 We will turn each and every stone. These are the words President Christine Lagarde used during her first ECB press conference in December 2019. She was announcing the launch of our Monetary Policy Strategy Review. It was the first one to take place since 2003. We spent the next 18 months working together with colleagues from central banks across the Euro area. Their task, to figure out whether our strategy was still fit for purpose. How does online shopping affect prices? Is the way we analyse the economy still up to date? And are we communicating with people in the right way? These were just some of the questions that guided the review. And earlier this summer, we announced our new Monetary Policy Strategy. You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. I'm here today with our Chief Economist, Philip Lane, to discuss what the review was all about. Philip, welcome to the ECB podcast. Good afternoon. It's a pleasure to be here. Now, this was the first time we reviewed our strategy in just under two decades. Very simple question to kick off. Why now? Well, I think maybe two reasons. One is clearly overdue. And I think every organisation should have a regular review. And by the way, one of the decisions we made was we were going to take a look at our strategy in 2025. So we've already said we're committing to the next review. During these years, between 2003 and 2021, of course, a lot happened. We had the global financial crisis. We had the euro area crisis. And of course, most recently, we've had a pandemic. So I think why now? Partly a lot of those crises and also slower moving structural changes in the world economy has raised questions for basically all central banks. And so it's very good timing to take a good look, a comprehensive look. And as you indicated, using all the resources of the euro system across all of the national central banks as well as the ECB. And I do think even though it took 18 months and took a lot of work, it was very important to do this review. Now, keeping prices stable is really at the core of what we do here at the ECB. And as part of the review, we adopted a new price stability objective of 2%. Can you explain why we went for 2%? So I think it's a balance between two considerations. One, if you like, is the traditional consideration, which all central banks in history have had, which is we know excessively high inflation is very costly. It's costly for economic performance. It's socially disruptive. It really is a problem, for example, which is extremely unequal in its impact. And where we know the poorest parts of society suffer the most. So it's always been the case that central banks dislike excessively high inflation. What is maybe new? I mean, there are elements of this already 20 years ago, but reinforced now is we also understand that it's a mistake to allow inflation to go too low. Very definitely problems if you have deflation, so prices falling. But in fact, you need a significant buffer above zero because you need a reasonable amount of inflation in order to allow the economy to work smoothly. To deal in particular with recessionary shocks, it provides a more stable environment. So I suppose that we ended up with 2% with that balancing act. And of course, it should be said 2% is an extremely popular target around the world because we're not the only central bank dealing with these considerations. And so I think having this 2% target at this point in time makes a lot of sense. Now, there are two things that I've read in relation to this 2%. Number one, that it's symmetrical. That's the idea that we want inflation to neither be too high nor too low, right? Right, so on that consideration, as I just indicated, for sure we don't like excessively high inflation and we don't like excessively low inflation. And if you like this idea of symmetry, it's one way to capture that sensation that we equally find it undesirable to have excessively high or excessively low. And of course, for a kind of technical economist in the audience, very many economic models have this feature of essentially a symmetrical target for a central bank. Okay, another thing that I've read about the objective is that it's clear and easy to understand. And this is an aspect that I quite like to unpack a little, this kind of communication aspect of it. Why is that so important? One important way in which central banks can deliver price stability is if you like, try to coordinate society. And coordinate in society where firms, when they are trying to work out where is inflation going to be, individuals. So often, of course, I don't need to be overly concerned with inflation on a day-to-day basis. But let's say I'm working out whether I should borrow to buy a house, to buy a car. I need to have a reasonable sense of the inflation rate I can expect in over the coming years. So governments need to take a view. Basically, all sectors of society need to take a view about where to think inflation is going to be on average. And so having a clear, easy to remember, easy to communicate at 2% target helps with that. I should also say it helps with accountability. We are holding ourselves up here because we're saying we're aiming to deliver 2% over the medium term. And it's reasonable to ask these questions if we do not deliver that clear target. Whereas if we had a very fuzzy definition of what it means to have price stability, it'd be very hard for anyone to kind of hold us to account in the sense of saying, you know, you're not doing your job. Whereas here we have invited accountability by saying, here's our aim. And if we have deviations from that aim, it would be on us to explain why inflation has deviated from the target. But of course anchored in delivering 2% in a stable way over the medium term. Okay. So it's basically a lot about helping people to plan and a little bit about this accountability as well. Right. So I