Ladies and gentlemen,
Let me first of all thank the Organising Committee for inviting me to the IX Conference on International Economics. This event has already become an important tradition and gained a considerable reputation, as shown by the quality of the contributors to this year’s programme. It is therefore a great pleasure to have the privilege of presenting a keynote speech here.
It is common knowledge that the European Central Bank (ECB) began to conduct monetary policy in 1999 with the inception of the euro. At that time, Europe was facing a major institutional change. Eleven national economies, retaining their sovereignty as regards fiscal policy and structural policies, merged their monetary policy and currencies, representing a major challenge. From the perspective of conducting monetary policy alone, the enormity of this challenge becomes clear if account is taken, for example, in the context of the new Monetary Union, of the fact that economic relationships that had been valid in the past risked becoming of limited value. This generated uncertainty over aspects as central as the functioning of the transmission mechanism of monetary policy or the properties of statistical indicators, which were harmonised across euro area countries prior to the start of Monetary Union.
It was against this background of uncertainty and based on the institutional framework of the Treaty on European Union that the ECB’s monetary policy strategy was devised. I would like to describe and explain the reasons for this strategy in the first part of my talk today. I will then provide some thoughts on comparing certain elements of this strategy with other international approaches. Last, I will comment on the most important challenges facing our monetary policy today.
The main feature of our monetary policy strategy is that the European Central Bank and the national central banks (NCBs) of the Eurosystem are fully independent, as provided for in Article 108 of the Treaty on European Union.
Why is it essential for a central bank to be independent to conduct monetary policy? The answer is that independence acts as a safeguard against any inflationary bias. Indeed, both theoretical analyses and empirical studies show that the credibility and success of monetary policy improve when related decisions remain outside the sphere of political influence.
Independence enhances the credibility of the central bank as regards its capacity to keep inflation in check and to anchor market expectations in line with price stability, thereby contributing to the achievement of other economic policy goals, such as sustainable growth and a high level of employment. It was therefore only logical to have the principle of independence enshrined in the Treaty.
Of course, since independence is a core element of democratic legitimacy, it must be accompanied by the strict application of controls. The independent central bank is accountable for its decisions to citizens and their representatives. Thus, this obligation, which is the flip-side of its independent status, effectively imposes discipline on the central bank to perform its tasks in line with its mandate.
A second key aspect of our strategy relates to the objective of monetary policy. Article 105(1) of the Treaty on European Union stipulates that the primary objective of the European Bank is to maintain price stability in the euro area. The setting of this objective is recognition of the theoretical and empirical evidence accumulated over time. This evidence suggests that high rates of inflation are detrimental to growth and employment in the longer run, while an environment of stable prices supports the functioning of the markets and contributes to sustainable economic growth and greater prosperity.
The Treaty, however, left open the question of what is meant by “price stability” in operational terms. In October 1998 the European Central Bank therefore published a quantitative definition of price stability as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%”. Subsequently, the Governing Council of the ECB further clarified this objective, explaining that it intended to keep inflation “below, but close to, 2% over the medium term”. It is worth going into more detail about various aspects of this definition.
First, with regard to the reach of the definition, price stability is assessed on the basis of price developments in the euro area as a whole. With a single monetary policy, decisions must be taken so that they reflect the conditions prevailing in the euro area as a whole, rather than those prevailing in specific regional or national contexts.
Second, the European Central Bank decided to choose a particular general price index, the HICP, as an instrument for measuring price stability from among other options such as underlying inflation. This choice was made mainly for reasons of transparency. The HICP is the only “high quality” price index in the euro area that is sufficiently harmonised across countries and published on a monthly basis. Moreover, this index is the closest approximation of the variations which are produced in the price of a representative basket of goods and services purchased by households in the euro area. Therefore, the use of this index clearly shows the Eurosystem’s commitment to full and effective protection against loss of purchasing power of the euro.
