Overcoming myopia in the ECB's 2025 monetary policy strategy review

van 't Klooster, Jens Research Report Overcoming myopia in the ECB's 2025 monetary policy strategy review Fachtexte Provided in Cooperation with: Dezernat Zukunft - Institute for Macrofinance, Berlin Suggested Citation: van 't Klooster, Jens (2025) : Overcoming myopia in the ECB's 2025 monetary policy strategy review, Fachtexte, Dezernat Zukunft e.V., Berlin This Version is available at: https://hdl.handle.net/10419/317066 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc/4.0/ 1 of 32 #MONETARYPOLICY #INFLATION #ECB Overcoming myopia in the ECB’s 2025 monetary policy strategy review Jens van ’t Klooster [email protected] 05.05.2025 • The ECB’s strategy is under review, and rightly so. Recent inflation shocks have exposed weaknesses in the ECB’s current approach. It focuses too narrowly on medium-term inflation expectations and relies almost exclusively on interest rate adjustments. • The strategy is blind to structural inflation risks. Supply-side disruptions, corporate pricing power, and climate-related shocks were key drivers of the 2022-23 inflation surge, yet these risks lie outside the ECB’s analytical framework and time horizon. • Rate hikes alone are a blunt and costly tool. The ECB’s reactive approach left it with few options beyond raising rates, which did little to curb cost-push inflation at the source and risked undermining investment in long-term resilience, especially in clean energy. • The ECB’s framework can be updated. Though mindful of 1970s-style inflation and inspired by the Bundesbank’s success in fighting it, the drafters of the ECB mandate recognised the uniqueness of these circumstances and deliberately gave the central bank the flexibility to adapt to new economic challenges. • The 2025 review is a chance to do so. The ECB must equip itself to detect and address structural risks before they materialise - and coordinate more effectively with other EU policy tools to preserve price stability in turbulent times. • This report makes three policy recommendations: 1. Broaden the time horizon of the ECB’s strategy to include the long-term preconditions for price stability. 2. Create a third analytical pillar dedicated to long-term risks, including climate change, energy dependence, demographics, market power and geopolitical disruptions. 3. Embed monetary policy in a wider EU inflation governance framework that supports strategic coordination with fiscal, industrial and competition policies. Executive Summary* Institute for Macrofinance *I want to thank Max Krahé for his very helpful comments and detailed edits as well as Ludovic Suttor-Sorel, Aurora Li and the rest of the Dezernat team for their editorial support. The European Central Banks (ECB) monetary policy strategy specifies its price stability objective and its approach to achieving it. Since starting operations in 1998, the ECB has reviewed that strategy and made minor changes in 2003 and 2021. A new review is taking place this year. The recent wave of record inflation has revealed limits in the ECB’s current strategy. Policy deliberation in its Governing Council has a narrow focus on expected consumer price increases on a twoto fiveyear time horizon, which also shapes its analytical framework. This focus reflects a specific theory of what is needed to achieve price stability derived from the Bundesbank’s success in taming inflation during the 1970s. Using a credible commitment to act on excessive demand, the ECB seeks to “anchor” inflation expectations and prevent self-reinforcing price-wage dynamics. In the face of large and persistent shocks, however, this approach creates a stark dilemma1. Unlike in wage bargaining or fiscal policy, where strategic players internalise the expected central bank reaction, well-anchored inflation expectations proved ineffective in preventing inflation driven by large, heterogeneous supply shocks and implicit coordination in firm pricing. As a result, the current ECB strategy did not prevent the initial surge of inflation from late 2021 on. Once a surge of this kind is underway, the central bank’s existing approach leaves it stuck between a rock and a hard place. It can do nothing and wait for the effects of the shock to dissipate; however, this still carries the risk of de-anchoring expectations. Alternatively, it can turn to economy-wide interest rate policy to bring down demand. This is effective at reining in inflation, but comes with collateral damage to investment, jobs and growth. To escape this dilemma, the optimal policy is neither to aggressively hike rates nor to do nothing; it is to pre-emptively avert such circumstances in the first place. This, however, requires a conception of price stability that is not limited to a medium-term time horizon. Prior to 2021, the ECB had a monetary pillar dedicated to threats to long-term price stability. Given its narrow focus on monetary aggregates, however, this pillar was abandoned, leaving the ECB without an analytical lens that reaches beyond the medium term. Hence this report’s main conclusion: The ECB must overcome the myopia embedded in its current strategy and analytical framework. Specifically, the ECB should: 1. Broaden the time horizon of its monetary policy strategy to make the long-term preconditions of price stability part of the price stability objective 2. Integrate the analysis of latent and structural risks to price stability into a third long-term pillar of its analytic framework 3. Position its monetary policy strategy within a wider EU inflation governance framework, emphasizing complementarities and scope for coordination. Moreover, building on recent scholarship, this report shows that the ECB’s legal mandate leaves ample room to introduce the necessary reforms. The drafters of the mandate deliberately left the monetary policy strategy open, allowing it to “respond adequately to changing market conditions”. Doing so now will equip the ECB to identify and potentially remedy structural risks to price stability before they materialise. When shocks do occur, as they inevitably will, both their impact as well as their proliferation and amplification may then be meaningfully dampened. Extended summary 2 of 32 Institute for Macrofinance Christine Lagarde, ‘A Robust Strategy for a New Era’ (25th ECB and Its Watchers conference organised by the Institute for Monetary and Financial Stability, Goethe University Frankfurt, 12 March 2025), https://www.ecb.europa.eu/press/key/date/2025/html/ecb. sp250312~915537d675.en.html. 1 3 of 32 BACKGROUNDPAPER Table of Contents 1. Introduction .....................................................................................................4 2. The ECB’s mandate and the historical origins of the strategy review ......7 2.1 The 1970s as a model for inflation fighting? ................................................................... 7 2.2 The deliberate openness of the ECB mandate ...........................................................10 3. The ECB’s monetary policy strategy and its medium-term orientation ......................................................................................................13 3.1. The ECB’s medium-term orientation ............................................................................ 13 3.2. The evolution of the ECB’s analytical framework ........................................................17 4. Lessons from the 2021-23 inflation experience .........................................19 4.1 Supply constraints, cost shocks and firm pricing strategies in the 2022 inflationary experience ................................................................................................... 