STUDY

RequestedbytheECONcommittee

MonetaryDialoguePapers,June2025

TheConductofECBMonetaryPolicyUnderInternationalUncertainty

Externalauthors: LauraBOTTAZZI CarloFAVERORubenFERNANDEZFUERTES

FrancescoGIAVAZZI VeronicaGUERRIERI GuidoLORENZONITommasoMONACELLI

EconomicGovernanceandEMUScrutinyUnit(EGOV)

Directorate-GeneralforEconomy,TransformationandIndustry

PE760.275-June2025EN

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TheConductofECBMonetaryPolicyUnderInternationalUncertainty

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TheConductofECBMonetaryPolicyUnderInternationalUncertainty

Abstract

ThispaperexaminesECBmonetarypolicyamidrisinginternationaluncertainty.Wefocusonthreeglobalrisks:renewedtradeprotectionism,euroappreciation,andUSfiscalfragility.Usinginflationforecastsandsurveydata,weevaluatetheECB’sevolvingpolicyframework.ApotentialUSfiscalcrisisposesrisksbutalsocreatesanopportunityforEuropetosupplyaglobalsafeasset.WearguethataEuropeanDebtAgencyissuingcommondebtcouldmitigatecontagionandenhanceEurope’sfinancialsovereignty.

ThisdocumentwasprovidedbytheEconomicGovernanceandEMUScrutinyUnitattherequestoftheCommitteeonEconomicandMonetaryAffairs(ECON)aheadoftheMonetaryDialoguewiththeECBPresidenton23June2025.

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ThisdocumentwasrequestedbytheEuropeanParliament'sCommitteeonEconomicandMonetaryAffairs.

AUTHORS

LauraBOTTAZZI,UniversityofBologna,IGIERandCEPRCarloFAVERO,BocconiUniversity,IGIERandCEPR

RubenFERNANDEZ-FUERTES,BocconiUniversity

FrancescoGIAVAZZI,BocconiUniversity,IGIERandCEPR

VeronicaGUERRIERI,TheUniversityofChicagoBoothSchoolofBusinessGuidoLORENZONI,TheUniversityofChicagoBoothSchoolofBusinessTommasoMONACELLI,BocconiUniversityIGIERandCEPR

ADMINISTRATORRESPONSIBLE

GiacomoLOI

DrazenRAKIC

MajaSABOL

RonnyMAZZOCCHI

EDITORIALASSISTANT

AdrianaHECSER

LINGUISTICVERSIONS

Original:EN

ABOUTTHEEDITOR

TheEconomicGovernanceandEMUScrutinyUnitprovidesin-houseandexternalexpertisetosupportEPcommitteesandotherparliamentarybodiesinshapinglegislationandexercisingdemocraticscrutinyoverEUinternalpolicies.

TocontactEconomicGovernanceandEMUScrutinyUnitortosubscribetoitsnewsletterpleasewriteto:

EconomicGovernanceandEMUScrutinyUnitEuropeanParliament

B-1047Brussels

E-mail:

egov@ep.europa.eu

ManuscriptcompletedinJune2025

?EuropeanUnion,2025

Thisdocumentwaspreparedaspartofaserieson“QuarterlyAssessmentoftheECB’sMonetaryPolicyStance”,availableontheinternetat:

https://www.europarl.europa.eu/committees/en/econ/econ-policies/monetary-dialogue

DISCLAIMERANDCOPYRIGHT

TheopinionsexpressedinthisdocumentarethesoleresponsibilityoftheauthorsanddonotnecessarilyrepresenttheofficialpositionoftheEuropeanParliament.Reproductionandtranslationfornon-commercialpurposesareauthorised,providedthesourceisacknowledgedandtheEuropeanParliamentisgivenpriornoticeandsentacopy.