Third, the setting of the quantitative definition of price stability at a positive but low rate of inflation is justified by a number of considerations:
On the one hand, this definition provides an adequate margin to avoid the risks of deflation. In this regard, it should be emphasised that many of the costs associated with inflation, such as relative price distortion, also apply in situations of a sustained decline in price levels. Also, prolonged deflation could involve risks for the stability of the economy. In particular, a prolonged period of deflation coupled with weak growth could hamper the central bank in conducting monetary policy because nominal interest rates cannot fall below zero. Any attempt to fix nominal interest rates below zero would doubtless be unsuccessful because the public would rather keep their money in cash than set up or hold savings at negative interest rates. In a deflationary environment, the existence of a zero lower bound for nominal interest rates restricts the central bank’s margin for reducing real interest rates in order to stimulate demand and counteract deflationary pressures. Various studies have tried to assess the probability of nominal interest rates being situated around the zero lower bound if the central bank were to set its definition of price stability at different levels. The majority of these studies show that this is much less likely if the objective of the central bank is to maintain the rate of inflation at above 1% in the medium term.
On the other hand, setting the definition of price stability above zero also takes into account the fact that any consumer price index may be subject to measurement bias, and therefore that HICP inflation may slightly overstate true inflation. Such bias can be attributed to the difficulties that statistical authorities have in adjusting the index in a timely manner to take account of ongoing improvements in the quality of goods and the changing patterns of consumer preferences. The precise magnitude of this bias for the euro area is difficult to estimate and probably rather small, given the continuous improvements made to the index by Eurostat.
Finally, aiming at an inflation rate that is below, but close to, 2% avoids that individual countries operating in the euro area have to structurally live with negative or too low inflation rates.
The European Central Bank’s definition of price stability refers to a medium-term horizon, in recognition of the fact that monetary policy can only control price developments in the longer term and never in the short term. By contrast with the practice typically observed in inflation-targeting regimes, the ECB has not specified a fixed policy horizon. There are many reasons for this decision. The lags with which monetary policy affects price developments vary and are unpredictable. Moreover, the optimum monetary policy response always depends on the specific type and magnitude of the shocks affecting the economy. A medium-term horizon allows central bankers the necessary flexibility to respond appropriately to economic shocks of a specific type. A medium-term orientation helps to avoid introducing unnecessary volatility into the economy and to stabilise output and employment.
In order to best serve its primary objective of medium-term price stability, the ECB has chosen a full-information approach which rests on two pillars: an economic analysis and a monetary analysis. Its aim is to ensure that all the information is taken into account and due attention is paid to different analytical perspectives. The metaphor of the two pillars highlights their complementary, but distinct, perspectives in the assessment of the risks to price stability.
The economic analysis focuses on short to medium-term risks to price stability and is mainly based on the assessment of economic and financial developments from the perspective of the interplay of supply and demand in the goods, services and factor markets. Macroeconomic projections by Eurosystem staff are regularly published for reasons of transparency and play an important role in the economic analysis. Its main purpose is to condense the information provided by economic indicators in a coherent and structured manner that is meaningful for the policy-maker.
Monetary analysis provides indications of future price trends from a medium to longer-term perspective, exploiting the long-term link between money and prices. In this context, the analysis of money and credit developments plays an important role in determining projected medium and long-term price developments.
These two perspectives on the functioning of the economy therefore provide complementary information. Both analyses have their comparative advantages. Economic analysis is well suited to the analysis of price developments at shorter horizons. Monetary analysis acts as an early warning system for upcoming inflationary or deflationary pressures at somewhat longer horizons. In the absence of a satisfactory macroeconomic model that fully integrates the information from both sets of indicators, the European Central Bank has chosen to regularly cross-check the information from both pillars in order to come to an overall judgement on the risks to price stability.
I would like to turn now to the final key aspect of our monetary policy, namely the accountability, transparency and the communication of the European Central Bank.
The fast and worldwide spreading of information by modern communication technologies has enhanced the role of the mass media in our daily lives. Wire services often publish the explanations of monetary policy-makers immediately after they have been presented. The information is analysed by financial analysts all over the world, and financial markets may react quickly to any news concerning the economy and the implied future monetary policy stance.