19 4.2 Five lessons from the 2022 experience ..........................................................................22 5. Moving beyond myopia in the ECB’s new strategy ....................................27 5.1 Implications for the objectives and analytical framework ........................................ 27 5.2 Implications for toolbox and inflation governance ......................................................29 4 of 32 BACKGROUNDPAPER Introduction1. The 2022 inflationary experience saw the European Central Bank fail to achieve its 2% inflation target, with inflation in some Member States reaching double digits (Figure 1). This report investigates which lessons are to be drawn from that experience. It asks: what changes are needed to the ECB’s monetary policy strategy in order for it to be adequately prepared for more volatile economic circumstances, such as those of the immediate aftermath of the COVID-19 pandemic or a trade war? The ideas concerning inflation and price stability that inform the ECB’s monetary policy strategy have not changed dramatically since the 1990s. The ECB’s understanding of the transmission mechanism between monetary policy and price stability focuses on the business cycle and economy-wide demand, particularly as driven by wage growth and government spending. By implementing a credible commitment to act on excessive demand, central banks today seek to “anchor” inflation expectations and prevent self-reinforcing dynamics of higher wages and prices from emerging. Figure 1: Euro Area Inflation; Sources: Macrobond, Eurostat 5 of 32 BACKGROUNDPAPER This report makes the case that the ECB’s current monetary policy strategy is unduly myopic. In counteracting inflation, the ECB’s 1998, 2003 and 2021 strategies have a medium-term focus, seeking to stabilise inflation over a twoto five-year time horizon. As a result of this medium-term focus, the current strategy lacks a framework to consider the long-term economic preconditions of price stability. This allows certain risks to price stability to build up under the radar, such as overextended supply chains, changes in firm pricing strategies, energy dependencies, demographic pressures from an ageing workforce, or the rising risks of trade conflicts or geopolitical conflict. Independently of whether the central bank is the best place to address each of these particular risks, it should maintain a systematic awareness of all of them. The strategy also focuses the ECB’s attention on demand-focused measures. However, not all risks to price stability are best managed via demand-side measures. This was the case for the main drivers of the post-pandemic inflation, for example, which fell almost entirely outside the scope of the ECB’s current monetary policy strategy. That inflation originated in long and ultimately brittle and overextended supply chains and from unreliable access to energy as an economic input. European policymakers had not paid enough attention to these drivers in the years leading up to 2022. These sectoral disruptions in turn coalesced into economy-wide inflation through anti-competitive firm pricing strategies. Such “sellers’ inflation” was possible because a synchronous rise in costs allowed competing firms to anticipate and coordinate price increases. This allowed firms to raise prices without the fear of losing market share. The ECB’s aggressive use of demand-focused monetary policy measures helped bring down inflation, but also had clear limitations. Looking at the 2022 experience implies clear lessons for the review of the ECB’s strategy. (1) Economies can become so vulnerable to shocks that central banks may struggle to mitigate their immediate effects with existing instruments. Even ex ante well-anchored inflation expectations proved ineffective in addressing inflation driven by large and heterogeneous supply shocks and amplified by firm pricing strategies. (2) The ECB's strategy of waiting for supply shocks to dissipate proved inadequate. While there were good reasons to wait initially, this approach left the ECB with few good options as inflation surged. (3) Using conventional monetary policy tools in this context also had important downsides from the perspective of long-term price stability. Curbing demand via interest rate increases can undermine long-term price stability by increasing the cost of crucial investments, particularly in clean energy. This myopic approach makes the EU economy more vulnerable to future inflationary shocks. This report’s main policy conclusion is that the ECB should extend the time horizon over which it considers and acts on risks to price stability. Extending this time horizon will allow the central bank to better identify and deal with existing trade-offs between the use of demandfocused interest rate hikes and their negative impact on both the supply-side long-term preconditions of price stability and the broader economic policies of the EU. These trade-offs exist irrespective of whether inflation has demandor supply-side origins. Incorporating these preconditions into the strategy will allow the ECB’s Governing Council to take them into account in its deliberations, e.g. for avoiding the trade-off by setting distinct interest rates for distinct purposes for which money is used. Accordingly, this report makes three proposals. The ECB should ●Broaden the time horizon of the ECB’s strategy to make the long-term preconditions of price stability part of the price stability objective ● Integrate the analysis of long-term risks to price stability into a third long-term price stability pillar of the analytic framework ●Position the ECB’s strategy within a broader EU inflation governance framework, emphasising complementarities and scope for coordination. 6 of 32 BACKGROUNDPAPER The report is structured as follows: Chapter 2 sets out the most recent legal research on the interpretation of the ECB mandate, presenting recent archival evidence concerning the deliberate choice to provide the ECB with ample scope for revising its monetary policy strategy. Chapter 3 turns to the strategy’s medium-term objective and its associated understanding of the transmission mechanism. Chapter 4 turns to the 2022 post-pandemic inflation episode to draw out important lessons for the monetary policy strategy review. Chapter 5 makes three proposals for said review. 