TheConductofECBMonetaryPolicyUnderInternationalUncertainty

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CONTENTS

LISTOFABBREVIATIONS6

LISTOFFIGURES7

LISTOFTABLES7

EXECUTIVESUMMARY8

1.INTRODUCTION9

2.THEECBDECISIONFRAMEWORK,THEMONETARYPOLICYSTANCEANDINFLATION10

2.1.TheECBdecisionframework10

2.2.Themonetarypolicystance11

2.3.Evolutionandoutlookforheadlineandcoreinflation12

2.3.1.InflationdifferentialsacrossMemberStates12

2.4.Chinaasapersistentsourceofexternaluncertainty14

2.4.1.Inflationdynamicsanddeflationarypressures14

2.4.2.Exportperformanceandtradediversification15

2.4.3.TradepolicydevelopmentsandEU-Chinarelations17

3.PERCEPTIONSOFECBMONETARYPOLICY18

3.1.Anchoringofinflationexpectations18

3.2.PerceivedTaylorRulesandECBcommunication20

4.GLOBALRISKANDCHALLENGESFORTHEEUROAREA24

4.1.Twinshocks:goodsmarketsandassetmarkets24

4.2.Implicationsformonetarypolicy25

4.3.Effectsonfinancialconditions27

4.3.1.Financialtensionsandcontagion28

4.4.OpportunitiesforEurope30

5.CONCLUSION32

REFERENCES33

ANNEX35

6.1.TheDashfortheDollars35

6.2.USExchangeRateDynamicsintheBlanchardetal.(2005)model36

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LISTOFABBREVIATIONS

APP

Assetpurchaseprogramme

DF

DepositFacility

EBA

EuropeanBankingAuthority

ECB

EuropeanCentralBank

ECB-SPF

EuropeanCentralBankSurveyofProfessionalForecasters

EDA

EuropeanDebtAgency

EP

EuropeanParliament

EU

EuropeanUnion

GDP

Grossdomesticproduct

HICP

Harmonisedindexofconsumerprices

MRO

MainRefinancingOperations

PCCI

PersistentandCommonComponentofInflation

PEPP

Pandemicemergencypurchaseprogramme

TLTRO

Targetedlonger-termrefinancingoperations

TPI

Transmissionprotectioninstrument

USD

USdollar

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LISTOFFIGURES

Figure1:WeightsofthemaincomponentsoftheeuroareaHICP,202513

Figure2:China’sinflationrate(consumerprices,%changeyear-on-year)15

Figure3:China’sexports(%Change,year-on-year)16

Figure4:China’selectriccarsexports(units)16

Figure5:Inflationexpectations,2021:03(pre-shock)19

Figure6:Inflationexpectations:2022:09(peakinflation)19

Figure7:Inflationexpectations:2024:09(after-shock)20

Figure8:ThevariablesintheTaylorRule21

Figure9:ThecoefficientsintheTaylorRuleovertime23

Figure10:Impulseresponsefunctionsofdomesticvariablestoareductionintheconvenienceyieldon

foreignassets(low,baselineandhighlaboursupplyelasticityscenarios)26

Figure11:Thedeterminationofequilibrium36

Figure12:AshifttowardsUSgoods37

Figure13:AshiftawayfromUSassets37

LISTOFTABLES

Table1ECBinterestratechanges(2024-2025)11

Table2:ECBinflationprojections(5June2025)12

Table3:Inflationbysectorintheeuroarea,Germany,Spain,France,andItaly14

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EXECUTIVESUMMARY

?ThispaperanalyseshowtheEuropeanCentralBank(ECB)conductsmonetarypolicyamidrisinginternationaluncertainty,focusingonthreemainglobalrisks:renewedtradeprotectionism,euroappreciation,andUSfiscalfragility.ThesefactorschallengetheECB'sabilitytomaintainpricestabilityandfinancialresilienceintheeuroarea.

?TheECB'smonetarypolicyreactionisstructuredaroundthreeexplicitcriteria—headlineinflationoutlook,underlyinginflationtrends,andthestrengthofpolicytransmission—withafourthimplicitanchor:long-terminflationexpectations.Thisframeworkhasguidedrecentratecutsamidfallinginflationandmoderategrowthforecasts.

