The European Central Bank must adapt to an environment of inflation volatility

The ECB must adapt its strategy to a new era of supply disruptions

Publishing date
12 June 2024
european central bank

The European Central Bank faces three major challenges in the short and medium terms. The first is to conduct monetary policy in an environment of much tighter fiscal policy, meaning that European Union governments may be constrained in supporting the ECB’s price stability objective if interest rates fall back to the zero lower bound (Darvas and Zettelmeyer, 2023). The second is the perennial problem of conducting monetary policy in the presence of fragmentation risk, a problem that the euro area has still not overcome and is unlikely to fully overcome in the medium term. Third, the ECB must adapt its monetary strategy to an environment of inflation volatility driven by supply shocks and structural changes on the supply-side of the economy. 

The first two problems are generally well understood. The ECB has worked extensively to tackle them in the past, including in its 2021 monetary strategy, and through the 2022 Transmission Protection Instrument (see Reichlin et al, 2024, for a recent discussion). This does not mean that there are easy solutions. Indeed, in an environment of high debt and constrained national fiscal policies, durable solutions would require politically difficult steps outside the control of the central bank, including establishing a central fiscal capacity and a euro-area safe asset.    

The third problem is more recent. Although the subject of a growing literature, it is not yet reflected in the ECB’s monetary strategy and has not fully ‘hit’ the reality of monetary policy making. It is therefore what we focus on here.

Monetary policy in the face of supply shocks: the traditional problem and its solution

Monetary policy acts mainly through its impact on aggregate demand. A negative supply shock increases prices while reducing purchasing power. Whether a monetary contraction is needed to further reduce demand and contain inflation is not clear. The conventional view is that central banks should accommodate supply shocks (do nothing initially) and take action only if there is a danger that the price push leads to a wage-price spiral. This may require tightening, creating rising unemployment beyond what normally would have occurred as a result of the supply shock. 

This view can to some extent explain why the ECB initially did not react to higher inflation resulting from higher energy prices in late 2021, and even after Russia’s invasion of Ukraine (the other reason was worry about fragmentation risks; see Reichlin et al, 2024). Once inflation had shot up much more than expected, however – and as the labour market continued to be tight – the ECB sought to pre-empt a wage-price spiral by raising rates quickly and sharply, even though inflation expectations had not moved much. The result was a quick drop in inflation, though at the cost of a sharp economic slowdown.

It is too early to evaluate whether this was the right strategy 1 Most recently, on 6 June 2024, the ECB cut rates by 0.25 percentage points, arguing its policy to combat inflation had succeeded and it was time “to moderate the degree of monetary policy restriction.” See Christine Lagarde, ‘Why we adjusted interest rates’, The ECB Blog, 8 June 2024,…. , and in any case a counterfactual scenario with less-aggressive monetary policy is hard to establish. What is clear, however, is that the environment in which supply and demand shocks happened in 2021-22, and in which they might happen in the future, might depart from the textbook model in multiple ways. To avoid major policy mistakes in the future, the ECB’s strategy might need to be adjusted in several ways.

Monetary policy in the face of supply constraints: new problems and their implications 

The textbook view may no longer be helpful for at least five reasons. 

First, it might involve not just more frequent supply shocks than advanced economies have experienced since the 1980s, but also a steepening of the supply curve. This is because supply disruptions – arising from geopolitical shocks, supply-chain disruptions, climate events and climate policies that limit the use of fossil fuel and reduce the elasticity of energy supply – imply that firms will frequently face higher marginal costs. This makes inflation more susceptible to shifts in demand, adding to inflation volatility (beyond the volatility induced by supply shocks directly) 2 Important contributions on the relevance of supply constraints for understanding inflation include Boehm and Pandalai-Nayar (2022), Fornaro and Romei (2024) and Comin et al (2024).

Second, supply constraints are likely to affect different sectors asymmetrically. While sectors hit by a supply shock may experience shortages and inflationary pressure, others may experience insufficient demand and unemployment. In this situation, aiming to reach the inflation target too rapidly could make it more difficult for the system to return to equilibrium, as this will require changes in relative prices (Guerrieri et al, 2021). For example, in the most recent inflation episode, headline inflation increased immediately but was only slowly propagated to services via the goods market (Guerrieri et al, 2023). This suggests that when shocks hit the economy asymmetrically, monetary authorities should lengthen the horizon for achieving the inflation target in order to facilitate the relative price adjustment. 

Third, in the textbook view, monetary policy acts on demand, while leaving potential output growth unaffected. This may no longer be the case. By dampening investment and innovation, contractionary monetary policy may have long-term effects, creating a trade-off between inflation stability today and lower productivity tomorrow. In turn, low productivity growth could make the economy more inflation-prone in the future 3 Recent research investigating the long-term effects on monetary policy on economic activity includes: Benigno and Fornaro (2019), Fatás and Singh (2022), Stadler (1990), Moran and Queralto (2018), Grimm et al (2022), Amador (2022), Fornaro and Wolf (2023), Jordà et al (2023), Ma (2023) and Ma and Zimmermann (2023). See also Demertzis (2024). .