7 of 32 BACKGROUNDPAPER 2. The ECB’s mandate and the historical origins of the strategy review 2 3 4 5 This chapter draws extensively on Jens van ’t Klooster, ‘The Case for a European Credit Council: Historical and Constitutional Fine-Tuning’, Accounting, Economics, and Law: A Convivium 14, no. 4 (1 November 2024): 519–32, This chapter draws extensively on Jens van ’t Klooster, ‘The Case for a European Credit Council: Historical and Constitutional Fine-Tuning’, Accounting, Economics, and Law: A Convivium 14, no. 4 (1 November 2024): 519– 32, https://doi.org/10.1515/ael-2022-0074 and a book project on the history of monetary policy since the 1970s. Kathleen McNamara, The Currency of Ideas: Monetary Politics in the European Union (New York, NY: Cornell University Press, 1998); Harold James, Making the European Monetary Union (Cambridge, MA: Harvard University Press, 2013). Thomas J. Sargent and Neil Wallace, ‘Some Unpleasant Monetarist Arithmetic’, Quarterly Review 5, no. Fall (1981); Leon Lindberg and Charles Maier, The Politics of Inflation and Economic Stagnation (Washington D.C.: Brookings Institute, 1985), https:/ /www.brookings.edu/book/the-politics-of-inflation-and-economic-stagnation__trashed/. Michel Crozier, Samuel P. Huntington, and Joji Watanuki, The Crisis of Democracy: Report on the Governability of Democracies to the Trilateral Commission (New York: New York University Press, 1975), 37–38. Lindberg and Maier, The Politics of Inflation and Economic Stagnation; Stefan Eich and Adam Tooze, ‘The Great Inflation’, in Vorgeschichte der Gegenwart. Dimensionen des Strukturbruchs nach dem Boom, ed. Anselm Doering-Manteuffel, Lutz Raphael, and Thomas Schlemmer (Berlin: Vandenhoeck & Ruprecht, 2016), 173–96. This chapter explores the historical context of the drafting of the ECB's mandate, focusing on the evolution of central banking strategies since the 1970s. It draws on recent legal and historical research into the ECB mandate.2 The success of the Bundesbank in managing inflation through rate hikes during supply shocks, such as higher oil prices, significantly influenced the ECB's approach. This success, however, reflected a historical context in which the amplification of inflation was driven by wages and government spending. The drafters of the ECB mandate were aware of the specificityof the circumstances in which that approach had worked. They deliberately gave the ECB space to adapt its strategy in the face of new circumstances. This highlights the important role of strategy reviews in updating the ECB's approach in response to new economic challenges: There is ample scope within the legal confines to respond with a thoroughly revised strategic reform to today’s new drivers of inflation. This open mandate also places a responsibility on the ECB to revise its monetary policy strategy when facing new drivers of inflation. 2.1 The 1970s as a model for inflation fighting? From the 1970s onwards, European central banks converged on interpreting their missions as the pursuit of a price stability objective, which the central bank could achieve by focusing on two crucial drivers of excessive demand: wages and government spending. In the years leading up to the signing of the 1992 Maastricht Treaty, the idea that monetary policy should take the lead in fighting inflation had become a subject of agreement within the community of central bankers.3 In the background of this new monetary policy focus was a specific critical diagnosis of democratic governance: the inability of democratic capitalism to resolve conflicts between capital, labour and government spending.4 This had led to the inflationary crisis of the 1970s, where the two oil shocks had translated into more persistent inflation via economy-wide demand from wages and government spending. Then, and in contrast to 2022, wage demands exacerbated the inflationary shock, turning the initial price increase into a decade of double-digit inflation. The 1975 report of the Trilateral Commission diagnosed the record levels of inflation as a crisis of democracy: Inflation can be considered a direct result of the ungovernability of Western democracies. It is an easy answer to the tensions of growth. The less a society is capable of facing them, the readier it is to accept inflation as a less painful solution. […] Basically, governments appear to be unable to induce groups which are in strategic positions to accept sacrifices.5 8 of 32 BACKGROUNDPAPER Countries with independent central banks did better at navigating these conflicts. As a result, over the course of the 1970s and 1980s, inflation governance was placed outside of democratic politics and entrusted primarily to central banks.6 By credibly committing to bring down economy-wide demand through its interest rate instrument, the Bundesbank managed to stop the ongoing wage-price spiral (Figure 2).7 A crucial part of that success was credibility. In 1973, the Bundesbank let money market rates climb up to 20% (with spikes of up to 40%).8 Figure 2: Year-over-Year Change in Real Wages vs. Labor Productivity During Inflationary Periods; Sources: Destatis, Eurostat, OECD, Our World in Data 6 7 8 John Singleton, Central Banking in the Twentieth Century (Cambridge: Cambridge University Press, 2010); Greta R. Krippner, Capitalizing on Crisis (Harvard University Press, 2011); Leon Wansleben, The Rise of Central Banks: State Power in Financial Capitalism (Cambridge, MA: Harvard University Press, 2023). While concerned about the first oil shock, the Bundesbank’s main concern in 1973 was preventing a wage-price spiral. As it explained in its Annual Report for that year: “The oil-producing countries' striving for a larger share in the national product and national income of the industrial countries need not necessarily result in a further acceleration of the pace of price rises. Whether this occurs depends in every country very greatly on whether it is made easier or more difficult to pass on the higher prices of these (and other) major imports – in other words, on whether the intensification of the international distribution struggle triggered off by the oil-producing countries' price agreement is followed by an intensification of the domestic struggle for the distribution of the national income, which in real terms is hardly growing.” (BuBa, ‘Annual Report 1973’ (Frankfurt: Bundesbank, 1974), 1). BuBa, 4. 15 of 32 BACKGROUNDPAPER However, the significance of individual transmission channels, the timing of their impact, and even the direction of their effects can change. Our understanding of monetary policy transmission is, hence, inherently incomplete. In the economically varied euro area, the outcomes of shifting financial conditions also differ significantly among member states and regions.27 A medium-term focus gives the ECB time to distinguish between types of economic shocks, such as demand and supply shocks, and devise the most appropriate response. Second, and crucially, it also provides flexibility to consider broader economic impact in line with the ECB’s secondary mandate. Raising central bank policy rates can be likened to deliberately inducing economy-wide shocks. Higher rates increase the cost of various economic activities, ultimately dampening aggregate demand. For businesses, increased interest rates raise the cost of capital, making investments more expensive. Furthermore, as monetary policy curbs economic activity, it directly impacts productivity-enhancing firm investments.28 The longer the period it will take to repay those investments, the greater the damage from high rates will be; this is crucial, since it means that long-term investments in general and investments in clean energy in particular are especially vulnerable to high interest rates. Accordingly, as long as inflation expectations do not de-anchor, the ECB can allow temporary divergence from the target to balance investment, employment and growth with short-term price stability, without compromising medium-term price stability: when adjusting its monetary policy instruments, the Governing Council will – provided that two configurations of the instrument set are equally conducive and not prejudicial to price stability – choose the configuration that best supports the general economic policies of the Union related to growth, employment and social inclusion, and that protects financial stability and helps to mitigate the impact of climate change, with a view to contributing to the objectives of the Union. In practice, the few periods that the ECB did raise rates were closely tied to preceding energy and food price shocks (see