?Despiteinflationfallingtowardthe2%target,risksremainduetouneveninflationdynamicsacrossMemberStatesandsectors.Coreinflationisprojectedtostayelevatedduetowagepressuresandservicesinflation,whileenergypriceshavehelpedreduceheadlineinflation.

?ProfessionalforecastersperceiveECBpolicyasbroadlycredible,withinflationexpectationsremaininganchored.However,theirviewsontheECB'sreactionfunction-modelledasaTaylorrule-suggestambiguityregardingthenaturalinterestrateandoutputgapresponsiveness.

?AsharpshiftinglobalinvestorpreferencesawayfromUSassets-drivenbyfiscalconcernsandpolicyunpredictability-hasledtoeuroappreciation,whichcouldweakeneuroareaexportsandeconomicactivity.Thisdeviationfrompastflight-to-safetydynamicssignalsapossibleregimeshiftinglobalfinance.

?Portfolioinflowsintoeuro-denominatedassetscaneasefinancialconditions,butitmayalsotriggercontractionaryeffectsviarealexchangerateappreciation.Thenetmacroeconomicimpactdependsonthecompositionofassetinflows(safevs.riskyassets)andtheirinteractionwithmonetarypolicy.

?Euroareabanksfacebalancesheetvulnerabilitiesduetodollarexposureandrelianceonsynthetichedging.Adisorderlydollardepreciationcouldstraineuroliquidityviaforeignexchange(FX)swapmarkets,despiteaseeminglyfavourableeuroappreciation.

?IncreaseddemandforsafeassetsoutsidetheUSmakesthismomentespeciallyfavourabletothecreationofaEuropeanDebtAgency(EDA)toissuecommoneuro-denominatedsafedebt.Thiswouldreducebondmarketfragmentation,absorbglobaldemandforsafeassets,andenhanceEurope'sfinancialsovereignty.

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1.INTRODUCTION

Recentshiftsinglobalfinancialconditionsandgeopoliticaltensionshaveheightenedconcernsaboutexternalrisksthatcouldsignificantlyimpacttheeuroarea’smacroeconomicoutlook.First,thewaveofprotectionistmeasuresfromtheUSisanimmediatecauseforconcernforEuropeanexports.Thefactthatthishasbeenaccompaniedbyanappreciationoftheeuro,ratherthanbyadepreciation,addstothisconcern,asastrongereuroreducesexportcompetitiveness.

Second,thepossibilityofadisorderlyUSdollarcrisispresentsamoresystemicthreat.Giventhedollar’scentralroleinglobaltrade,finance,andreserveholdings,asharpanduncoordinateddeclinecoulddisruptinternationalcapitalflows,increasemarketvolatility,andtriggerflight-to-safetydynamicsthatwouldreverberatethroughEuropeanmarkets.

Third,afiscalcrisisintheUnitedStates,particularlyonedrivenbyunsustainabledebtdynamicsorpoliticalgridlock,coulderodeinvestorconfidenceinsovereigndebtmarketsglobally.SuchascenariomaynotremaincontainedwithintheUS,asfinancialcontagioncouldspillovertoEurope,raisingriskpremiaandstrainingfiscalpositionsinvulnerablememberstates.

ThispaperanalysestheconductofECBmonetarypolicyunderinternationaluncertaintybyexamininghowtheECB’sdecisionframeworkrespondstodifferenttypesofexternalshocks,howmarketparticipantsperceiveitsstrategy,andhowtheseshockstransmitthroughtrade,financial,andportfoliochannels.

Atthesametime,thepotentialfiscalinstabilityintheUSalsopresentsauniqueopportunityforEurope.AsthecredibilityofUSsovereigndebtweakensandinvestorsseekalternativesafeassets,theeuroareacouldstrengthenitsinternationalrolebyofferingacrediblesubstitute.Buttodoso,itmustovercomethepersistentfragmentationofitssovereignbondmarkets.AEuropeanDebtAgency,taskedwithissuingacommoneuroareasafeasset,wouldaddressthisfragmentationandserveasastabilisinganchorintimesofglobalturmoil.Suchaninstitutionwouldnotonlyshieldtheeuroareafromspilloversbutalsoprovidethefoundationforgreaterfinancialintegrationandresilience—turningaglobalriskintoaEuropeanstrategicadvantage.