Fourth, an important consequence of tight financial conditions discouraging investment is that the energy transition will happen more slowly. Preliminary evidence shows that the number of green patents is indeed affected negatively by changes in the tightness of financial conditions and that this effect is larger than for non-green patents (Fornaro et al, 2024). In this case, monetary policy will face a potential conflict between the primary objective of price stability and the secondary objective of successful emissions reduction. Since the ECB’s mandate does not allow it to compromise price stability, addressing this trade-off is mainly a task for fiscal policy. That said, there is also a role for ECB policies in ameliorating the trade-off, as explained below.

Implications for monetary policy and the monetary-fiscal policy mix

The above discussion is relevant for at least three policy problems that the ECB’s next strategy review should address.

1 The horizon for reaching price stability

While the ECB’s mandate rules out a trade-off between price stability and secondary objectives, there can be a trade-off in terms of the speed with which the primary mandate is attained (because it must hold over the medium term, and the definition of the medium term is a matter of judgment). Depending on whether it helps or hurts the secondary objective, the return to price stability could be accelerated, or the ECB could be patient. For example, after a negative supply shock that hurts both output and raises inflation, the ECB could be more patient. After a negative demand shock that drives interest rates close to the zero lower bound and creates problems for financial stability, the ECB could be more aggressive.

There is a need to establish a framework for flexible inflation targeting in which the time horizon for reaching the objective is linked to the cost in terms of secondary objectives.

2 The definition of price stability 

Relative price changes have an impact on the optimal level of inflation targeting. In a realistic situation in which prices are sticky, systematic firm-level productivity trends imply higher optimal trend inflation and therefore a higher inflation target. As Adam and Weber (2019) showed empirically for Italy and the UK, that level should be higher than 2 percent. 

This does not necessarily mean that the euro-area inflation target should be raised. But it suggests that the inflation target should be reviewed in light of the changing structure of the economy and of the economic shocks driving inflation. To allow the ECB to do this without risking a loss of credibility – as may occur if the inflation target is seen as ‘following’ actual inflation – it would be advisable to revise the numerical inflation target regularly, on the basis of a calendar established in advance (Reichlin et al, 2021).

3 Reinforcing monetary-fiscal coordination

As argued above, monetary policy may have non-neutral effects on productivity and the reallocation of investment. In particular, sluggish aggregate demand driven by contractionary monetary policy may penalise green investment and slow the energy transition.

Given the ECB’s primary mandate, the appropriate response would not be to rely on monetary policy alone but rather to design an appropriate monetary-fiscal mix with targeted fiscal policy offsetting the undesirable effects of price-stabilising monetary policy. From a policy-design perspective, the ECB should consider the combined effects of monetary and fiscal policy on prices, productivity and whether green investment happens in sufficient amounts. 

With a single monetary authority and several independent fiscal authorities, this is hard to do. Better coordination among fiscal authorities and/or a larger EU budget would help but this is politically difficult. However, because the motivation would be to reconcile price stability, emissions reduction and productivity growth, it may be less difficult than common fiscal policy for the purpose of raising aggregate demand.

To conclude, among several challenges ahead for the ECB, the toughest relates to the increasingly important links between monetary policy and the supply side of the economy. This will make inflation control harder and will increase the impact of ECB policy beyond the short and medium terms. The ECB must face up to this challenge.


Adam, K. and H. Weber (2019) ‘Optimal Trend Inflation’, American Economic Review 109(2): 702-737

Amador, S. (2022) ‘Hysteresis, endogenous growth, and monetary policy’, Working Paper 348, University of California, Davis, Department of Economics, available at  

Benigno, G. and L. Fornaro (2018) ‘Stagnation traps’, Review of Economic Studies 85(3): 1425–1470

Boehm, C.E. and N. Pandalai-Nayar (2022) ‘Convex Supply Curves’, American Economic Review 112(12): 3941–3969

Comin, D.A., R.C. Johnson and C.J. Jones (2024) ‘Import Constraints’, Working Paper 32072, National Bureau of Economic Research, available at 

Darvas, Z. and J. Zettelmeyer (2023) The economic governance review and its impact on monetary-fiscal coordination, study for the European Parliament Economic and Monetary Affairs Committee, available at

Demertzis, M. (2024) ‘The European Central Bank, inflation tolerance and the last mile’,  Blog, Cyprus Economic Society, 29 March, available at 