Figure 6). In those moments, fears of a return to 1970s inflation loomed large. As Jean-Claude Trichet explained the ECB’s 2011 hike: The increase in inflation rates in early 2011 largely reflects higher commodity prices. Pressure stemming from the sharp increases in energy and food prices is also discernible in the earlier stages of the production process. It is of paramount importance that the rise in HICP inflation does not lead to second-round effects in price and wage-setting behaviour and thereby give rise to broad-based inflationary pressures over the medium term.29 27 28 29 Giancarlo Corsetti, Joao B Duarte, and Samuel Mann, ‘One Money, Many Markets’, Journal of the European Economic Association 20, no. 1 (1 February 2022): 513–48, https://doi.org/ 10.1093/jeea/jvab030. James K. Galbraith, ‘Time to Ditch the NAIRU’, The Journal of Economic Perspectives 11, no. 1 (1997): 93–108; Oscar Jorda, Sanjay Singh, and Alan Taylor, ‘The Long-Run Effects of Monetary Policy’, NBER Working Paper (National Bureau of Economic Research, Inc, January 2020), https://econpapers.repec.org/paper/nbrnberwo/26666.htm; Luca Fornaro and Martin Wolf, ‘The Scars of Supply Shocks: Implications for Monetary Policy’, Journal of Monetary Economics, Inflation: Drivers and Dynamics 2022, 140 (1 November 2023): S18–36, https://doi.org/10.1016/ j.jmoneco.2023.04.003. Jean-Claude Trichet, Introductory statement to the press conference of 7 April 2011, Frankfurt: European Central Bank, 2011, https://www.ecb.europa.eu/press/pressconf/2011/html/ is110407.en.html. 16 of 32 BACKGROUNDPAPER In pursuing price stability over the medium term, the ECB has consistently emphasized the importance of distinguishing supply and demand shocks. Demand shocks are events such as higher wages or increases in government spending where demand in the economy goes up, increasing economic activity and thereby raising pressure on prices. Facing demand shocks, the ECB seeks to bring down the additional demand that comes from credit creation and investment through raising interest rates, aiming to keep the economy at a pace consistent with its long-term potential. This in turn shapes the expectations of economic actors, wage bargaining between employers and unions, and government fiscal space. In macroeconomic theory, this dynamic is captured by the idea of forward-looking expectations. In principle, demand shocks do not create trade-offs with economic output. If the monetary policy reaction is well calibrated, it merely keeps the economy on its long-term growth path, without causing collateral damage. Supply shocks are different. Although predominantly concerned with demand shocks, the ECB’s strategies to date all recognise that supply shocks create a trade-off between fighting inflation and other economic policy objectives. Events such as higher energy prices and natural disasters can raise prices while output slumps. In these circumstances, using monetary policy instruments to fight supply shocks is costly, further suppressing output. Hence, the ECB seeks to avoid responding overly rapidly to supply shocks. Figure 6: Euro Area Inflation and ECB Rate Hiking Periods; Sources: ECB Datawarehouse, Eurostat, based on Van ’t Klooster & Weber (2024) ‘The EU’s Inflation Governance Gap: The Limits of Monetary Policy and the Case for a New Shockflation Toolbox’. 17 of 32 BACKGROUNDPAPER As the ECB summarised the outcome of the 2003 strategy review: [M]onetary policy needs to be tailored to the nature of the shocks hitting the economy, and their size, source and potential for propagation. On this basis, the key ECB interest rates must evolve in such a way that the path of future inflation remains in line with the ECB’s objective of price stability over the medium term.30 Similarly, the 2021 review explained: As different types of shock may move inflation and real economic activity in the same direction (as in the case of demand shocks) or create a temporary trade-off (as in the case of supply shocks), the medium-term orientation also provides the policy flexibility to assess the origin of shocks and look through temporary shocks that may dissipate of their own accord, thus avoiding unnecessary volatility in activity and employment.31 As we saw in Chapter 2, this interpretation of the monetary policy task reflects the specific historical experience of the Bundesbank. Raising rates helped bring down inflation in Germany during the first oil shock, but did so in a context where the amplification of the initial shock had clear demand-side origins. 3.2. The evolution of the ECB’s analytical framework The ECB’s monetary policy strategies not only set out the high-level objectives and instruments, but also the analytic framework by which the Governing Council pursues those objectives in practice. Its role is underappreciated, but it is at the core of how day to day monetary policy setting functions, since it structures deliberation inside the Governing Council and the ECB working groups that decide on monetary policy.32 The ECB’s current analytical framework focuses deliberation on drivers of inflation with an eye towards two questions: How will consumer prices evolve over the medium-term time horizon? And are those changes driven by the demand side or the supply side? The 2021 analytical framework has two pillars. The economic pillar studies potential drivers of inflation, all of which relate to decision-making on the short or medium-term monetary policy stance:33 ● Developments in the short term in economic growth, employment and inflation, ● The assessment of the drivers of shocks that hit the euro area economy, ● The Eurosystem and ECB staff projections of key macroeconomic variables over a medium-term horizon ● A broad-ranging evaluation of the risks to economic growth and price stability. An important corollary of the focus on responding “flexibly” to shocks as drivers of inflation is that the 2021 strategy pays little attention to anticipating potential future drivers and understanding the structural causes of, or (potential) risks to, price stability. While a monetary pillar in the 2003 strategy focused on the analysis of monetary aggregates for the purpose of identifying long-term risks to price stability, the 2021 strategy relaced this with a monetary-financial pillar focused on the transmission of monetary policy. 30 31 32 33 ECB, ‘The Outcome of the ECB’s Evaluation of Its Monetary Policy Strategy’, 88. ECB, ‘An Overview of the ECB’s Monetary Policy Strategy’. Alexander Jung, Francesco Paolo Mongelli, and Philippe Moutot, ‘How Are the Eurosystem’s Monetary Policy Decisions Prepared? A Roadmap’, JCMS: Journal of Common Market Studies 48, no. 2 (2010): 319–45, https://doi.org/10.1111/j.14685965.2009.02054.x. ECB, ‘An Overview of the ECB’s Monetary Policy Strategy’, 13. 