In this regard, these days central banks around the world attach a great deal of importance to achieving an optimal degree of transparency, which increases the effectiveness of monetary policy. An appropriate and transparent strategy complemented by explanations of day-to-day monetary policy decisions provides guidance to the markets, notably concerning inflation expectations and the future monetary policy stance.
The issue of credibility is another important aspect of this debate. In the words of Alan Blinder (1999), “A central bank is credible when people believe it will do what it says”. I share his view that credibility will be enhanced if there is a close correspondence between words and deeds. This means, of course, that central banks must choose their words very carefully. At the same time, a central bank should do all it can to ensure that both the conditional nature of forecasts and statements on the future monetary policy stance are properly understood. Otherwise, if, for example, the “true world” outcome differs from what was suggested, the central bank could see its credibility jeopardised. The inherent uncertainty necessarily faced by the central bank therefore has to be addressed in its communications.
To this end, the European Central Bank has adopted a number of important communication tools, which, together, have proven satisfactory. After the first Governing Council meeting of the month, a press conference is held in which the main economic arguments underlying the decisions and the thrust of the discussion are conveyed to journalists almost in real time. We regard the President’s Introductory Statement as coming close to summary minutes. It contains all the relevant information for the public and is published on the European Central Bank’s website. There is also the possibility for journalists to address questions directly to the President and the Vice-President. This feature makes the European Central Bank’s approach to communication extremely timely and transparent. Further channels for communicating the European Central Bank’s monetary policy assessment in more detail are its Monthly Bulletin and interviews and speeches given by the members of the Governing Council to many different audiences, including the European Parliament.
Having briefly described our monetary policy approach, let me now say a little about our institutional framework by comparison with that of other central banks.
In such a comparison, one of the first aspects to be singled out is generally the different objectives of the ECB and the US Federal Reserve. The ECB’s primary objective, as I have mentioned, is price stability, while the Federal Reserve has a dual mandate that obliges it to give equal weight to the objectives “price stability” and “sustainable economic growth”. However, in my opinion the implications of this difference have no great significance for the conduct of monetary policy, as shown by the fact that both central banks stress that price stability is the best contribution to sustainable economic growth. In the words of Alan Greenspan (1996) “In a democratic society such as ours, the central bank is entrusted by the Congress, and ultimately by the citizenry, with the tremendous responsibility of guarding the purchasing power of money. It is now generally recognized that price stability is a prerequisite for the efficient allocation of resources in our economy and, indeed, for fulfilling our ultimate mandate to promote maximum sustainable employment over time”.
As for the question of how this mandate should be implemented, an international comparison of central banks suggests that there is no unique solution, rather actual practices and operational concepts vary.
Looking again at the comparison of the ECB and the Federal Reserve, while the former has published a precise quantitative definition of its primary objective – price stability – the Federal Reserve provides only a qualitative definition stated by its Chairman, Alan Greenspan (2004), which makes clear a commitment to low inflation (“price stability obtains when people do not consider inflation a factor in their decisions”) and which is supported in the FOMC. I am sure the Federal Reserve has good reasons for its approach and it is not my role to assess these reasons. In our case, the uncertainties associated with the regime shift implied by the introduction of the euro made it particularly important for the ECB to be precise about the quantitative definition of its primary objective. In my view, the ECB’s approach has three main benefits: it is good for transparency since it enables everybody to know precisely what we are aiming at; it is good for accountability as the public can judge how and to what extent we meet our aims; and, lastly, it is good for medium and long-term credibility since inflationary expectations can be anchored more easily.
There is a further important difference between our monetary policy concept and that of the Federal Reserve. We find it very useful to incorporate an important role for monetary analysis in our strategy in order to permit the cross-checking of our economic analysis from a medium to long-term perspective. This feature of our approach contributes to the anchoring of medium to long-term inflation expectations, which is particularly important for the ECB, as it does not have a track record as long as the Federal Reserve’s as regards the guiding of expectations.
