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The objective of the European Central Bank (ECB) is price stability – an inflation rate of 2%. It seeks to realise this with its monetary policy, and this includes setting interest rates. In doing so, the central bank takes into account economic developments. Below, we describe the key points of the ECB's monetary policy.

Inflation target of 2%

The principal objective of the European Central Bank (ECB) is price stability – an inflation rate of 2% in all countries that use the euro. This is because an economy works best when prices are stable. Inflation that is too low is just as undesirable as inflation that is too high. But inflation may temporarily be slightly above or below 2%. For example, in the case of economic shocks, such as the COVID-19 crisis. So temporary deviations from the inflation target are not a problem. In monitoring price developments the ECB looks at the medium term. This provides more flexibility in terms of its policy.

Toolbox

The ECB has no direct influence on rising and falling prices, but it can use its monetary policy to exert indirect influence on inflation. To support its monetary policy, the ECB has a well-assorted toolbox. Important tools are the key interest rates, which are the rates at which banks borrow money from the ECB or deposit money with the ECB. There are also other tools which the ECB can use to influence inflation. Over the past few years, the ECB has added new tools to its toolbox to maintain price stability in response to the huge changes that the economy has been undergoing, such as the special purchase programmes.

Decisions on interest rates

The ECB's Governing Council takes decisions on interest rates. DNB President Klaas Knot has a seat on the Council, as do the governors of the other euro area central banks and the members of the ECB's Executive Board.

Adjusting interest rates

If inflation is above or below 2% for too long in the medium term, the ECB can adjust the key interest rates.

  • Too high If inflation is persistently too high, the ECB can raise interest rates. It will do so if it wants to depress inflation to achieve price stability. The idea is that if interest rates are high, people will borrow and spend less, firms will invest less and inflation will fall.
  • Too low If inflation is persistently too low, interest rates can only become negative to a limited extent. Deeply negative interest rates will damage the economy, for example because they put pressure on the financial positions of banks and pension funds. So if key interest rates are already low, the ECB cannot lower them much further. It must then use other monetary instruments to pursue an accommodative monetary policy. Examples include launching purchase programmes to allow extra money to circulate in the economy. Read more about accommodative monetary policy and purchase programmes. 

Interest rate hikes of July and September 2022

Inflation has skyrocketed over the past year. This is partly due to soaring energy and food prices, which are caused in part by the war in Ukraine. As a result, demand is now higher than supply, causing many prices to rise. The ECB expects inflation to remain above 2% in the medium term, which is why it is raising interest rates to curb demand and bring down inflation. The ECB raised interest rates by 0.5% in July 2022 and by another 0.75% in September 2022. Read more about inflation.

Outlook

Central banks publish their outlook on monetary policy. This is called forward guidance. In doing so, they manage expectations about future monetary policy, including interest rates. The ECB explains what monetary policy can be expected for specific trends in inflation, which investors can then take into account. In this way, they will not be faced with surprises that could send shocks through the financial markets.

Inflation measure to include cost of home ownership

The ECB uses the European Harmonised Index of Consumer Prices (HICP) as its measure of inflation. It measures price movements of all kinds of products that we consume. The ECB will in the future also include the cost of home ownership, such as renovation, maintenance and insurance premiums. This also includes the costs incurred in the purchase of newly built homes or former rented accommodation, such as real estate agents' and civil-law notaries' fees. It does not include house prices, because asset prices are not included in the calculation of inflation. The ECB plans to use the so-called OOHPI house price index as a measure of the cost of home ownership. This requires some adjustments and preliminary work. Read more about how the ECB will include the cost of home ownership.

Analyses for monetary decision-making

Well-informed monetary decisions require the ECB to have a clear picture of the current economic and financial conditions and outlook. The ECB uses an analytical framework to systematically assess information and consistently communicate on developments in the economy and financial markets. It will revise this framework and widen its scope. The aim is to be able to assess economic and monetary analyses more coherently. The ECB will place increased focus on longer-term developments and financial stability. In addition, it will more explicitly weigh the benefits of policy decisions against undesirable side effects. Read more about the revision of the analytical framework. 

The ECB's monetary policy and climate change

Climate change and climate policies can have an impact on inflation and thus affect the ECB's objective of price stability. The ECB will incorporate climate change into its monetary policy in several ways.

  • It will take into consideration the climate change risks inherent in its financial market operations, for example its purchase programmes, such as the Corporate Sector Purchase Programme (CSPP). Emission-intensive companies have a relatively large share in the CSPP because they make extensive use of debt financing. The ECB is examining whether and how purchases under the CSPP can be adjusted on the basis of climate criteria.
  • It will make climate-related reporting a precondition for financial institutions' participation in monetary operations and for the qualification for purchase and eligibility as collateral of assets.
  • It will include climate considerations in its own risk management. This is because climate change can lead to write-downs of bonds in monetary policy portfolios, and can therefore impact central banks’ balance sheets.
  • It will disclose the climate risks to which it is exposed.
  • It will study possibilities for incorporating climate change risks in the collateral framework, for example by applying haircuts in the valuation of collateral. This is because the credit quality of that collateral may deteriorate as a result of climate-related damage or transition risks.

Read more about the ECB's focus on climate change in the implementation of its monetary strategy.