think both dimensions are important. Okay. So we've spoken a lot about what we want inflation to be 2%. Now to know how far or close you are to achieving that goal, you obviously need to be able to measure prices and how they change over time. And I can't imagine that's very easy in the euro area because what we have 19 countries using the euro and they're all very different in the kind of things that they spend their money on. And Philip, this idea of measuring inflation was indeed one of the topics in the review. And I'm keen to know a bit more about why you included it and the kind of things that you looked at. So you raise some fundamental issues here. So let me start off by saying, of course, the measurement of inflation is actually conducted by Eurostat, the European Statistical Agency. So let me broaden your question to really be not just about measurement, but interpretation. And also in terms of scope, and maybe the scope issue is important, is one feature that has been many times raised with the ECB was essentially, we didn't pass the common sense test for many people in the sense of when they say, well, how do I spend my income? Housing costs featured a lot more in many people's internal accounting than appeared to be the case in our price index. And in particular, although those who rent the rental costs have been in the price index and are important, a lot of people in the area own their home. And so the costs associated with owning a home, whether buying the home, maintaining it, the occasional renovation, ensuring that home, that was under counters in the price index. So we do think, and by the way, this came out loud and clear when we did the various ECB listens events. And I should say, your system listens really, because a lot of national central banks had these types of event. And this was, I think, really just common sense. We need to find ways to expand the measurement of the price index to do a better job of including those costs. This is going to be a long-term project because it requires all sorts of regulatory changes, new approaches, which of course, the lead role with your stat. But of course, if you have a long-term goal, you should start now in order to make sure you ultimately achieve that. And I should say in the meantime, we also made clear in the review, we already have various partial pieces of information, and we will take these into account when studying inflation. Let's dive a bit deeper into some of the other areas that we looked at. Now, the review itself was made up of 14 key topics, and they ranged from very specific things like our monetary policy toolbox, or how we analyze the economy to much broader developments like globalization and even digitalization. Now, for those listeners who are keen to go into a little bit more depth, we've actually just published several papers with background material on our review, and you'll be able to find all the links to that in the show notes. So the thing I'd like to look at next is employment. In other words, how many people have jobs? What kind of jobs do they have and how much are they paid for those jobs? Philip, could you explain a bit why the employment situation is important for our monetary policy? How do our decisions impact jobs and vice versa? Sure. So I think this was a very important work stream in the overall review for several reasons. One is we know in the end a large fraction of what goes into prices, in fact, are wages. So about two thirds of the economy can be thought of as the contribution from workers. Two thirds. Two thirds. And of course, that varies a little bit across countries, but more or less that's a broader proxy. So when you know that two thirds of prices basically reflect wage developments, you have to understand what's driving wage dynamics in the economy. And of course, a pretty basic overall factor there is how hot is the labor market? Clearly, wage is going to grow more quickly if there's a high level of labor demand. So that is a kind of classic issue. But let me emphasize also, again, going back to the point I just made about data, in a world where we know more and more about kind of individuals, know more and more about different sectors, we can also understand that that overall dynamic can also be better understood by understanding the dynamic of, for example, differences in participation rates across age groups between men and women. As you said earlier on across countries, because of course, labor markets differ quite a bit in the euro area. So having that granularity, having that kind of concentration on understanding the full range of what goes into the European labor market is very important. So that is essentially a pretty basic building block for understanding inflation. Let me mention as well as a second dimension, which has always been there. It was there from where it go at the ECB and it's there all the time for every central bank, which is right now essentially in a world where we have inflation below our targets and we have accommodative monetary policies. By and large, these policies are pro-employment. Low interest rates stimulate firms to expand to hire more workers, most basically. But there are scenarios where essentially there could be a tension between what we need to do to control inflation and what is good for employment. For example, in the 1970s, we had these large oil shocks, which drove up inflation, but were also pretty bad for employment. So one important element in the review was we spent quite a bit of time reviewing and returning to the topic of the medium term. Because what we essentially say is we aim to stabilize inflation at 2% over the medium term. And that medium term perspective gives us the room if it's needed to tolerate some short-term deviation of inflation from the target. If that is what is needed to allow the labor market to handle one of these shocks. So it's always been