18 of 32 BACKGROUNDPAPER This pillar of the analytical framework covers the transmission of changes to policy rates via credit, bank lending, risk-taking and asset pricing channels, as well as financial vulnerabilities, imbalances and possible macroprudential responses.34 However, the framework currently omits consideration of potential real economy drivers of future shocks. Implicitly, these topics appear to be assumed to fall outside the topics relevant for setting monetary policy; since they are not something the central bank affects directly through its monetary policy stance, they are not seen as relevant for deliberation in the Governing Council. This is inadequate. Even if the ECB cannot directly affect the relevant mechanisms – which is itself an open question – the effective pursuit of its mandate requires systematic awareness of their functioning. This gap in the ECB’s current analytical framework mirrors its strategy’s medium-term focus. At its core, the various ECB strategies have all focused on maintaining “well anchored” inflation expectations, either by acting forcefully on demand shocks as soon as they are identified as such, or by seeing through supply shocks, until and unless they started to affect demandside factors. In the face of persistent and large shocks, this strategy presents a stark dilemma.35 The central bank can do nothing and wait for the effects of a shock to dissipate, at the risk of still de-anchoring expectations. Or it can turn to economy-wide interest rate policy to bring down demand. This is effective in reining in inflation, but comes with collateral damage to investment, jobs and growth. In addition – and unlike in wage bargaining or fiscal policy, where strategic players internalise the expected central bank reaction – credibly threatening ex post rate hikes is ineffective at preventing an initial surge itself if the surge is not driven by strategic actors like governments or well-coordinated trade unions. The optimal policy is neither to aggressively hike rates nor to do nothing; it is averting such situations in the first place. This, however, requires a conception of price stability that is not limited to a medium-term time horizon. 34 35 ECB, 13. Lagarde, ‘A Robust Strategy for a New Era’. 19 of 32 BACKGROUNDPAPER 4. Lessons from the 2021-23 inflation experience36 36 37 38 39 40 This chapter draws on Jens van ’t Klooster and Isabella M. Weber, ‘The EU’s Inflation Governance Gap: The Limits of Monetary Policy and the Case for a New Shockflation Toolbox’, Study requested by the ECON Committee (Brussels: European Parliament, 2024); for a similar diagnosis, see: David Barmes et al 'The case for adaptive inflation targeting: monetary policy in a hot and volatile world' (London: Centre for Economic Transition Expertise (CETEx), LSE, 2025). Terms introduced by Isabella M. Weber and Evan Wasner, ‘Sellers’ Inflation, Profits and Conflict: Why Can Large Firms Hike Prices in an Emergency?’, Review of Keynesian Economics 11, no. 2 (14 April 2023): 183–213, https://doi.org/10.4337/roke.2023.02.05; van ’t Klooster and Weber, ‘The EU’s Inflation Governance Gap: The Limits of Monetary Policy and the Case for a New Shockflation Toolbox’; Isabella M. Weber et al., ‘Carbon Prices and Inflation in a World of Shocks: Systemically Significant Prices and Industrial Policy Targeting in Germany’ (Gütersloh: Bertelsmann Stiftung, 2024). On this combination of factors, see also Viral V. Acharya et al., ‘How Do Supply Shocks to Inflation Generalize? Evidence from the Pandemic Era in Europe’, NBER Working Papers, NBER Working Papers, October 2023, https://ideas.repec.org//p/nbr/nberwo/31790.html Isabella M. Weber, et al., ‘Implicit Coordination in Sellers’ Inflation: How Cost Shocks Facilitate Price Hikes’, 2024. BIS, ‘Annual Economic Report’ (Basel: Bank for International Settlements, 2022); Mai Chi Dao et al., ‘Understanding the International Rise and Fall of Inflation since 2020’, Journal of Monetary Economics, 13 August 2024, 103658, https://doi.org/10.1016/ j.jmoneco.2024.103658. Hansen, Toscani, and Zhou, Euro Area Inflation After the Pandemic and Energy Shock; Jakob Feveile Adolfsen et al., ‘Gas Price Shocks and Euro Area Inflation’, Working Paper Series (European Central Bank, February 2024), https://ideas.repec.org//p/ecb/ecbwps/20242905.html. Daniel Rees and Phurichai Rungcharoenkitkul, ‘Bottlenecks: Causes and Macroeconomic Implications’, BIS Bulletins, BIS Bulletins, 11 November 2021; Hyun Song Shin, ‘Bottlenecks, Labour Markets and Inflation in the Wake of the Pandemic’ (G20 International Seminar “Recover together, recover stronger”, Bali, 2021), https://www.bis.org/speeches/sp211209.pdf. Maria Grazia Attinasi et al., ‘The Semiconductor Shortage and Its Implication for Euro Area Trade, Production and Prices’, 24 June 2021, https://www.ecb.europa.eu/pub/economic-bulletin/ focus/2021/html/ecb.ebbox202104_06~780de2a8fb.en.html. The 2021-23 post-pandemic inflation experience differed significantly from the inflationary episodes of the 1970s. The latter were characterised by class conflic, and the initial shock was amplified into general inflation by higher wages and government spending. The recent inflation was characterised by sellers’ inflation: the initial shock was amplified by tacitly coordinated price setting. This chapter draws five lessons from that experience. (1) The 2022-23 inflation revealed that economies can become so vulnerable to shocks that central banks may struggle to mitigate their effects at impact. (2) Conventional monetary policy, and in particular the anchoring of expectations, proved ineffective in addressing inflation driven by both large and heterogeneous supply shocks and by firm pricing strategies. (3) The ECB's strategy of waiting for supply shocks to dissipate proved inadequate. While there were good reasons to wait initially, this approach left the ECB with few good options as inflation surged. (4) Using monetary policy in this context may have important downsides from the perspective of longterm price stability by increasing the cost of crucial investments, particularly in clean energy. This risks making the economy more vulnerable to future inflationary shocks. Finally, (5) over-dependence on the dollar comes with important, but thus far underappreciated risks to price stability. 4.1 Supply constraints, cost shocks and firm pricing strategies in the 2022 inflationary experience Just as the ECB finalised its 2021 strategy review, inflation started to pick up. In the aftermath of the COVID-19 pandemic, interlocking supply shocks amplified by new firm pricing strategies gave rise to new inflationary dynamics. The roots of the 2022 inflation can be traced back to a combination of “shockflation”, inflation that originates in supply constraints and sectoral disruptions as well as “sellers inflation”, inflation caused by firm pricing strategies.37 Supply constraints and cost shocks materialised as the economy began to recover from the pandemic.38 During the COVID-19 pandemic and concurrent (semi-)lockdowns, consumers had changed their spending patterns, and these reversed as the pandemic ebbed.39 Initially, the disruptions were concentrated in specific sectors such as shipping, intermediate goods like auto parts and semi-conductors, and essential commodities including chemicals, metals, wood, and fossil fuels. By 2021, 23% of euro area firms reported limitations in production capacity due to a lack of materials and equipment, a stark deviation from historical averages of 6% (Figure 7).40 Natural gas prices, exacerba- 20 of 32 BACKGROUNDPAPER ted by geopolitical tensions such as the Russian invasion of Ukraine, reached record levels, while food prices soared in part due to climate changeinduced agricultural challenges. The initial shocks resist easy summary: A drought in Taiwan, similarly connected to climate change, significantly impacted semiconductor production, which in turn impacted a range of manufactured goods.41 The inflationary dynamics of 2022 were exacerbated by firms' strategic responses to these supply shocks.42 Firms across various sectors adopted aggressive pricing strategies, raising unit prices to protect or even increase their profit margins.43 This behaviour was not driven by traditional anti-competitive conduct such as formal cartels