Fatás, A. and S. Singh (2022) ‘Supply or Demand? Policy Makers’ Confusion in the Presence of Hysteresis’, CEPR Discussion Papers 17232, Centre for Economic Policy Research, available at 

Fornaro, L., V. Guerrieri and L. Reichlin (2024) ‘Monetary Policy for the Energy Transition’, Working Paper

Fornaro, L. and F. Romei (2023) ‘Monetary Policy in an Unbalanced Global Economy’, Working Paper 1814, Universitat Pompeu Fabra Department of Economics and Business 

Fornaro, L. and M. Wolf (2023) ‘The scars of supply shocks: Implications for monetary policy’, Journal of Monetary Economics 140 (Supplement): 18-36

Grimm, N., L. Laeven and A. Popov (2022) ‘Quantitative Easing and Corporate Innovation’, CEPR Discussion Paper 17280, Centre for Economic Policy Research, available at

Guerrieri, V., G. Lorenzoni, L. Straub and I. Werning (2021) ‘Monetary Policy in Times of Structural Reallocation’, Proceedings of the Jackson Hole Symposium, available at 

Guerrieri, V., M. Marcussen, L. Reichlin and S. Tenreyro (2023) Geneva 26: The Art and Science of Patience: Relative prices and inflation, CEPR Press, available at

Jordà, Ò., S.R. Singh and A.M. Taylor (2023) ‘The long-run effects of monetary policy’, Federal Reserve Bank of San Francisco Working Paper 2020-01, available at 

Ma, C.S. (2023) ‘Firm Liquidity and the Innovation Channel of Monetary Policy’, Working Paper, Korea Development Institute, available at

Ma, Y. and K. Zimmermann (2023) ‘Monetary Policy and Innovation’, NBER Working Paper 31698, National Bureau of Economic Research, available at 

Moran, P. and A. Queralto (2018) ‘Innovation, productivity, and monetary policy’, Journal of Monetary Economics 93: 24–41

Pisani-Ferry, J., L. Reichlin and J. Zettelmeyer (2024) The Euro at 25: Fit for purpose? study for the European Parliament Economic and Monetary Affairs Committee, available at 

Reichlin, L., K. Adam, W. McKibbin, M. McMahon, R. Reis, G. Ricco and B. Weder Di Mauro (2021) The ECB strategy: The 2021 review and its future, CEPR Press, available at 

Stadler, G.W. (1990) ‘Business Cycle Models with Endogenous Technology’, American Economic Review 80(4): 763–778

About the authors

  • Lucrezia Reichlin

    Lucrezia Reichlin is a Non-Resident Fellow at Bruegel and a Professor of Economics at the London Business School, a trustee of the Center of European Policy Research (CEPR) and of the International Financial Reporting Standards (IFRS).  Lucrezia’s research is in applied time series, business cycle and macroeconomic policy. Her work at Bruegel will focus on monetary policy and fiscal policy in particular in Europe and on disclosure standards for climate related risks. She is an applied macroeconomist and econometrician, who has pioneered methods for forecasting with large datasets and for now-casting. She is a Fellow of the British Academy and of the Econometric Society and an honorary International Fellow of the American Economic Association. Reichlin was Director General of Research at the ECB from 2005 to 2008 and she co-founded Now-Casting Economics in 2011.

    Lucrezia is a member of a few commercial boards and research institutes and advises central banks and governments on issues related to macroeconomy policy and the financial sector. In 2021 she was a member of the G20 high Level Independent Panel on financing the Global Commons for Pandemic Preparedness and Response and a panel member of the G7 Impact task force. She is a member of the French national productivity council.


  • Jeromin Zettelmeyer

    Jeromin Zettelmeyer has been Director of Bruegel since September 2022. Born in Madrid in 1964, Jeromin was previously a Deputy Director of the Strategy and Policy Review Department of the International Monetary Fund (IMF). Prior to that, he was Dennis Weatherstone Senior Fellow (2019) and Senior Fellow (2016-19) at the Peterson Institute for International Economics, Director-General for Economic Policy at the German Federal Ministry for Economic Affairs and Energy (2014-16); Director of Research and Deputy Chief Economist at the European Bank for Reconstruction and Development (2008-2014), and an IMF staff member, where he worked in the Research, Western Hemisphere, and European II Departments (1994-2008).

    Jeromin holds a Ph.D. in economics from MIT (1995) and an economics degree from the University of Bonn (1990). He is a Research Fellow in the International Macroeconomics Programme of the Centre for Economic Policy Research (CEPR), and a member of the CEPR’s Research and Policy Network on European economic architecture, which he helped found. He is also a member of CESIfo. He has published widely on topics including financial crises, sovereign debt, economic growth, transition to market, and Europe’s monetary union. His recent research interests include EMU economic architecture, sovereign debt, debt and climate, and the return of economic nationalism in advanced and emerging market countries.    

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