Inevitably, there are also many similarities between the approaches of the ECB and the Federal Reserve. Both institutions have been afforded a high degree of formal independence which, as already mentioned, is an essential component in the credibility of central banks. Moreover, both place significant emphasis on achieving an optimal degree of transparency and we both appear frequently before the legislature to explain our monetary policy decisions. Another important similarity between the ECB and the Federal Reserve is our reliance on a strategy that is based on a very comprehensive analysis of indicators. Likewise, both central banks have to date been sceptical of the benefits of adopting an inflation-targeting approach similar to other central banks, such as the Bank of England or the Sveriges Riksbank. Why is that?
While there are many similarities between the inflation-targeting approach and the ECB’s concept, there are some significant differences. First of all, we consider that inflation forecasts have important limitations that may matter for the conduct of monetary policy. Consequently, we did not assign an all-encompassing and overriding role to such forecasts. The projections published by the ECB every quarter are staff forecasts, which play an important role as input for monetary policy decisions. They are, however, not endorsed by the Governing Council. Inflation forecasts are useful summary indicators of a wide range of variables. They are not, however, a sufficient statistic for monetary policy in the sense that monetary policy decisions could be mechanically linked to this indicator. The same inflation forecast figure can be associated with quite different circumstances and may therefore imply quite different reactions on the part of the central bank.
Moreover, inflation forecasts are typically informed by an econometric model. There is, regrettably, no single model that can adequately explain developments in output and inflation. There is also the possibility of model misspecification. Consequently, in order to obtain robust results, we need to employ expert judgement and to consult a variety of econometric tools and models. There is no alternative to this, although we are continuously seeking to enhance our analytical tools.
Second, as I have said, I regard the use of a fixed forecast and policy horizon as somewhat arbitrary in the presence of large macroeconomic shocks of different kinds.
Policy-makers should assess the state of the economy beyond the typical fixed forecast horizon of two or three years ahead, given that the transmission process evolves over time with variable and uncertain lags. By contrast, limiting attention to a specific projection horizon may lead to policy errors, the effects of which can be undone only later at the cost of increased output volatility or lower growth rates.
In addition, appropriate monetary policy responses always depend on the nature of shocks hitting the economy. An essential element of monetary policy decision-making is to evaluate and compare the robustness of the information stemming from various sources. A strong focus on a fixed horizon would not do justice to the complexity of the transmission mechanism. This is particularly the case when large shocks or special circumstances arise.
With its medium-term orientation, the ECB avoids any problems associated with a fixed horizon, but pays due attention to the entire horizon over which monetary policy impacts on the economy.
However, I do not think that the differences between our strategy and inflation targeting should be exaggerated when it comes to the actual conduct of monetary policy. Neither am I advocating one single way of ensuring its success. The different approaches that exist reflect the need to adapt to different institutional and economic environments. In this context, it is striking that practices among successful central banks have increasingly converged over recent years. For example, nearly all today recognise that no single or “true” model for assessing the economy exists. They emphasise the need to adopt a robust approach to policy-making which takes into account uncertainty regarding the interpretation of information and they acknowledge that the reaction to inflation forecasts cannot be mechanistic. Moreover, in recent years a number of inflation-targeting central banks have also acknowledged the need to look at the medium term instead of a fixed horizon.
Monetary policy is conducted in a constantly changing environment which poses ever more challenges. Let me close by focussing on a description of some of the most important challenges that we now face.
I. First, the question of heterogeneity in a monetary union and how to deal with it had attracted the attention of academics long before the single currency was introduced. In this context, it should be said, however, that inflation dispersion across the countries of the euro area has stabilised at low levels since the inception of the euro. Taking a longer perspective, the degree of inflation dispersion, measured as the (unweighted) standard deviation among the 12 euro area countries, was characterised in the 90s by a strong downward trend. Moreover, by way of comparison, since 1999 inflation dispersion across the euro area has been fluctuating close to the level observed across the 14 metropolitan statistical areas in the United States.
Inflation differentials, which should be viewed as a normal phenomenon in any monetary union and an integral part of the adjustment mechanism of relative prices, have, however, been very persistent in the euro area which, to some extent, is due to misaligned national fiscal policies, improper wage developments, deep-seated structural inefficiencies such as nominal and real rigidities in product and factor markets, and insufficient structural reforms. Addressing the challenge posed by heterogeneity therefore implies an important role for structural policies to encourage greater mobility of production factors and flexibility in terms of real wages.
