Monetary policy in a world of overlapping shocks

The European Central Bank highlights the return of inflation as a persistent challenge, compounded by new shocks that disrupt the post-pandemic recovery. These shocks influence household behavior, inflation expectations, and the persistence of price pressures, complicating monetary policy decisions. The ECB has responded by enhancing transparency in its policy framework, explicitly outlining the factors guiding its decisions, including inflation outlook, underlying dynamics, and policy transmission strength. This approach, termed 'framework guidance,' aims to build public trust and reduce uncertainty in an environment where inflation remains highly visible.

Since June, the ECB has raised key interest rates by 50 basis points, increasing the deposit facility rate from 2% to 2.5%, in response to a deteriorating inflation outlook linked to geopolitical developments. The Governing Council’s actions were designed to ensure inflation returns to the 2% target over the medium term. The ECB notes that its decisions have been well-anticipated and are being transmitted smoothly to financing conditions, with framework guidance helping to mitigate excess market volatility.

The ECB explains that the nature of a shock—whether supply or demand-driven—does not inherently dictate the policy response. Instead, the central bank focuses on the shock’s impact on projected inflation over the policy horizon. If a supply shock, such as the Middle East conflict, pushes projected inflation above target, tightening monetary policy becomes necessary to realign the forecast. This approach counters the risk of higher inflation expectations lowering real interest rates and amplifying price pressures.

The ECB emphasizes that its policy adjustments have stabilized real bank lending rates, which had declined following the rise in inflation expectations tied to the Middle East conflict. By counteracting these pressures, the ECB’s tightening measures aim to prevent a self-reinforcing cycle of higher inflation and weaker economic conditions. The central bank underscores the importance of incoming data and inflation forecasts in shaping its policy assessments.