a part of I think every central bank's philosophy, which is you don't need to hit 2% every week or every month. If there is a conflict between what is needed to deliver price stability and what is needed to support the labor market, having a flexible interpretation of the medium term allows us to make a contribution to managing that trade-off. I should say it's always going to be over a limited time period. It's not something right now that that is kind of to the forefront. Because we have been in this phase right now for quite a while of monetary policy with low interest rates and our other instruments. We do think it's quite supportive of employment. And for example, in this pandemic period, we do calculate that the level of employment recovery in Europe would have been a lot less without the policies we have adopted. So we do very much take into account the impact of our policies on employment. Number one, because it matters for the inflation dynamic. And number two, where there are kind of a trade-off, we recognize that we can manage those trade-offs to a flexible view of the medium term concept. Well, it's really incredible to hear just how many things you've had to have on your radar during this review. And the last topic I'd like to discuss is actually another one, climate change. Now, two years ago, nobody would have thought that climate change would have been on a central bank's agenda. And here we are now with a whole action plan for taking climate change into account in our work. This was actually one of the big outcomes of the strategy review. Philip, as the chief economist of the ECB, you're most concerned about meeting our inflation goal. What's climate change got to do with that? Let me emphasize is that the topic of climate change has been around honestly for decades. I did my PhD in the early 90s, and even in the early 90s, many of my colleagues were working on this topic. So what is maybe new now is we all also recognize that climate change is quite non-linear. I think the evidence is accumulating that climate change matters right now. It's no longer just a topic for the future. And of course, with the Paris Accord and with the implementation of those commitments here in Europe, we know a lot is going to happen in terms of transition policies over the next decade. So it's very much a here-and-now issue now, whereas maybe a number of years ago you could say, well, we will have to deal with it in the future, but the day has come. And let me emphasize maybe two parts of that from a multi-policy point of view. One is already over the two years since I've been here at ECB, understanding the implications of extreme weather events. For example, the very hot summer we had in Europe in 2019. This winter around the world has been quite a lot of disruption to production of semiconductors, to the coffee prospects for coffee harvests from extreme weather. So we already, in terms of the usual cyclical variation, weather shocks are becoming more important. But maybe a bigger issue, because of course the central banks we are forward-looking, is the implication of all of the policies we know will need to be adopted to allow a transition to a low-carbon or a zero-carbon economy. And this is a major structural change, which will involve a major reform, if you like, especially of the energy-producing sector, a major reform of how we use energy across the economy. So it's an economy-wide pervasive structural change. And we need to model this, we need to understand it, because it really is a first-order macroeconomic issue. So it's not complicated in terms of the basic conclusion that central banks need to invest in understanding the carbon transition, understanding the increased frequency of extreme weather events, because clearly these are macroeconomic implications and therefore implications for price stability. Okay, before we wrap up, I ask all our guests here on the podcast for a hot tip on today's topic. Philip, what tip would you like to share with our listeners? Let me offer two tips. One is anyone who is listening to this podcast should really make plans to also, in the next few days, keep track of the ECB Central Banking Forum, which we always refer to as the Cintra Forum, even though, of course, it's online this year. So we're going to be looking at the challenges facing multi-policy beyond the pandemic. It's going to be some very good academic sessions, some important policy panels, and maybe the highlights will be the interaction between President Lagarde, Chairman Powell of the Federal Reserve, and then Andrew Bailey, the Governor of the Bank of England in the policy panel. So this for Central Banking, those interested in Central Banking is a real highlight for the year. But maybe also we've talked a lot today about the major challenges facing the world economy, the challenges facing policymakers. So I will just offer also a personal recommendation. Last week, I also had the chance to read the memoir written by Amartya Sen called At Home in the World. And Amartya Sen is just a remarkable economist and, of course, a philosopher. And anyone interested remotely in economics, I think will find a lot of value in reading his memoir of his early years. Two great tips. Thank you so much, Phillip. It's been a real pleasure speaking today. Indeed. Thank you for your questions and your interest. Well, that brings us to the end of this episode. I should mention that we have a lot of information about the strategy review in simple everyday language on our website. We've even got cartoons. So if you're interested in learning more, do check out the show notes for the links. You've been listening to the ECB podcast with Katie Ranger. If you like what you've heard, please subscribe and leave us a review. We'd also love to hear from you, so do share your feedback and ideas with us via social media. Until next time, thanks for listening.