Thereportisorganisedinthreemainsections.

Section2containsasummaryofthecurrentstanceofmonetarypolicy,inlightofrecentavailabledataonthekeycriteriaguidingtheECBdecisions.

Section3focusesonacentralissueinmonetarypolicycommunication:howthepublicinterpretsmonetarypolicyactions.Thechapterusessurveydatatoprovideaninterpretationofhowthepublichasviewedtheconductofmonetarypolicyinthelastfewyears.

Section4providesanevaluationofwhatweseeasmainsourcesofrisksfortheeuroareainthenearfuture,mostlycomingfromUSprotectionismandfromshiftsinglobalassetmarketsassociatedtoincreasedperceivedrisksinUSinvestments.ItalsocontainsourdiscussionofthemeritsofproposalsforthecreationofaEuropeanDebtAgency,andwhytheyseemespeciallytimelyinthecurrentenvironment.

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2.THEECBDECISIONFRAMEWORK,THEMONETARYPOLICYSTANCEANDINFLATION

Inthissection,wefirstdescribetheECBdecisionframework,aslaidoutinthe2024AnnualreportoftheECB,wethenillustratebrieflythemonetarypolicystancerecentlyadoptedtothenassessinflationforecastsandthemainfactorsofriskfortheinflationscenariowithaparticularfocusontheroleofChina.

2.1.TheECBdecisionframework

The2024AnnualReportoftheEuropeanCentralBank(2025a)outlinesthecontextinwhichtheECBaddressesrisksarisingfromglobaluncertaintiesandexchangeratefluctuations.ItalsodetailsthecriteriaguidingECBdecision-making—specifically,itsmonetarypolicyreactionfunction—bypresentingadecisionframeworkbuiltonthreekeypillars:theinflationoutlook,theunderlyinginflationdynamicsandthemonetarypolicytransmissionstrength.Kamps(2024)referstotheseasthe“ABCs”oftheECB’sreactionfunctionandidentifiesanimplicitfourthelement,ahidden“D”:anchoringofthelong-terminflationexpectations.

Monetarypolicymustbeforward-lookingbecauseofthetimeittakesforpolicychangestoinfluencetheeconomyandinflation.Accordingly,theECBusesprojectionstoassesswhereinflationisheadingoveratypicalhorizonoftwotothreeyears.Ifinflationisexpectedtobeabovetargetattheendofthatperiod,theECBmayraiseinterestrates;ifitisexpectedtobebelowtarget,itmaylowerthem.However,theheightenedeconomicuncertaintyofrecentyears—drivenbyrepeatedshockssuchastheglobalfinancialcrisisandtheCOVID-19pandemic—hascastdoubtsonthereliabilityofforecasts.Insuchenvironments,theECBtendstoprioritizenear-termdevelopmentsoverlonger-termprojections,makingtheforecasthorizonmorecontext-dependentthanfixed.

Thedynamicsofunderlyinginflationhighlightstheimportanceofisolatingitspersistentcomponent,whichprovidesvaluableinsightsintomedium-terminflationarytrends.Duringperiodsofheighteneduncertainty,theECBplacesgreateremphasisonmeasuresofunderlyinginflationtosupplementheadlineprojections.Notableamongthesearecoreinflation(whichexcludesfoodandenergy),thePersistentandCommonComponentofInflation(PCCI),anddomesticinflation(whichexcludesitemswithhighimportcontent).Whilecoreinflationiswidelyused,itdoesnotalwaysserveasareliablepredictor.Incontrast,PCCIanddomesticinflationhavedemonstratedabetterperformanceovertime.Divergencesamongtheseindicatorscansignaldifferentsourcesofinflationarypressure—suchasdomesticallydriven,wage-relatedinflation,andbroadersupply-sidedynamics.TheECBcloselytracksthesemetricstoinformitspolicydecisionsinadata-dependentmanner.

