As one of the world's key central banks the European Central Bank comes under intense public scrutiny. Yet, its constituency is diverse, with different national traditions of central banking and varied views about the conduct of monetary policy. The ECB acts on behalf of all the members of EMU, but belongs to no particular member state. It is accountable to the European Parliament, which has only a very recent tradition of oversight of monetary policy. For these reasons, there is a need for a regular, rigorous, non-partisan and pan-European analysis of the options facing the ECB and the policies it pursues. Monitoring the European Central Bank addresses this need. Written by a team of distinguished academic economists known internationally for their work on macroeconomics and monetary policy, MECB produces a full report and a spring Update each year. The full report describes the issues faced by the ECB during the preceding year; assesses the policy choices that were made; and sets out the issues likely to arise during the coming year. The Update offers a follow-up to the main report, and is written in the light of the Bank's own annual report. This year's report, the third in the MECB series, begins by addressing the two main challenges for the Bank in the year ahead. First, what attitude should it take vis-a-vis the EMU fiscal authorities? Should it volunteer to participate in coordination exercises? Second, how should it deal with inflation differentials between high-growth countries, such as Ireland and Spain, and the core of EMU? More generally, how should the adjustment mechanism work inside a monetary union? The ECB's stance on these questions will affect its reputation and the macroeconomic performance of the Euro Area for many years to come. The report then looks at the operation of the ECB and its track record so far, specifically at the following issues: * Interest Rates. The track record is now sufficiently long to reveal some underlying patterns in the way the ECB sets interest rates. Have ECB interest rate decisions since the beginning of EMU been consistent with its stated strategy? * Inflation. Has the ECB missed its pre-announced inflation targets and therefore lost credibility? * Exchange Rate of the Euro. Should the ECB worry about the exchange rate of the euro? * Inflation Projections. Are these a good idea, and are they constructed accurately? The report concludes by explaining why 'inflation targeting' is an 'employment-friendly' way of running monetary policy and makes the case for abandoning the 'two-pillars' strategy and moving to inflation targeting.