Economy & Markets

2021-08-27 Donato Masciandaro

ECB: The New Route Between Hawks and Doves

In July, the ECB announced its new monetary policy strategy. The start of the strategy review will coincide with delicate decisions to be made: it will be necessary to determine, in a phase of economic recovery, but still characterized by extraordinary uncertainty, how to normalize the level of interest rates and monetary aggregates. It is easy to predict that both the hawks and the doves will make their voices heard, and that dialectic cannot but improve the final decisions; provided that the crows don’t appear.

Last July, the president of the European Central Bank Christine Lagarde announced a strategy review of ECB monetary policy. There was great anticipation of what the new inflation target would be. The expectations were understandable: explicitly stating the inflation target, as we will see later, is the key to monetary policy, representing the main tool to orient expectations. The importance of the link between the inflation target and management of expectations is an issue on which hawks and doves can generally agree. But things change when we question the quantitative formulation of that target.

It can be useful to recall the experience of the ECB over time. Let’s look at the timeframe that goes from January 1999 – the year the ECB was born – to May 2003, the month in which the Central Bank decided to adjust its inflation target for the first time. Up until then, the numerical target was an inflation rate below 2 percent. What had the corresponding inflation performance been until that point? If we look at the annual trend of inflation in the 53 months under observation, we discover that the average value was 1.97 percent. If we then examine the monthly variations, we see that in 20 out of 53 months – 37 percent – consumer price growth was below 2 percent. But above all, we discover that inflation expectations were between 1.7 and 1.9 percent. All of the data supported the thesis that the target worked. Despite this, the ECB decided to reformulate the target, adding “but close” to 2 percent.

Why? At the time, the ECB had two messages to launch. First, it was necessary to signal to the hawks that a little inflation is better than zero inflation. Second, at the same time it wanted to stress to the doves that playing with inflation, and perhaps raising the target, would be dangerous. A little inflation was considered desirable for at least three reasons. On the one hand, while it is appropriate for nominal interest rates to follow the trend of inflation, some inflation reduces the risk of having zero nominal rates, with all of the problems this implies for monetary policy, that are well-known to everyone today. On the other hand, a little inflation allows for better absorbing both the measurement errors in consumer price dynamics, and any inflation differentials between the various Member States of the euro area. Secondly, at the time, some – and the hawks in particular – would have preferred a precise quantitative target. Yet the ECB decided to confirm its preference for an imprecise target, to send a signal that control of inflation is endemically imperfect.


So what is the message that the ECB decided to send with its reform of the inflation target now? Simple: if the North Star is inflation, the route of the ECB must be symmetrical: during navigation the ship can stray, east or west, but not too much, and not for too long. Is this the best route it could have chosen? In the design of monetary policy there is no one route better than others, but rather two rules of navigation to respect. First rule: the main goal of a central Bank is to orient mid-term expectations of families, businesses, and markets. Second rule: to try to influence expectations, a Central Bank must announce an inflation target.

But what target? The different possible monetary policies can be classified in three categories – a fixed target, a flexible target, and a target interval – because when the central bank makes an announcement, it must seek a compromise between two goals. The first goal is to follow the principle of Ulysses: if I want to be believed, I have to tie myself down, just as the king of Ithaca did to resist the siren song. With respect to the principle of Ulysses, who puts his credibility up front, the best goal of monetary policy is a fixed target: the desired growth of consumer prices is expressed by a number.

There is also a second goal, that is to apply the principle of Delphi: the announcement must allow those who formulate it to be flexible, so it cannot be precise. The advantage is that making a mistake is less likely; the disadvantage is that the announcement becomes like the predictions of the famous oracle: general, and thus open to interpretation, for better or for worse. With respect to the principle of Delphi, the ideal formulation of monetary policy announcements is a target interval: inflation must oscillate between a number, that acts as the floor, and another number, the ceiling.

It is evident then, at least in theory, that announcements formulated with a flexible target are set at a position of equilibrium between the two options, the fixed target and the target interval. This is the choice made by the ECB, formalizing a method for announcements that had already become practice from the time of the Mario Draghi’s term.

International experience also confirms that a flexible target is preferred by central banks. The policy of monetary announcements on inflation targets can be traced back to 1989, in New Zealand. From that time on, more and more central banks adopted that policy: today there are 42, of which 14 in advanced economies, and 28 in emerging economies. Among this group, 14 central banks have a fixed target, 23 a flexible target, and 5 a target interval. Above all, though, the data tells us that central banks are continuously seeking a better balance between credibility and flexibility, that can be different depending on the country and the macroeconomic context. The choice of strategy regarding monetary announcements is not written in stone. In fact, it has happened that the monetary announcement strategy has changed – 28 times – just as the inflation target value has been modified – 119 times – along with the temporal horizon – 14 times; especially if the uncertainty linked to consumer price dynamics is high. But what do we know about inflation today? An up-to-date and complete analysis has been provided by economists from the World Bank, who have analyzed the dynamics of six different price change indicators, calculated on a monthly, quarterly, and annual basis, relating to 196 countries, and for a timeframe going from 1970 to 2021. The goal of the research was to answer the question: what is special about the dynamic of inflation that is characterizing the pandemic recession, with respect to the four global recessions that preceded it? There are two results that interest us here. 