ThestrengthofmonetarypolicytransmissionreferstotheextenttowhichchangesinECBpolicyratesaffectbroaderfinancialconditions,economicactivity,andinflation.Althoughpolicyratesplayacentralrole,theeffectivenessoftransmissionisnotconstant:itvariesbasedonfactorssuchasthestructureofthefinancialsystem,thestateoftheeconomy,andprevailingliquidityconditions.Themostrecenttighteningcyclefacedadditionaluncertainty,giventheprecedingeraofexceptionallylowinterestrates,elevatedexcessliquidity,andtheunprecedentedspeedofrateincreases.Nevertheless,emergingevidenceindicatesthatmonetarypolicyhasbeentransmittingeffectively,particularlythroughthebankingsector.Tightercreditstandardsandsubduedloangrowthindicatethathigherratesarefeedingthroughtotherealeconomy,whichiscrucialforbringinginflationbacktotarget.ThiscriterionprovidesalsoarationalisationfortheTransmissionProtectionInstrument(TPI),designedtopreventEuropeanbondmarketfragmentationcausedbydeviationsofgovernmentbondpricesfromfundamentalsinsomeoftheMemberStates.

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Finally,theanchoringofinflationexpectationsisakeyindicatorofmonetarypolicycredibility.Whenpolicyiscredible,long-terminflationexpectationsremainalignedwiththeECB’sstatedinflationtarget.

2.2.Themonetarypolicystance

ThecurrentECBmonetarypolicystanceisdefinedbyconventionalandnon-conventionalmonetarypolicy.

Table1illustratestheevolutionofconventionalmonetarypolicythatshowsatransitionfromatighteningphase(July2022–September2023)toagradualeasingphasesinceJune2024.AsofJune2025,thedepositfacilityratestandsat2%.

Table1ECBinterestratechanges(2024-2025)

Date

DF

MRO

MLF

Notes

December14,2023

4.00%

4.50%

4.75%

Holdingphase

June6,2024

3.75%

4.25%

4.50%

Startofeasing

September12,2024

3.50%

3.65%

3.90%

Continuedeasing

October17,2024

3.25%

3.40%

3.65%

Furtherreduction

December12,2024

3.00%

3.15%

3.40%

Endof2024rate

February5,2025

2.75%

2.90%

3.15%

First2025cut

March12,2025

2.50%

2.65%

2.90%

Second2025cut

April23,2025

2.25%

2.40%

2.65%

Third2025cut

June11,2025

2.00%

2.15%

2.40%

Fourth2025cut

Note:DepositFacility(DF)rate,MainRefinancingOperations(MRO)rate,MarginalLendingFacility(MLF)rate.Source:ECB.Non-conventionalmonetarypolicyismeasuredbythesizeoftheEurosystem’sbalancesheet,whichbyEUR0.5trilliontoEUR6.4trillionin2024.Inparticular,thereductionsintheAssetPurchaseProgramme(APP),thePandemicEmergencyPurchaseProgramme(PEPP)andtheTargetedLonger-TermRefinancingOperations(TLTROIII)madetheEurosystemassetsfallin2024byEUR0.8trilliontoEUR4.3trillion,withreserveholdingsatEUR3trillion.

TheECBplanstoreassessitsoperationalframeworkparametersin2026,withtheTPIremaininginplacetosafeguardmarketstability.

Thisstanceisconsideredasappropriatetoachievethe2%inflationtarget,supportingeconomicrecoveryalongside0.9%GDPgrowthin2024.(EuropeanCentralBank,2025b,2025c,2025d,2025e).