or collusive agreements, but was instead facilitated by the economy-wide nature of the cost shocks. The synchronous rise in costs across industries allowed firms to coordinate price increases implicitly, as each firm anticipated similar actions by its competitors. This implicit coordination mechanism enabled firms to raise prices without the fear of losing market share, thereby transforming sectoral cost shocks into a generalised inflationary environment. Figure 7: Manufacturing Production Limits in the Euro Area; Source: European Commission (2025): Business and con sumer surveys 41 42 43 Teng Kai-Yuan, ‘How Taiwan’s Expanding Semiconductor Industry Deals with Water Shortages’, CommonWealth Magazine, 2022, https://english.cw.com.tw/article/article.action?id=3236. Weber and Wasner, ‘Sellers’ Inflation, Profits and Conflict’; Acharya et al., ‘How Do Supply Shocks to Inflation Generalize?’; Isabella M. Weber, et al., ‘Implicit Coordination in Sellers’ Inflation: How Cost Shocks Facilitate Price Hikes’, 2024. Fabrizio Colonna, Roberto Torrini, and Eliana Viviano, ‘The Profit Share and Firm Markup: How to Interpret Them?’, Bank of Italy Occasional Paper, 12 May 2023, https://papers.ssrn.com/ abstract=4464310; ECB, ‘How Have Unit Profits Contributed to the Recent Strengthening of Euro Area Domestic Price Pressures?’; Michalis Nikiforos, Simon Grothe, and Jan David Weber, ‘Markups, Profit Shares, and Cost-Push-Profit-Led Inflation’, Industrial and Corporate Change 33, no. 2 (1 April 2024): 342–62, https://doi.org/10.1093/icc/dtae003. 21 of 32 BACKGROUNDPAPER Once underway, shifting consumer perceptions also mattered. While supply shocks were the primary drivers, robust consumer demand enabled the pass-through of input price hikes. Firms, confident in the resilience of demand, were emboldened to raise prices, further fuelling the inflationary spiral. As firms raised prices in response to initial cost shocks, the generalised inflationary environment provided legitimacy for further price increases. Consumers, facing widespread price hikes, became more accepting of these increases, reducing the elasticity of demand and reinforcing firms' ability to raise prices. This self-reinforcing cycle contributed to the perpetuation of inflation, as the initial cost shocks were compounded by the cumulative effects of firms' pricing strategies. In this regard, the 2022 inflation should be understood as a "sellers' inflation" as defined by Abba Lerner: price increases originated in firm pricing strategies, rather than starting with worker demands for higher wages.44 Within sellers’ inflation, it is crucial to distinguish between inflation caused by markup protection and inflation caused by markup increase strategies.45 Markup protection involves firms raising prices to maintain their profit margins in the face of rising costs, while markup increase entails raising prices beyond what is necessary to offset cost increases, thereby expanding profit margins. In the latter case, firms not only mitigate the impact of cost shocks but also capitalize on the inflationary environment to enhance profitability. In media narratives, the emphasis has been on the latter, whereas the most prominent macroeconomic effects come from the former. 44 45 Abba Lerner, ‘Inflationary Depression and the Regulation of Administered Prices’, in The Relationship of Prices to Economic Stability and Growth: Compendium of Papers Submitted by Panelists Appearing before the Joint Economic Committee., by Joint Economic Committee, (Washington, D.C., 1958), 257–68; cf. Weber and Wasner, ‘Sellers’ Inflation, Profits and Conflict’. Colonna, Torrini, and Viviano, ‘The Profit Share and Firm Markup’; Nikiforos, Grothe, and Weber, ‘Markups, Profit Shares, and Cost-Push-Profit-Led Inflation’; Weber, et al., ‘Implicit Coordination in Sellers’ Inflation: How Cost Shocks Facilitate Price Hikes’. Figure 8: The ECB’s strategy only made new drivers a concern for the central bank once inflation was already well under way; Source: Based on van ’t Klooster & Weber (2024) 22 of 32 BACKGROUNDPAPER The ECB's monetary policy measures were guided by the 2021 strategy review. However, its focus on demand management left unaddressed the underlying supply-side issues and the role of firm pricing strategies in perpetuating inflation. From late 2021 onwards, as inflationary pressures mounted, it became increasingly clear that the price pressures were not just driven by typical demand-side dynamics. In line with the 2021 strategy, most policymakers initially took the view that the inflationary effect of supply shocks could be transient and did not require a policy response.46 As inflation surged, however, central banks, including the ECB, responded with unprecedented monetary policy measures. Starting in July 2022, the ECB raised interest rates to their highest levels in history, aiming to reduce economy-wide demand and stabilise prices. The rapid pace of these rate hikes reflected the urgency of addressing inflationary pressures, which had become too large to ignore (see Figure 6 above). 4.2 Five lessons from the 2022 experience The experience of the 2022 inflation contains five key lessons for policymakers that the ECB should draw on in reviewing its strategy. First, it became clear that latent risks to price stability can develop over time, making the economy so vulnerable to shocks that the central bank is powerless to stop those shocks at impact. While the circumstances of the pandemic were particularly harsh, the extent to which supply chains had become vulnerable to shocks had grown considerably in earlier years. For example, supply constraints had built up over the years prior to 2022 as firms increasingly relied on longer value chains and just-in-time production. These developments reflect a specific market failure, where upstream sectors in which firms underinvest in capacity see their market power increase.47 They can charge high prices if a supply constraint occurs, but see few benefits from overinvestment in capacity, which brings down sectoral prices. The causes of Europe’s vulnerability to energy price shocks are similarly structural and built up over time. The choice of member states to rely excessively on fossil fuels, in particular those imported from Russia, goes back decades. It had become clear with the Russian invasion of Crimea, at the latest that these came with severe geopolitical risks. These long-term risks to price stability fall outside the ECB’s current conception of its price stability objective. Comprehensively addressing these drivers of inflation requires a complex combination of economic policies, including regulatory, industrial and competition policy, which fall outside the ECB’s toolbox. However, as the EU’s main policymaker for price stability, the ECB cannot simply ignore these factors. The ECB’s legal mandate is to maintain price stability, not just to prevent inflation that stems from medium-term demand-side drivers of inflation. The second lesson to draw from the experience of 2022 is that conventional monetary policy is not always an adequate tool to respond to an inflationary environment, even if it has an important demand component. Where inflation has its origins in wage developments or government spending, the central bank can bring it down to a level compatible with medium-term price stability. Consumers care directly about their purchasing power, whereas governments care about macroeconomic outcomes. Credible commitment by the central bank to offset inflationary demand increases can impact these