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Monetary policy in EMU

Speech by Dr. W. F. Duisenberg, President of the European Monetary Institute Universidade Nova De Lisboa Lisbon, 15 November 1997

It is a great pleasure to be here to speak to you about monetary policy in Stage Three. Whereas the Maastricht Treaty assigns an unambiguous primary objective to the ESCB, which is "to maintain price stability", the strategy to pursue this objective was not laid down, and hence a choice needs to be made. In fact, the monetary policy strategy for the euro area will only be chosen after the establishment of the ESCB, shortly after the initial composition of the Monetary Union is decided in May 1998. Nevertheless, the EMI has an important role to play in preparing the decision on a appropriate strategy for the ESCB. In my remarks, I shall first discuss the importance of price stability before going on to examine the two possible monetary policy strategies in Stage Three.

I Monetary policy and price stability

The importance of price stability to the successful long-term performance of the economy is now widely recognised. Indeed, there seems to be a world-wide convergence of thinking among central bankers and politicians alike on the importance of price stability as the primary goal of monetary policy. Empirical research has shown that both the average rate of inflation and its variability tend to decline in line with increased central bank independence. Accordingly, a growing number of central banks have been given a legal mandate to ensure price stability in recent years.

Ensuring price stability must be viewed in a long-term context as a permanent goal and not as a short-term one-off objective. Companies and households are concerned about the long-term effects of inflation and price developments on decisions related to investment and saving. Alan Greenspan, the chairman of the US Federal Reserve, has said that price stability is achieved when the public no longer takes account of actual or prospective inflation in its decision-making. To achieve that goal means that monetary policy must be oriented beyond the horizon of its short-term impact on inflation and the economy.

The purpose of monetary policy actions is to set the economy on a long-term, permanent path to price stability and thereby to create the conditions for sound economic growth. Price stability is a means of promoting sustainable economic growth, employment creation and of improving productivity levels and living standards. Conversely, a rising price level - even at moderate rates - imposes substantial economic costs, such as those arising from increased uncertainty about the outcome of investment decisions and profitability, the distortionary effects on the tax system, rising risk premia in long-term interest rates and the reduced allocative effectiveness of the price and market systems. In addition, social costs arise because the weaker members of society have more difficulty in protecting themselves against the adverse effects of inflation.

The Maastricht Treaty guarantees the independence of the European System of Central Banks (ESCB), which is made up of the European Central Bank and the national central banks of the EU. It assigns an unambiguous primary objective to the ESCB, namely "to maintain price stability". Some would argue that focusing on price stability as the primary goal of monetary policy means that the ECB will be no longer concerned about output and employment growth. I believe this view to be wrong.

First, the most important contribution that monetary policy can make towards balanced growth and employment is to provide for a stable price environment. It would be misleading to assume that the ESCB bears sole responsibility for establishing and maintaining price stability for the euro. Monetary policy needs to be supported by sound budgetary policies and wage developments in line with productivity growth. In other words, the overall policy mix must be appropriate. Without adequate support from other policy areas, the ESCB may be forced to take measures in the fight against inflation which entail a short-term loss in output and employment. This explains why it is so important that the Maastricht Treaty assigns a high degree of independence to the ESCB in carrying out its mandate. The credibility of its monetary policy is further supported by the budgetary provisions of the Treaty which oblige Member States to avoid excessive budget deficits. The Stability and Growth Pact clearly defines the exceptional circumstances under which excessive deficits are allowed and provides for a procedure which will ensure that excessive deficits are swiftly corrected should they nevertheless arise.

Second, one should realise that monetary policy in EMU applies to the euro area as a whole. As a consequence, it cannot be used for solving regional problems or country-specific economic shocks. These require above all well-functioning labour and product markets which allow wages and prices to adjust if local economic conditions have changed. In addition, national budgets must have sufficient room for manoeuvre to let automatic stabilisers work. As a key element of the Stability and Growth Pact, all Member States have therefore committed themselves to the achievement of a budgetary position close to balance or in surplus over the medium term

Third, sustainable growth and creation of employment require more than just an appropriate monetary policy. This can be illustrated by the current unemployment problem in Europe. As its underlying causes are structural, its solution requires structural remedies and not an expansionary monetary policy. As the experience of recent years shows, those Member States that have undertaken fundamental labour market reforms have achieved both a strong recovery of employment and stable prices. At the same time, they often successfully managed to reduce their budget deficits. The general lesson to be learnt is that if all policy areas contribute to creating the right conditions, price stability will over the longer term go hand in hand with a balanced economic development.