First of all, in the last fifty years, the change in consumer prices has gradually seen a structural reduction. The fall began in the middle of the 1980s in advanced countries, to which emerging countries were added in the 1990s. On average, inflation went from 17 percent in 1974 to 2.5 percent in 2020. The lesson for the ECB is that from here on out, speaking of monetary policy, it is prudent to set aside the traditional distinction between ordinary instruments – interest rates – and extraordinary ones – interventions on financial markets and binding announcements. Structurally low inflation is reflected in nominal rates that systematically risk being close to zero, such that the distinction between ordinary and extraordinary interventions must at least be reconsidered.

Secondly, the variation in prices during the pandemic recession has been different than all of those that characterized previous global recessions. In the past, the recession was accompanied by a considerable drop in prices, that lasted for a period of one to three years, on average. This is the sum of two effects: the Phillips effect, that tells us that less production is associated with lower prices, and the hysteresis effect, that indicates that the recovery of prices comes slowly. This time is different. Neither of the two effects showed the same importance: prices fell less than predicted, and then rose again much faster. This means that the ECB must be prudent in reacting to the current dynamic of consumer prices, given its unpredictability.

Here a third rule of navigation emerges: there is no one strategy that is absolutely superior to the others, in terms of ability to influence expectations. Yet this does not mean that the choice of strategy is irrelevant: a recent empirical study shows that, whatever the strategy adopted, its efficacy on expectations is reduced the more inflation actually detected is, or even only appears, inconsistent with the announced monetary policy. Once a route has been chosen, you need to be able to follow it.

This leads to an easy conclusion: in the coming months, the success of the ECB will depend on the ability of Christine Lagarde to make the best choice between the three key elements – or the “three Ds” – that characterize monetary policy choices; decisions to share, discussions to manage, and denunciations to avoid.

The decisions to be shared will all start from the unanimous choice made in terms of strategy: the inflation target is equal to 2 percent, and may oscillate, both upwards and downwards. The new monetary constitution has been approved unanimously. This is an essential result, because in principle, it could have been unwelcome to both hawks and doves, with opposing motivations, as usual.

The reason is understood simply by recalling that since November 2003 – the date of the ECB’s first strategy review – until last May, consumer prices have varied on average by 1.5 percent. This is a number that summarizes all of the arguments of those who believe that inflation has been too low, and thus a new strategy was necessary. But what strategy? A hawk will prefer fixed monetary rules: the inflation target must be defined precisely and low. Translation: it would have been better for the ECB, recognizing a structural drop in the inflation rate, to have reduced its target, maybe to 1 percent. A dove, on the other hand, prefers maximum flexibility in monetary policy actions, aiming for higher inflation. Translation: it would have been preferable for the ECB to have defined a band of oscillation as its target, perhaps between 2 and 4 percent.

The unanimous choice of the ECB Council, though, was a flexible rule, centered symmetrically on a value of 2 percent. The reasons are those indicated above: on the one hand, the definition of a rule is a necessary, although not sufficient condition for a credible monetary policy; on the other hand, flexibility has the advantage of calibrating the design and implementation of the instruments in the short term.

The calibration of the instruments, from the standpoint of both methods and times, is where the second key point emerges: the management of the debate between hawks and doves. It is evident that the desired positive evolution of the economic situation will be reflected by a return to monetary normalcy. The activism of the ECB on financial markets will have to be reduced, and nominal interest rates must return to positive territory. The discussion on monetary normalization will bring out the positions of hawks and doves.

In and of itself, a discussion is not cause for worry. The debate between different orientations on monetary action is a normal, even desired element. A difference of visions in the debate can improve the final decisions. Therefore, we should welcome hawks and doves, provided that none of them transform into crows. This is the third problem to be resolved, or better, avoided. Unfortunately, in recent months there have been anonymous comments, “escaping” from the ECB Council, that have found their way into the media. Dissent among central bankers makes news, especially if it is created deliberately. So we need to hope that crows don’t squawk anymore. European monetary policy needs shared decisions, even if it takes lively debate to reach them, but it cannot afford governors who are disloyal or opportunist.


To learn more:

Bini Smaghi L., 2021, The New ECB Strategy: What Will Change?” Luiss, School of European Political Economy, Policy Brief n.13.

Brunnermeier M.K., 2021, De- and Inflationary Traps: Strengthening ECB’s Second Pillar to Avoid Fiscal and Financial Dominance, in ECB Forum on Central Banking, 275-282.

Ehrmann M., 2021, Point Targets, Tolerance Bands or Target Ranges? Inflation Target Types and the Anchoring of Inflation Expectations, ECB Working Paper Series, n.2562.

Ha J., Kose M.A. and Ohnsorge, F., 2021, One-Stop Source: A Global Data Base of Inflation, CEPR Discussion Paper Series, n.16327.

Masciandaro D, and Eijffinger S., 2018, Hawks and Doves: Deeds and Words. Economics and Politics of Monetary Policymaking, (ed.), CEPR Press, London.


Donato Masciandaro is a Professor of Political Economy at the Bocconi University, where he holds the Intesa Sanpaolo Chair in Economics of Financial Regulation. Since 1989 he has written for the newspaper il Sole 24 Ore. Since 2005, he has contributed to Economia & Management drawing on and developing his comments and analysis published in that economic-financial daily.