Monetary policy in EMU
Speech by Dr. Willem F. Duisenberg President of the European Monetary Institute Third International Finance and Economic Forum Vienna, 20 November 1997
It is a great pleasure to be here to speak to you about monetary policy in Stage Three. Although the Maastricht Treaty assigns the European System of Central Banks, which will be composed of the European Central Bank and the national central banks of the EU, the unambiguous primary objective "to maintain price stability", the strategy for pursuing this objective is not laid down in the Treaty, and hence needs to be defined. 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 Monetary Union is decided in May 1998. Nevertheless, the EMI has an important role to play in preparing the decision on an 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 for Stage Three.
I Monetary policy and price stability
The importance of price stability for 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. Moreover, 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 in recent years to ensure price stability.
The aim of ensuring price stability must be viewed in a long-term context as a permanent goal and not as a short-term one-off objective. Enterprises 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 Board of Governors 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 this goal, 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 towards price stability and, in so doing, to create the conditions necessary for sound economic growth. Price stability is a means of promoting sustainable economic growth and job creation, and improving both productivity levels and living standards. Conversely, a rising price level - even at moderate rates of inflation - 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 ESCB, which will be composed of the European Central Bank (ECB) and the national central banks of the EU. As I explained a moment ago, 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 no longer be concerned about output and employment growth. I do not agree with this view.
First, the most important contribution that monetary policy can make towards balanced growth and employment is to provide a stable price environment. However, it would be misleading to assume that the ESCB will bear 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 will entail a short-term loss in output and employment. This explains the importance attached to the fact 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 permitted and, should any arise, provides for a procedure which will ensure their swift correction.
Second, it should be clear that the single monetary policy in EMU will apply to the euro area as a whole. As a consequence, it cannot be used for solving regional problems or responding to country-specific economic shocks. These require, above all, smoothly functioning labour and product markets which allow wages and prices to be adjusted, should local economic conditions change. In addition, national budgets must allow sufficient room for manoeuvre to enable automatic stabilisers to work. As a key element of the Stability and Growth Pact, all Member States have committed themselves to achieving a budgetary position close to balance or in surplus in the medium term.
Third, sustainable growth and job creation 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 will require structural remedies and not an expansionary monetary policy. As the experience of recent years has shown, 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 have 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 go hand in hand with a well balanced economic development in the longer term.
To summarise, it will be essential to ensure that an appropriate overall policy mix is achieved in Stage Three of EMU. A stable price and financial environment enhances the capacity of monetary policy to react appropriately to cyclical weakness in the economy. Some would argue that focusing on price stability as the primary goal of monetary policy means that the ESCB will act contrary to output and employment growth. I believe this view to be wrong. Rather, stable prices are a condition for sound long-term growth and the sustainable creation of employment. Moreover, if price pressures are lowest at the trough of the business cycle, monetary policy can, in pursuing its objective of price stability, as a by-product also contribute to smoothing the business cycle. Such a result requires, however, that price stability be established and the credibility of the central bank in respect of its efforts to safeguard that goal be not in doubt.
II Monetary policy strategy in EMU
Given the lead times involved, both the framework for monetary policy implementation and the instruments and procedures required for this needed to be prepared well in advance of EMU. The EMI also has an important role to play in selecting a strategy for the ESCB. On the basis of current practice at the central banks and taking theoretical considerations into account, two potential candidate 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 should be noted 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 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 which practise 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 helps to indicate that, in practice, the differences between monetary and inflation targeting strategies are not overwhelming, since 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 monetary policy stance.
The main distinguishing factor between the two strategies is the role played by monetary aggregates. While monetary aggregates are taken into account as part of inflation targeting strategies, a strategy which publicly sets targets for monetary growth clearly places more emphasis on monetary developments. This central role of monetary aggregates in the monetary targeting strategy is based on the assumption that excessive money growth will generate inflation and that the chosen monetary aggregate has certain properties which make 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. Allow me to say a few words about 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 EU-wide money demand functions appear to be 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. An inflation targeting procedure would directly stress the responsibility of the ESCB for maintaining price stability, although it should be noted that inflation is affected by numerous factors beyond the control of the central bank. On the other hand, a monetary targeting strategy would make the central bank responsible for developments which are directly observable by the public and which are more directly under control.
Both strategies can be seen as being 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 hitherto performed the anchor function in the ERM. On the other hand, it could be argued that the experience so far of those EU central banks which use direct inflation targets has also been relatively successful.
Under any monetary strategy, the ESCB will also have to define "price stability". While it is difficult to provide a precise theoretical definition of price stability, it would be fair to say that a rate of consumer price inflation not exceeding 2% is probably close to a level with which central banks would normally be quite satisfied. In this context, issues of price measurement will be especially important. Progress towards a consistent measure of inflation across the EU countries has been made with the publication of harmonised consumer price indices by EUROSTAT. It is particularly important to cater for the effects of rapid technological progress, innovation and the role of consumer services. As noted by my colleague, Alan Greenspan, in a recent speech, inflation may be overestimated if such elements are not dealt with carefully and accurate measurement of inflation is especially crucial when the overall rate of inflation is low. In the same speech, Mr. Greenspan pointed out that further progress may be necessary to ensure the broadest possible coverage of consumer goods and services. The EMI also advocates as broad a coverage as possible; to meet this aim, EUROSTAT has already proposed a timetable for an expansion of the coverage of the harmonised index of consumer prices, part of which will take place in January 1999 at the outset of Monetary Union.
Before moving on from the issue of monetary policy, I should like to add that preparation of the infrastructure needed for either monetary policy strategy is proceeding satisfactorily. Statistical preparation is well under way, notably for the case of monetary data. The EMI has also started to prepare tools for forecasting, such as a "multi-country econometric model", that will be made available to the ESCB. Furthermore, the preparation of a number of tools for analysing and monitoring the economic situation in Stage Three is ongoing.
Work on the instruments and procedures to be used in EMU is also progressing well. In September, the EMI published a further report on monetary policy instruments and procedures, the so-called "General documentation". The 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 the report is to provide financial institutions with the information they need in order to prepare for participation in monetary policy operations with the ESCB.
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 in the light 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 use of a wide range of indicators in determining the monetary policy stance. In selecting its strategy, the ESCB will be confronted with a situation in which there will still be some structural differences between 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 this respect, a thorough analysis of all the relevant factors will be essential, whatever the circumstances, as will a careful explanation of the ESCB's monetary policy actions in the context of its monetary strategy. This will also make it easier to cope with a new and changing environment at the start of Stage Three./.