It is generally agreed that assigning monetary policy the further role of directly tackling the issue of relative balance between the sectors or regions of a currency area in the process of adjusting to shocks would overextend it to the detriment of its primary objective. A monetary policy that focuses on price stability can, however, foster the correct adjustment of relative prices and the efficient allocation of resources across the sectors and countries of the euro area when asymmetric shocks occur. Moreover, the ECB’s aim of maintaining inflation rates below, but close to, 2% can accommodate small regional inflation differentials, while providing an adequate safety margin to avoid some regions having to structurally operate at negative inflation rates. Moreover, we closely monitor sectoral and national developments on a regular basis in order to better formulate our assessment of the economic situation and its possible evolution for the euro area as a whole. In this respect, the analysis of disaggregated information is crucial in order to understand the nature of shocks, as many shocks of area-wide relevance originate in specific countries or sectors.
II. Central banks face a second challenge that stems from asset price bubbles. Historical episodes have shown that they can evolve quickly and that the costs of their bursting can be very high for the economy. Moreover, they are difficult to identify in real time and are thus often only recognised ex post.
The academic debate suggests that several approaches are conceivable when it comes to asset price bubbles. Even in the rare cases in which the central bank can confidently claim to be facing an unusual and possibly destabilising asset price movement, its reaction cannot be automatic but requires careful thought.
In this context, the ECB does not target asset prices. However, it pays close attention to asset price movements with a view to preserving the stability of consumer prices over longer horizons. In this respect, the prominent role of money and credit in the ECB’s approach may help it to assess asset price developments and the degree to which they pose a risk to price stability in the more distant future.
III. A further challenge that the ECB has faced in recent years arises from a number of shocks that have influenced both monetary and price developments, thereby complicating the extraction of medium to long-term signals as regards risks to price stability. For example, the exceptional economic, financial and geopolitical uncertainties between 2001 and 2003 contributed to a strong preference for liquid assets among agents, leading to sizeable portfolio shifts.
In this environment, the ECB’s monetary analysis has made use of a variety of analytical tools and conceptual frameworks to extract from monetary developments the information relevant for monetary policy decisions. A combination of institutional and model-based analyses has enabled the ECB to derive a modal scenario on the basis of an M3 series corrected for the estimated impact of the aforementioned portfolio shifts, which series was then used as input for simple monetary models that forecast inflation, for example leading indicator models based on monetary growth or P-star models based on measures of the money gap. A second scenario, reflecting possible upward risks to price stability as compared with the modal view, was subsequently derived using the official M3 series. Used together, they provide a better assessment of the uncertainties related to monetary developments to be made. In this context, it should be borne in mind that similar money growth figures can have quite different implications for the risks to future price stability, depending on prevailing macroeconomic conditions and, in particular, on the underlying factors driving monetary growth.
IV. Finally, let me mention a further challenge that we currently face, which is the budgetary position in a number of European countries. Public finances can have a profound influence on the environment in which monetary policy operates. Along with a monetary policy geared towards maintaining price stability, sound fiscal policies are essential for stability and growth in the euro area. This is why, prior to the introduction of the euro, it was decided to put in place a rule-based framework for Member States’ fiscal policies in the form of the Stability and Growth Pact.
Some countries have managed to meet the Pact’s objectives and maintain sound budgetary positions over recent years. However, in others public finance positions have deteriorated. Excessive deficits have emerged, and the procedures of the Stability and Growth Pact aimed at preventing and correcting these have not always been properly complied with.
In the light of these difficulties, a reform of the Stability and Growth Pact has recently been agreed. The stated aim of this reform is to strengthen the Pact’s implementation. It is now essential to ensure the rigorous and consistent implementation of the new rules in order to achieve budgetary discipline and restore the credibility of European fiscal policies. Restoring sound public finances is becoming more urgent as ageing-related government spending is projected to increase substantially in the decades to come as a result of demographic developments. In many countries, maintaining sustainable public finances in this context requires not only urgent action to reduce high debt ratios but also reforms of pension and healthcare systems to keep ageing-related expenditure at affordable levels in the future.
