.
Exchange rate movements have a direct effect on price developments through their impact on import prices. Changes in the exchange rate may also alter the price competitiveness of domestically produced goods on international markets, thereby influencing demand conditions and potentially the outlook for prices. If such exchange rate effects alter the expectations and behaviour of wage and price-setters, the potential for second-round effects may exist.

Monetary analysis: The ECB’s monetary analysis relies on the fact that monetary growth and inflation are closely related in the medium to long run. Assigning money a prominent role therefore underpins the medium-term orientation of the ECB’s monetary policy strategy. Indeed, by taking policy decisions not only on the basis of the short to medium-term indications stemming from the economic analysis, but also on the basis of money and liquidity considerations, the ECB is able to see beyond the transient impact of the various shocks and avoids any temptation to take an overly activist course.

To signal its commitment to monetary analysis and provide a benchmark for the assessment of monetary developments, the ECB has announced a reference value for the growth of the broad monetary aggregate M3. This reference value refers to the rate of M3 growth that is deemed to be compatible with price stability over the medium term.

In December 1998 the Governing Council set this reference value at 41⁄2 per cent per annum and confirmed it in subsequent reviews. The reference value is based on the definition of price stability and on the medium term assumptions of potential real GDP growth of 2-21⁄2 per cent and a decline in the velocity of circulation of
money of between 1⁄2 per cent and 1 per cent.

The reference value is not a monetary target but a benchmark for analysing the information content of monetary developments in the euro area. Owing to the medium to long-term nature of the monetary perspective, there is no direct link between shortterm monetary developments and monetary policy decisions. Monetary policy does not therefore react in a mechanical way to deviations of M3 growth from the reference value.

The ECB’s monetary analysis is not limited to the assessment of M3 growth in relation to its reference value. Many other monetary and financial variables are closely analysed on a regular basis.

Source: The European Central Bank

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