Why did we write this paper?
The past decades central bank interest rate policy was widely seen as (almost) sufficient for low and stable level of inflation. But we just experienced the largest inflation since the 1970s and monetary policy did not live up to expectations. Instead, policymakers turned to a wide range of new inflation-fighting instruments. The contribution (if any) that interest rate policy made remains contested.
Going forward, inflation may return in new guises: climate and environmental crises, demographic pressures from an aging workforce, rearmament, trade conflicts, and geopolitical shocks including war. For this reason we were interested in questions such as: To what extent are interest rates still the right lever to deal with inflation? How can it be combined with other policy measures? And, in particular, how should the ECB define its own role in relationship to other EU and member state level policies?
What did we learn?
One crucial insight from the report is that a serious rethinking of the role of monetary policy is overdue. As the report shows, monetary policy as practiced today arose in response to the inflation of the 1970s. During that episode, central banks learned the importance of “well-anchored inflation expectations”, in particular to prevent self-enforcing wage-price dynamics. However, this model inherited from the 1970s lack any clear account of how to respond to inflation that originates in costs shocks and firm pricing behaviour.
A second insight is that there is no simple answer concerning what the ECB and other central banks should do if inflation does return. The report suggests the need to address and monitor latent drivers of inflation. It also argues for the central bank to be more precise concerning the limitations of monetary policy and position the role of the central bank within a broader inflation fighting toolbox.
Many follow up questions result from these insights. More work needs to be done on structural preconditions of price stability, which requires looking at inter alia supply chains, market power, and climate and energy policy. It seems that competition policy in particular could be complementary to monetary policy in addressing firm pricing behaviour. It will also be important to think more about how any changes to the role of central banks can increase agility in the face of a crisis and how to square all of that with the ideal of central bank independence.
