ECB monetary policy: “Scope for clearer guidance on the reaction function”

Researchers at the Centre for Central Banking at Frankfurt School of Finance & Management prepared a study for the Committee on Economic and Monetary Affairs (ECON) of the European Parliament, published on 1 October 2025 ahead of the Monetary Dialogue with the ECB President on 6 October 2025. The study, authored jointly with a researcher at the University of Bonn, assesses the euro area’s economic outlook, the ECB’s policy stance, and its evolving communication strategy.

Titled “Wait and Watch: Steering Monetary Policy Under Balanced Inflation Risks”, the study concludes that inflation has stabilised at the ECB’s 2% target. While energy and goods prices have eased, services inflation remains sticky, keeping underlying price pressures contained but persistent. Risks to the inflation outlook are considered balanced, with fiscal expansion, trade frictions and energy markets on the upside, and softer global demand, a stronger euro and cooling labour markets on the downside.

“The disinflation process that began in late 2022 appears to have run its course. Inflation is now close to target and risks are broadly balanced, allowing the ECB to steer policy with a steady hand,” says Professor Benjamin Born, Professor of Macroeconomics at the University of Bonn and co-author of the report.

The report notes that, after eight consecutive rate cuts ending in June 2025, markets now expect a flat rate path while the ECB continues to reduce its balance sheet. Taken together, these measures leave the monetary stance broadly neutral. However, overall financial conditions remain somewhat tight: Corporate borrowing costs have declined, but pass-through to households and sovereigns is still incomplete. Long-term yields remain sticky as higher term premiums offset declining rate expectations.

“Our analysis shows that sovereign bond market fragmentation, while elevated at the start of the tightening cycle, has since receded. This has improved the transmission of monetary policy, but risks of renewed fragmentation persist and warrant monitoring,” explains Professor Emanuel Mönch, Professor of Financial and Monetary Economics at Frankfurt School of Finance & Management and co-author of the report.

ECB communication: Scope for clearer guidance on the reaction function

The authors also discuss changes in the ECB’s communication. Its shift to a data-dependent, meeting-by-meeting approach is seen as broadly appropriate in a period of high uncertainty. At the same time, clearer guidance on the ECB’s reaction function – how it would respond under different contingencies – could strengthen transparency, reduce uncertainty about the inflation outlook, and better anchor expectations.