ECB Strategy Update: Marked by Uncertainty and Structural Change

The European Central Bank (ECB) reviewed its monetary strategy for the first time in 2021. At that point, the euro area economy had gone through the difficult trials of the global financial crisis and the European sovereign debt crisis, and was only beginning to recover from the COVID shock. Crisis episodes significantly lowered both inflation and inflation expectations, while interest rates had remained close to zero for an extended period. The direction of the strategy review was clear: to expand the scope for monetary policy flexibility in order to build inflation buffers against the risk of intensifying deflationary pressures. However, subsequent developments turned out to be the opposite of what the strategy had anticipated.

Strategy review: from 2021 to 2025

In 2025, the ECB is clearly altering its rhetoric. The experience of the inflationary shock of 2021–2023, the geopolitical shock, and Russia’s war against Ukraine have contributed both to the strengthening of already-formed structural shifts and to the emergence of new ones in the global economy. As a result, today’s conceptual framework for updating the strategy is much broader. The ECB does not dismiss the risks identified during the 2021 strategy review but places greater emphasis on new ones: structural uncertainty; uncertainty about the nature of shocks; uncertainty regarding the prospects of global integration, and others. In other words, structural changes in the global economy and in the euro area can both weaken inflationary pressures and reinforce them. After all, the impact of a demand shock on inflation and economic growth can suddenly and unexpectedly outweigh the effect of a supply shock—and vice versa.

When reviewing its strategy in 2025, the ECB in some respects appears in a stronger position compared with the Federal Reserve, whose experiment with average inflation targeting—in light of the record price growth of the past 40 years—turned out to be more rhetoric than a new monetary regime. This time, the central bank of a united Europe demonstrated flexibility by recognizing that structural uncertainty, global fragmentation, and an increased likelihood of divergent shocks will create an environment in which inflation may deviate substantially from the target in either direction.

The ECB states that keeping inflation permanently at the target level is impossible and has never been the objective. Anchoring expectations around the target and the variability of deviations of inflation from it are the main criteria for assessing the success of the price stability policy. The updated strategy is clearly structured around the idea of restrained flexibility. On the one hand, the possibility of inflation deviaton from the target is seen as a contribution to supporting growth and employment. Supply shocks often push inflation and output in opposite directions, creating a trade-off for the central bank. Choosing not to react to such shocks (“look through”) helps preserve the long-term sustainability of the growth trajectory. This is the traditional refrain in favor of flexibility. Yet even this stance appears more restrained compared with the advocacy of inflation buffers during the 2021 strategy review.

On the other hand, the 2025 strategy makes it explicit that non-reaction to supply shocks is not unconditional. In other words, a “look through” requires clearly defined conditions, and its application is subject to procedural limitations. To this end, the strategy stipulates that any deviation of inflation from the target must be assessed in the specific context of the drivers of inflationary dynamics, the causes of shocks and their consequences, taking into account the nature of the anchoring of inflation expectations and the effectiveness of monetary transmission. The ECB allows for constructive uncertainty about what “look through” means in operational terms. However, it assumes that certain preconditions must be met for non-reaction to supply shocks: the shock’s limited force, its transience, and the unquestionable anchoring of inflation expectations.

In the updated strategy, the ECB states that the reaction to deviations of inflation from the target should take into account the principle of proportionality, the operation of channels that either strengthen or weaken the arguments in favor of “look through,” as well as the actual level of inflation.

Such strong attention to the need to limit discretion in disregarding deviations of inflation from the target is nothing other than a response to the growing criticism of the linear character of the macro-forecasting tools of modern central banks. The “two regimes” approach to inflation has, in fact, been incorporated into the monetary vision of Europe’s central bank. Within this approach, the transition from a low-inflation regime, in which inflation is self-sustaining, to a high-inflation regime, in which it is self-reinforcing, is non-linear.