To summarise, it is essential to ensure that in Stage Three of EMU an appropriate overall policy mix is achieved. A stable price and financial environment enhances the capacity of monetary policy to react appropriately to cyclical weakness in the economy. A central bank's long-term commitment to price stability does not mean that monetary policy will ignore the short-term impact of economic events and developments in the business cycle. When price stability is established and the credibility of the central bank in respect of its efforts to safeguard that goal is not in doubt, monetary policy can play a role in stabilising the business cycle, provided this is not at the cost of price stability and provided so-called fine-tuning is avoided.

II Monetary policy strategy in EMU

Given lead times, the framework for monetary policy implementation, the instruments and procedures needed to be prepared well in advance of EMU. The EMI has also an important role to play in preparing for the decision on a strategy for the ESCB. On the basis of current central bank practices and taking into account theoretical considerations, two possible strategies have been considered by the EMI for Stage Three: monetary targeting and direct inflation targeting.

The application of these two strategies in different countries has shown that several variants combining elements of both strategies exist, with the borderlines between them being sometimes blurred. In its extreme theoretical variant, monetary targeting would involve the central bank choosing a monetary aggregate as its intermediate target and deciding on its monetary policy actions on the sole basis of comparisons between the target and actual monetary developments. In practice, a central bank following monetary targeting adopts a more flexible approach which involves, in addition to the pursuit of the target, the monitoring of supplementary variables, including indicators of future inflation. It is notable that several central banks pursuing monetary targets also set quantitative medium-term norms for the final objective, price stability, in order to increase the transparency of their policy.

Inflation targetingstrategies, in contrast, aim to steer the final target variable, the inflation rate, directly without having recourse to the use of a separate intermediate target variable. Since monetary policy affects the final objective only with a lag, monetary policy actions under direct inflation targeting strategies are based on a comparison between the target for inflation and the forecast inflation rate. In several countries pursuing inflation targeting, monetary aggregates play a prominent role among the various inflation indicators that are employed, including the setting of quantitative "monitoring ranges" as reference values for these variables.

This brief description already indicates that, in practice, differences between monetary and inflation targeting strategies are not overwhelming. In fact, both strategies typically have the following key features in common: they are based on the same final objective, price stability, they are forward-looking (i.e. they are not based on current inflation developments) and they employ a wide range of indicators to assess the appropriateness of the stance of monetary policy.

The main factor distinguishing the two strategies is the role played by monetary aggregates. While monetary aggregates are taken into account under inflation targeting strategies, more emphasis is clearly placed on monetary developments in a strategy which publicly sets targets for monetary growth. This central role of monetary aggregates is based on the assumption that excessive money growth will generate inflation and that the chosen monetary aggregate satisfies properties which makes it a suitable intermediate target variable for monetary policy.

The assessment of alternative monetary policy strategies for the ESCB should be guided by a certain number of principles, including effectiveness, accountability, medium-term orientation and continuity. Let me say a few words on these guiding principles.

The effectiveness of monetary targeting depends very much on whether a stable (or at least predictable) relationship exists between the chosen monetary aggregate and the final price objective. It also depends on whether monetary aggregates possess desirable leading indicator properties for future inflation. Recent empirical studies carried out for different groups of EU countries show that area-wide money demand functions appear relatively stable and some monetary aggregates have leading indicator properties for inflationary developments. On the other hand, these studies may not be representative of the situation in Stage Three. The possibility of damage to the credibility of the ESCB under a monetary targeting strategy could not be excluded if monetary aggregates were highly volatile at the start of Stage Three. Direct inflation targeting provides a quantitative reference for future inflation which is aimed specifically at anchoring inflation expectations. Its effectiveness, however, depends on the ability of the central bank to forecast accurately and to control future inflation.

With regard to accountability, any strategy will need to involve the formulation and announcement of targets so that the ESCB can be held accountable to the public for its actions. Targeting inflation directly would stress the ESCB's responsibility of maintaining price stability, although it should be noted that inflation is affected by numerous factors outside the control of the central bank. On the other hand, a monetary targeting strategy makes the central bank responsible for developments which are directly observable by the public and which are more directly under the control of the central bank.