economic actors’ inflationary choices in various ways. This transmission mechanism not only has a basis in macroeconomic theory but is also well-established in the political economy and historical literature.48 46 47 48 Fabio Panetta, ‘Patient Monetary Policy amid a Rocky Recovery’ (Sciences Po Paris, 24 November 2021), https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp211124~a0bb243dfe. en.html. Agostino Capponi, Chuan Du, and Joseph E. Stiglitz, ‘Are Supply Networks Efficiently Resilient?’, Finance and Economics Discussion Series 2024-031 (Washington: Board of Governors of the Federal Reserve System, 2024), https://papers.ssrn.com/abstract=4754766. Hall and Franzese, ‘Mixed Signals’; Hancké, Unions, Central Banks, and EMU. 23 of 32 BACKGROUNDPAPER In contrast to wage setting and government fiscal policy, there may not be a simple connection between inflation expectations and firm pricing strategies. Academic disagreement focuses on whether it is nonexistent or just not well understood.49 On balance, a monetary policy announcement, or even more indeterminate expectations about the economy-wide price level, may be at best a secondary concern for an individual firm’s decision as to whether to change its markup in the face of a cost shock. In a competitive environment, its main concern should be its ability to absorb the input cost increase and whether it can raise prices without losing market share. The few experimental studies on this topic show that high inflation expectations may lead firms to raise prices, but can also have the opposite effect.50 For a recent empirical study, I read hundreds of earnings call transcripts in which US executives discuss cost shocks. The Federal Reserve is almost never mentioned. Where executives do see monetary policy as impacting their pricing, the focus is backward-looking. As one executive explained in 2021: Thank you, Federal Reserve and the U.S. Congress, for fiscal and monetary stimulus. We could debate transitory or otherwise, but those things are translating into, broadly, a more highly inflationary environment. And that applies to us, too, and that obviously is helping from a pricing power point of view.51 Using interest rate hikes to response to sellers’ inflation is not only ineffective, but also exacerbates its impact on households. Since monetary policy shapes the financing conditions available for households and firms, it can also indirectly shape firm pricing decisions. However, to the extent that there is such a transmission mechanism, it works in part by further reducing household purchasing power. This is economically costly and exacerbates inequality.52 From the perspective of households, monetary policy counteracts what is in principle a desirable catching-up of wages with a higher price level. Due to the important role that mortgages themselves have in determining the purchasing power of consumers in many countries, restrictive monetary policy also impacts households’ costs of living.53 A third lesson to draw from the post-pandemic experience is that some cost shocks are such that the central bank cannot simply wait for them to happen and see them through. Despite the novelty of the post-pandemic inflationary dynamics, the ECB stuck closely to its existing monetary policy strategy. While central bank research departments were relatively quick to identify both costs shocks and firm pricing strategies as the key drivers, this did not translate into a rethinking of inflation governance. The Governing Council had good reason to initially wait for the inflationary effect of supply shocks to pass. As a central bank, the ECB lacked the tools to address supply chain disruptions or reduce the price of energy. However, the 2021 strategy created a dilemma: either act with an inappropriate instrument or do nothing (or not enough) and risk losing credibility. Letting major inflationary waves ripple through the economy had a dramatic impact on households’ cost of living, with real wages declining at 5.1% year-on year at the peak of inflation in the third quarter of 2022.54 While wages did go up, 49 50 51 52 53 54 Not yet well understood: Olivier Coibion et al., ‘Inflation Expectations as a Policy Tool?’, Journal of International Economics, NBER International Seminar on Macroeconomics 2019, 124 (1 May 2020): 103297, https://doi.org/10.1016/j.jinteco.2020.103297. Non-existent: Rudd, ‘Why Do We Think That Inflation Expectations Matter for Inflation?’ Olivier Coibion, Yuriy Gorodnichenko, and Saten Kumar, ‘How Do Firms Form Their Expectations? New Survey Evidence’, The American Economic Review 108, no. 9 (2018): 2671–2713; Olivier Coibion, Yuriy Gorodnichenko, and Tiziano Ropele, ‘Inflation Expectations and Firm Decisions: New Causal Evidence’, The Quarterly Journal of Economics 135, no. 1 (1 February 2020): 165–219, https://doi.org/10.1093/qje/qjz029. Hilton Worldwide Holdings Inc. earnings call Q3 2021 (Oct 27, 2021). Luiz Awazu Pereira da Silva et al., Inequality Hysteresis (Basel: Bank for International Settlements, 2022), https://www.bis.org/ publ/othp50.htm. Marijn A. Bolhuis et al., ‘The Cost of Money Is Part of the Cost of Living: New Evidence on the Consumer Sentiment Anomaly’, Working Paper, Working Paper Series (National Bureau of Economic Research, February 2024), https://doi.org/10.3386/ w32163. EC, ‘Labour Market and Wage Developments in Europe - Annual Review 2023’ (Brussels: European Commission, 2024), https:// data.europa.eu/doi/10.2767/1277. 24 of 32 BACKGROUNDPAPER this only compensated for around 20% of the cost shock (see also Figure 3 above).55 Across the EU, the impact on cost of living was felt most strongly by low and below-median income households, with more households living in absolute poverty; some member states saw increases by up to 19%.56 The impact of inflation also set the stage for global electoral turmoil, as angry electorates voted out incumbent governments.57 This brings us to the penultimate lesson from the 2022-23 experience: The use of interest rates to bring down economy-wide demand does not necessarily promote long-term price stability and can even undermine it. By increasing the cost of long-term investments, the ECB’s monetary policy approach of 2022-23 may have made the EU economy more vulnerable to future inflationary shocks. For firms, higher interest rates raise the cost of capital, thereby making investments more expensive. Moreover, as monetary policy drives down economic activity, it strikes directly at productivityenhancing firm investments.58 Additionally, the more long-term those investments, the greater the damage high rates will do. While these demandand investment effects are in part exactly the way in which monetary policy achieves its price stability objectives, there is no reason to be indifferent to their long-term effects on price stability. A particularly nefarious way in which high rates undermine long-term price stability is likely by undermining clean energy investments.59 From the perspective of a central bank with a price stability mandate, investments in decarbonising energy systems have various attractive properties.60 They make the economy less dependent on imports. Macroeconomically, their prices are also less volatile, since they are less affected by trade and geopolitical developments: once installed, their average annual cost base is stable. Investments in energy efficiency measures have similar benefits in making the economy less vulnerable to energyrelated shocks. Using monetary policy to pursue price stability may harm precisely those