The problem of non-linear relationships in macroeconomics and the experience of the inflationary shock of 2021–2023 have led the ECB to make an unambiguous statement about how the strategy defines the reaction to an intensifying deviation of inflation from the target. For this purpose, the strength and the duration of the reaction are considered separately. Thus, a significant downward deviation of inflation from the target implies a monetary response of substantial duration, while the opposite movement of price pressures calls for a strong reaction that is then gradually eased.

The ECB’s direct acknowledgment of how it should respond to accelerating inflation is, in a sense, a way to forestall potential accusations of an excessive tilt toward soft monetary policy. Clearly, the experience of fighting the recent inflationary surge has its impact. Both the Fed and the ECB, along with several other central banks, despite their delayed monetary response to accelerating inflation in 2021, were ultimately forced to raise rates at the fastest pace of any episode of monetary tightening.

Uncertainty and structural changes

The ECB’s 2021 strategy review recognized the fading impact of global factors in slowing inflation and the emergence of traditional Keynesian drivers of deflationary bias. By 2025, however, the situation had changed fundamentally. Structural adaptation and the lack of macroeconomic dynamism were no longer regarded as the consequences of successive crises. On the contrary, structural adaptation itself was being called into question, as the very structural factors of global economic development were undergoing profound distortion from technological change and a radical rethinking of political sentiment toward global integration.

The rightward shift in the policies of a number of countries and the outbreak of trade wars have raised the question of how quickly the once favorable global drivers of disinflation might turn into their opposite. Will the global economy be able to adapt to the quasi-isolationism of the United States? To what extent will the green transition affect commodity prices? How will rising military spending and the continued aging of the population affect neutral interest rates?

It is no coincidence that the key word of the 2025 strategy is uncertainty. This concerns both how structural changes will affect inflation and market dynamism, and what kinds of shocks are more likely over the strategic horizon. The same applies to uncertainty regarding the behavior of neutral rates or the impact of the digitalization of money on the transmission mechanism.

Among the structural changes, the following are worth highlighting:

• global fragmentation
• geopolitical tensions
• the spread of artificial intelligence (AI)
• climate change
• green transition policies
• demographics
• uncertainty regarding the behavior of neutral rates

Behind each of these structural changes lie inflation drivers that can both increase and restrain it. Similarly, each of the listed structural changes can at the same time intensify both demand and supply shocks, creating significant uncertainty about how to interpret the data when choosing the optimal monetary response. The corresponding structural changes and their implications for monetary policy are grouped in Table 1.

To address the problem of uncertainty, the ECB focuses on:

• improving its modeling toolkit by developing additional models for cross-checking disputed trends (models for cross-check)
• taking into account the nonlinearity of relationships
• using disaggregated data (granular analysis)
• combining data-driven and model-driven approaches to decision-making
• clearly separating economic analysis from monetary and financial analysis
• recognizing that financial imbalances develop slowly but can threaten financial stability, which in turn can endanger price stability
• ensuring the effectiveness of monetary transmission and taking this into account when calibrating decisions on key rates

The high likelihood of divergent effects on inflation and growth, combined with the rapid replacement of demand shocks by supply shocks and vice versa, calls for flexibility. At the same time, the ECB’s strong focus on the conditions for allowing deviations of inflation from the target indicates that it is prepared to accept that flexibility—when constrained by procedures and analytical practices—is the best way to preserve trust in an environment of rapid change.

Conclusions

Global changes are transforming the monetary policy environment. Before the global financial crisis, factors arising from global integration and technological shifts created a favorable setting for easing inflationary pressures and mitigating supply shocks. In its aftermath, however, the deflationary bias was driven by the consequences of successive economic stresses. Looking ahead, the picture changes. The global monetary policy environment and technological change now allow for divergent effects on the drivers of inflationary pressure.

Uncertainty, which is becoming the new normal, calls for flexibility. Yet flexibility cannot rely solely on the resource of trust, which is quickly depleted if not replenished by convincing actions to achieve the inflation target. Shifts in preferences and changing political contexts will always encourage greater discretion than the current monetary context warrants. This is why the strategy’s detailed specification of the conditions under which the central bank permits deviations of inflation from the target, or chooses to look through certain shocks, is a vital element of institutional self-discipline.