In conclusion, there is no doubt in my mind that a monetary policy strategy based on a quantitative definition of price stability and an economic and monetary analysis is the right framework for monetary policy in the euro area. In my view, this approach has been essential to ensuring the high level of credibility of the ECB and its monetary policy. This monetary policy has enabled inflation to be stabilised in the euro area and inflation expectations to be firmly anchored in line with price stability, even in the face of a number of challenging situations.
This is no mean achievement, given that the ECB had no track record for credibility to rely on. I can assure you that the ECB will continue to focus on its primary objective of maintaining price stability in an uncertain and changing environment. This is doubtless the best contribution we can make to economic prosperity and job creation in Europe.
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 Article 108 of the Treaty on European Union provides that “When exercising the powers and carrying out the tasks and duties conferred upon them by this Treaty and the Statutes of the ESCBs, neither the ECB nor the national central banks, nor any member of their decision-making bodies, shall seek or take instructions from European Community institutions or bodies, from any government of a Member State. The Community institutions and bodies and the governments of the Member States must respect this principle and not seek to influence the members of the decision-making bodies of the ECB or of the national central banks in the performance of their tasks.”
 See, for example, Cuckierman (1992), Alesina and Summers (1993) and Posen (1993).
 See, for example, Herrero, Gaspar, Hoogduin, Morgan and Winkler (2001).
 The ECB’s definition is fully consistent with definitions adopted by the majority of national central banks in the euro area prior to the start of Stage Three of Economic and Monetary Union, which provides an important element of continuity with the monetary policy strategies which they successfully conducted in the past. For example, the Deutsche Bundesbank, in setting its monetary target for 1997-1998, adopted a medium-term price assumption of between 1.5% and 2%. In 1998 the Banque de France defined price stability as a CPI inflation rate not exceeding 2% over the medium term. A similar objective was adopted by the Banca d’Italia for 1998. Moreover, when adopting the Broad Economic Policy Guidelines in July 1995, the ECOFIN Council indicated that a value of 2% would be the maximum rate of inflation compatible with price stability. This was implicitly reconfirmed in the 1998 Guidelines (see Duisenberg (2001)).
 See ECB (2003).
 The ECB also regularly consults other measures, although it does not use them to define price stability as some aspects of the way in which they are calculated are not sufficiently transparent. See ECB (2001).
 See Coenen (2003) and Klaeffling and Lopez Perez (2003).
 See Wynne and Rodriguez Palenzuela (2002).
 See ECB (2005b).
 See ECB (2004a).
 For example, to date, some central banks (Federal Reserve, Bank of Japan) have defined price stability only in rather broad, qualitative terms. Other central banks (Bank of England, Sveriges Riksbank, Reserve Bank of New Zealand) have gone further and have announced precise numerical inflation targets in the form of a point or a range.
 In February of this year the FOMC discussed the merits for the Federal Reserve of announcing a quantitative definition of price stability. Some central bankers – including Chairman Greenspan – were sceptical of the benefits of a numerical definition or an inflation target. In their view, it could unduly constrain monetary policy in the presence of unforeseen macroeconomic shocks. A numerical value for price stability could also be inconsistent with the Federal Reserve’s dual mandate that obliges it to give equal weight to the objectives “price stability” and “sustainable economic growth”. See FOMC (2005).
 There is no widely agreed definition of inflation targeting. According to a broad definition, most central banks with a focus on the objective of price stability could be characterised as pursuing inflation targeting. Bernanke and Mishkin (1997) characterise inflation targeting “by the announcement of official target ranges for the inflation rate … and by explicit acknowledgement that low and stable inflation is the overriding goal of monetary policy”.
 Recourse to monetary indicators may also help policy-makers to look beyond a forecast horizon of two years ahead. See Issing (2004).
 See the seminal contribution by Mundell (1961).
 See Trichet (2005), Detken and Smets (2004) and Borio and Lowe (2002).
 See also ECB (2005a).
 See ECB (2004b) and Issing (2005).
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