investments most needed to protect the European economy against future shocks. Reflecting its 2021 strategy, the ECB designed its inflation fighting measures to focus on demand-side origins of inflationary pressures, in particular wage development. As Isabel Schnabel explained in January 2023: Tighter financing conditions will slow growth in aggregate demand, which is needed to reduce the upward pressure on prices that has resulted from the longlasting damage to the euro area’s production capacity inflicted by the energy crisis.61 55 56 57 58 59 60 61 Adolfsen et al., ‘Gas Price Shocks and Euro Area Inflation’. Balint Menyhert, ‘The Effect of Rising Energy and Consumer Prices on Household Finances, Poverty and Social Exclusion in the EU’, Publications Office of the European Union (Luxembourg, 18 October 2022), https://doi.org/10.2760/418422. Carin van der Cruijsen, Jakob de Haan, and Maarten van Rooij, ‘The Impact of High Inflation on Trust in National Politics and Central Banks’, DNB Working Paper (Amsterdam, 3 May 2023), https://papers.ssrn.com/abstract=4437041. Galbraith, ‘Time to Ditch the NAIRU’; Jorda, Singh, and Taylor, ‘The Long-Run Effects of Monetary Policy’; Fornaro and Wolf, ‘The Scars of Supply Shocks’. Florian Egli, Bjarne Steffen, and Tobias S. Schmidt, ‘A Dynamic Analysis of Financing Conditions for Renewable Energy Technologies’, Nature Energy 3, no. 12 (December 2018): 1084–92, https:// doi.org/10.1038/s41560-018-0277-y; Tobias S. Schmidt et al., ‘Adverse Effects of Rising Interest Rates on Sustainable Energy Transitions’, Nature Sustainability 2, no. 9 (September 2019): 879–85, https://doi.org/10.1038/s41893-019-0375-2; Seyedeh Fatemeh Razmi, Marjan Heirani Moghadam, and Mehdi Behname, ‘TimeVarying Effects of Monetary Policy on Iranian Renewable Energy Generation’, Renewable Energy 177 (1 November 2021): 1161–69, https://doi.org/10.1016/j.renene.2021.06.020; Jens van ’t Klooster, ‘The European Central Bank’s Strategy, Environmental Policy and the New Inflation: A Case for Interest Rate Differentiation’ (London: Grantham Research Institute on Climate Change and the Environment, 2022); Shabir Mohsin Hashmi, Qasim Raza Syed, and Roula Inglesi-Lotz, ‘Monetary and Energy Policy Interlinkages: The Case of Renewable Energy in the US’, Renewable Energy 201 (1 December 2022): 141–47, https://doi.org/10.1016/j.renene.2022.10.082; Dan Zhang, Yunpeng Wang, and Xinyu Peng, ‘Carbon Emissions and Clean Energy Investment: Global Evidence’, Emerging Markets Finance and Trade 59, no. 2 (26 January 2023): 312–23, https://doi.org/10.1080/1540496X.2022.2099270; Taner Akan, ‘The Impact of Monetary Policy on Climate Change through the Mediation of Sectoral Renewable Energy Consumption’, Energy Policy 192 (1 September 2024): 114244, https://doi.org/10.1016/j.enpol.2024.114244; Shiu-Sheng Chen and Tzu-Yu Lin, ‘Monetary Policy and Renewable Energy Production’, Energy Economics 132 (1 April 2024): 107495, https://doi.org/10.1016/j.eneco.2024.107495. Rizwan Ahmed et al., ‘Inflation, Oil Prices, and Economic Activity in Recent Crisis: Evidence from the UK’, Energy Economics 126 (1 October 2023): 106918, https://doi.org/10.1016/j.eneco.2023.106918. Isabel Schnabel, ‘Monetary Policy Tightening and the Green Transition’ (International Symposium on Central Bank Independence, Sveriges Riksbank, Stockholm Stockholm, 10 January 2023, 2023), https://www.ecb.europa.eu/press/key/date/2023/ html/ecb.sp230110~21c89bef1b.en.html. More recently, Frank Elderson, ‘Sustainable Finance: From “Eureka!” To Action’ (Sustainable Finance Lab Symposium on Finance in Transition, Utrecht, 2024), https://www.ecb.europa.eu/press/key/date/2024/ html/ecb.sp241004~e2c8a5aae1.en.html. 31 of 32 BACKGROUNDPAPER other EU-level policymakers through its monetary policy instruments as well as (ii) based the design of its decision on policies of the EU’s political bodies – primarily the Commission, Council, European Council, and/or the European Parliament – and the member states. Coordination is also clearly permitted by the ECB’s mandate, particulary where it serves to achieve the objective of price stability.83 The European Court has consistently interpreted the ECB’s independence as “functional”, serving to protect its ability to maintain price stability. In the 2004 OLAF case, it also clearly rejected the claim that the ECB's independence isolates it completely from other EU institutions and bodies.84 The fact that the treaties contain numerous provisions that formalise the exchange of views and mutual consultation among various economic policymakers reinforces this interpretation.85 The primary challenge in coordinated monetary policy geared towards long-term price stability concerns its governance. Two potential approaches can ensure legitimacy in this context. The first is an approach of independent policy coordination, where the design of monetary policy measures is managed internally by the central bank. This requires a solid legal basis in existing economic policies that set out the longterm policy arc of the EU. For example, for clean energy investments, this could involve following the Taxonomy Regulation, but also more ad hoc policies such as RePowerEU or the Clean Industrial Act. Here, it is also crucial to monitor whether a conflict can occur with medium-term price stability for sectors already at capacity. Multilateral coordination, in contrast, involves a degree of shared decision-making over the design of monetary policy measures. Such multilateral coordination has clear advantages. The ECB can directly coordinate the selection of investments crucial for longterm price stability by creating new agencies, supporting existing public development banks, or through credit councils or other standing bodies. A combination of both is likely needed. By ensuring adequate support for sectors that are crucial for long-term price stability, the ECB can overcome myopia and avoid an incoherent policy mix. 83 84 85 van ’t Klooster and de Boer, ‘What to Do with the ECB’s Secondary Mandate’; Nik de Boer, Seraina Grünewald, and Jens Van ’t Klooster, ‘The Law and Politics of Independent Policy Coordination: Fiscal and Sustainability Considerations in the European Central Bank’s Monetary Policy’, EBI Working Paper (Frankfurt: European Banking Institute, 2024). Case C-11/00 Commission v. ECB, ECLI:EU:C:2003:395, para. 134 and 135 e.g. Article 284(1) and (2) TFEU, Protocol No. 2, Article 7 and Protocol No. 14, Article 1 TFEU. 32 of 32 TESTNAME This work is supported by Laudes Foundation, Open Philantropy, Open Society Foundations and William & Flora Hewlett Foundation. Impressum Published by: Dezernat Zukunft e.V., Chausseestraße 111, 10115 Berlin www.dezernatzukunft.org Representative of the Board Dr. Maximilian Krahé Members Board: Dr. Maximilian Krahé, Janek Steitz, Dr. Maximilian Paleschke Register of Associations of the District Court of Charlottenburg Association register number 36980 B Responsible for content according to §55 RstV: Dr. Maximilian Krahé Publisher: Dr. Maximilian Krahé, Berlin E-Mail: [email protected] Design: Burak Korkmaz This content is licensed by Dezernat Zukunft under CC BY-NC 4.0 . Content may be used with clear attribution to the source and, where noted, the author(s). Dezernat Zukunft is a non-partisan policy institute that aims to explain and re-think monetary, fiscal, and economic policy in an accessible and coherent way. In doing so, we are guided by our core values: Democracy, Dignity, and universal Prosperity. www.dezernatzukunft.org @DezernatZ Institute for Macrofinance