Both strategies can be seen as oriented towards the medium-term, thereby providing an anchor for inflation expectations. In this respect, both strategies provide some scope for allowing short-term deviations from the target, if these can be explained to the public. Finally, the adoption of monetary targeting would offer the advantage of ensuring continuity with the strategy of the EU central bank whose currency has performed the anchor function in the ERM. On the other hand, it might be argued that the experience of EU central banks with direct inflation targets so far has also been relatively successful.

Under any monetary strategy, the ESCB will also have to define what "price stability" means. While theory does not provide a precise definition of price stability and while there are various statistical measures of inflation, one could say that a rate of consumer price inflation not exceeding 2% is probably not far off what central banks would normally be quite satisfied with.

At this point, let me briefly mention the issue of the external value of the euro. The average degree of openness of the Member States of the EU (as measured by the share of exports in GDP) is currently 30%, compared with 8% for the United States and 9% for Japan. If intra-EU trade is excluded, the degree of openness of the European Community is 10%, similar to that of the United States and Japan. Its economic and commercial weight is comparable to that of the United States and larger than that of Japan. In other words, we are dealing with a large but relatively closed economy. With a low import and export ratio, the effect of exchange rate movements on internal price developments and competitiveness will be limited. This will allow the ESCB to focus primarily on "domestic" inflationary risks and to consider fluctuations in the euro exchange rate only to the extent that these significantly affect "domestic" prices. This also explains why any so-called orientations that might be formulated by the ECOFIN Council in the field of exchange rate policy for the euro area will have to be limited to exceptional circumstances. As stated in the Treaty, such general orientations shall be without prejudice to the primary objective of the ESCB to maintain price stability.

This does not mean that the euro area should adopt an attitude of "benign neglect" with regard to the external value of the euro. First, exchange rate developments will continue to be monitored informally by the major global players, as is currently the case although in the context of new institutional arrangements to be devised. The introduction of the euro may indeed strengthen policy co-ordination between the US, Japan and Europe and contribute to the promotion of exchange rate stability since these three blocs are each pursuing policies aimed at internal stability. Of course, there may still be residual fluctuations in exchange rates owing to differences in cyclical positions and associated policy responses.

Second, in terms of the exchange rate, the relationship between the euro area and the non-euro area EU countries will be of considerable significance. Following preparatory work by the EMI, the European Council adopted a resolution on the new mechanism (ERM II) this year. ERM II will ensure that trade and financial flows between the euro area and the non-euro area EU countries will not be distorted by large swings in exchange rates. It will also help those countries not joining EMU at the beginning of Stage Three to orient their policies towards convergence, so that they may qualify for participation as soon as possible after the start of Stage Three. To summarise, the internal value of the euro - price stability - will be the objective of the ESCB and when other countries also adhere to this objective, this will create favourable conditions for a stable external value of the euro.

Before leaving the issue of monetary policy, I may add that preparation of the framework for monetary policy implementation, the instruments and procedures in EMU has advanced. The EMI has published in September a further report on monetary policy instruments and procedures, the so-called "General Documentation". That report updates the "Framework Report" and takes into account the progress made in the specification of the ESCB's monetary policy instruments and procedures in the meantime. The main aim of this report is to provide financial institutions with the information they will need in order to prepare for participation in monetary policy operations with the ESCB. Moreover, the EMI has started preparing tools for forecasting, such as a "Multi-country econometric model", that will be made available to the ESCB. Furthermore, preparation of a number of tools for the analysis and monitoring of the conjunctural situation in Stage Three is ongoing.

Conclusion

The continuing challenge for central banks is to ensure long-term credibility for monetary policy by sustaining an environment of low inflation. Maintaining price stability will be the ESCB's primary responsibility. With regard to monetary strategy, monetary and inflation targeting are seen as the two main benchmarks on the basis of which the choice of the ESCB's strategy in Stage Three will be made. Both strategies have a number of key elements in common, such as the objective of price stability, a forward-looking nature and the employment of a wide range of indicators in the determination of the monetary policy stance. In the selection of its strategy, the ESCB will be confronted with a situation in which there will be remaining structural differences across participating countries as well as cross-country differences in economic policies. Furthermore, the transition to Stage Three will increase uncertainty about the monetary policy transmission process. In that respect, a thorough analysis of all relevant factors will be requested under all circumstances as well as a careful explanation of the ESCB's monetary policy action in the context of its monetary strategy. That will also help to cope with a new and changing environment at the start of Stage Three./.

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