Initslatestdeliberations,theGoverningCouncilreviewedrecentmacroeconomicdevelopments.EuroareaGDPgrowthwasrecordedat0.9%in2024,withprojectionsmaintainedat0.9%for2025,1.1%for2026,and1.3%for2027.Theunemploymentrateremainedstablein2024at6.2%.Againstthisbackdrop,thefourratecutsimplementedthusfarin2025—amountingtoacumulativereductionof100basispoints—weredeemedappropriate.

TheECBunderscoredtheimportanceofeffectivepolicytransmissionandreaffirmeditsconfidenceinconverginginflationtowardthe2%medium-termtarget.Lookingahead,monetarypolicydecisionswillcontinuetobalancethepaceofeasingagainstevolvingwagedynamicsandexternalrisks,particularlythoserelatedtogeopoliticaltensionsandshiftsinUSmonetarypolicy.

Theprimarychallengeinthecurrentenvironmentremainselevatedeconomicuncertainty,largelydrivenbygeopoliticaldevelopmentsandexternalpolicyspillovers.InthenextsectionsweexplicitlyconsidertheinflationoutlookandtheroleofChinaasapersistentsourceofexternaluncertainty.

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2.3.Evolutionandoutlookforheadlineandcoreinflation

Thedatashowthatheadlineinflationdeclinedfrom2.9%inDecember2023to2.4%inDecember2024.TheJune2025projections,reportedinTable2,estimate2%in2025,1.6%in2026,and2%in2027(ECB,2025d,2025e).Coreinflationalsodeclinedbutisstillprojectedtoberelativelyelevatedin2025(2.4%)duemostlytodomesticfactors.

ThemaindriversofrecentinflationdynamicshavebeenidentifiedbytheECBasthediminishingeffectsofsupplyshocks,includingtheunwindingofenergypricespikesandsupplychaindisruptions.

Additionalfactorshavebeenweakerdemand,andnominalwagegrowthlargelyoffsetbyarecoveryinproductivity.Ontheriskside,externalfactorssuchasexchangeratevolatilityandglobaluncertainties—drivenbytradetensions,ambiguousUSeconomicandfiscalpolicies,andtheevolvingroleoftheUSdollarintheinternationalsystem—remaintheprimaryconcerns,mostlyonthedownside.Table2:ECBinflationprojections(5June2025)

Year

Headlineinflation

Coreinflation

2025

2.0%

2.4%

2026

1.6%

1.9%

2027

2.0%

1.9%

2.3.1.InflationdifferentialsacrossMemberStates

Table3presentsinflationdynamicsacrossthefourlargesteconomiesintheeuroarea—France,Germany,Italy,andSpain,disaggregatedbyfourmaincomponents.

TherelativeweightsofthemaincomponentsoftheHarmonisedIndexofConsumerPrices(HICP)intheeuroareafor2025areillustratedinFigure1.Eachcomponentcontributestoheadlineinflationtovaryingdegrees.Servicesrepresentthelargestshare,accountingforapproximately45.7%ofhouseholdfinalconsumptionexpenditure.Thisisfollowedbynon-energyindustrialgoodsat25.6%.Food,alcohol,andtobaccoconstitute19.3%,whileenergyaccountsfor9.4%.Althoughfoodandenergytogetherrepresentlessthanone-thirdofthetotalconsumptionbasket,theirpricevolatilitymeanstheycanexertadisproportionateinfluenceonheadlineinflation.

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Figure1:WeightsofthemaincomponentsoftheeuroareaHICP,2025

Source:Eurostat(onlinedatacode:prc_hicp_inw).

Theannualinflationrateintheeuroareawasconfirmedat2.2%inApril2025,remainingslightlyabovetheECB’smedium-termtargetof2.0%.

Themainupwardpressurecomesfromtheservicessector,followedbyfood,alcohol,andtobacco,whileenergyhadadampeningeffect.Servicesinflationnotablyacceleratedto4%inAprilfrom3.5%inMarch,potentiallyinfluencedbycalendareffectssuchasthetimingofEaster,assuggestedbysomeanalysts(OECDEconomicOutlook,April2025).

Lookingahead,geopoliticalfactorsmayintroducefurtherinflati