The role of monetary policy in economic policy

Speech delivered by Dr. Willem F. Duisenberg, President of the European Central Bank, to the Economic and Social Committee of the European Communities Brussels, 3 December 1998

Ladies and gentlemen, in less than one month's time Stage Three of Economic and Monetary Union (EMU) will start and the euro will be launched. This event will have wide-reaching implications for the orientation of economic policy in the euro area. Moreover, the creation of a single currency is also likely to have a significant effect on the role of Europe in the international economy. As with any fundamental change, the start of Stage Three will be characterised by considerable uncertainty and the European System of Central Banks (ESCB) will not have an established track record. Therefore, it is particularly important to explain to the public as clearly as possible both our objective of price stability and the framework or monetary policy strategy that we shall use to achieve our main goal. I shall consider the role of monetary policy in economic policy in this context.

The ESCB's monetary policy strategy

The Treaty establishing the European Community (the "Treaty") assigns to the ESCB the overriding objective of maintaining price stability in the euro area. This mandate reflects the conviction that price stability is a key condition for creating a stability-oriented environment which is beneficial to economic activity, employment and, more generally, to the welfare of society, thereby contributing to the achievement of the objectives of the Community. As you will be aware, the Treaty also stipulates that the ESCB shall be independent in the performance of its tasks and duties. The reason for including this provision in the Treaty is that an independent central bank may be more effective in the pursuit of price stability - which is, in essence, a long-run commitment - without being pressured by the political authorities to achieve short-run objectives. In a democratic society, this gives rise to special requirements in terms of accountability and transparency, which are issues to which I shall return presently. The Governing Council of the European Central Bank (ECB) has carefully considered how these requirements could be fulfilled most effectively. One of the key results of these deliberations was the recent decision to announce a quantitative definition of price stability by which the ESCB's performance can be easily assessed by the public. Price stability was therefore specified as a "year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%". The term "increase", in particular, implies that a situation of deflation - i.e. a sustained and ongoing decline in the consumer price level - is not consistent with price stability. Price stability is a medium-term concept. The ESCB will not smooth any short-term deviations in price developments from this quantitative perspective. As monetary policy measures affect the economy with long and unpredictable time lags, it is not feasible for central banks to control prices in the short run. Moreover, the benefits of price stability pertain more to the long-run development of the price index than to its short-term fluctuations. In addition to the definition of price stability, the monetary policy strategy of the ESCB consists of two key elements. As a first pillar, the Governing Council attributed a "prominent role" to money, as the empirical evidence suggests that inflation is essentially a monetary phenomenon in the long run. For this reason, the Governing Council decided to announce a reference value for money growth. The first reference value was recently determined at 4.5% and refers to the broad monetary aggregate M3. This should allow for an adequate provision of money to the economy at a rate consistent with the achievement of sustainable non-inflationary economic growth in the euro area. The choice of this reference value was also determined by reasons other than the empirical relationship between broad money growth and inflation in the euro area. Money growth will provide a reference value for assessing the monetary policy stance. Indeed, money can help the general public to understand correctly what monetary policy can and cannot do, thereby enhancing the central bank's transparency and accountability. While money will have a prominent role, it will not be the sole and automatic guide for the monetary policy of the ESCB. Especially at the start of Stage Three, when significant and mostly unpredictable changes are likely to occur in the economic, monetary and financial environment, there will be a need to monitor a wide range of indicators. For example, the changeover to Stage Three may lead members of the public to adjust their investment portfolios and this could make the behaviour of monetary aggregates more difficult to explain. Moreover, there is considerable uncertainty surrounding future price-setting behaviour in the euro area, especially in those Member States with more limited experience of price stability. This might also blur the relationship between money and prices. The evaluation of the economic and financial indicators that will be monitored will be based exclusively on their expected influence on future price developments. For instance, the ESCB will follow closely long-term interest rates, confidence indicators, output measures, the behaviour of wages, the price of commodities and also the external value of the euro insofar as it affects prices in the euro area.

The benefits of price stability

I should now like to elaborate a little on the benefits of price stability, before moving on to the role of monetary policy in economic policy. I have already highlighted the importance of price stability in shaping a stability-oriented macroeconomic context in the euro area. Indeed, the empirical evidence suggests that price developments are more predictable when the inflation rate is low; price stability thus enhances the predictability of the macroeconomic environment. A situation of low inflation also allows households and firms to base their economic decisions on more reliable information, as they may find it easier to distinguish movements in relative prices from movements in the general price index. Both of these aspects of price stability lead ultimately to a more efficient allocation of resources, which is of vital importance for the economic welfare of society in the long run. For instance, firms may engage in long-term investments without fearing that an unexpected surge or decline in the inflation rate could cause their commitment to be sub-optimal or even unsustainable. In the same vein, households may plan an optimal allocation of saving and consumption over their lifetime, without facing the risk of the real value of financial assets changing on account of an unexpected rise or decline in the inflation rate. This enables financial markets to function more smoothly and perform more effectively their basic function of channelling funds to their most productive use. One particular benefit to be derived from a stable price environment is that borrowers are not requested to pay extra, to cover the risk of an unexpected rise in the general price level. As a consequence, real interest rates, i.e. interest rates corrected for expected inflation, will be lower, thereby encouraging people to commit more resources to productive activities. A situation of price stability also avoids the risk of borrowers being confronted with a rising real value of financial debts, which are normally fixed in advance in nominal terms, in the event of an unexpected and persistent decline in prices. Such a rising real debt burden may have negative effects on real economic activity, as borrowers are normally more engaged in productive activities than lenders. High inflation or persistent deflation is costly for society even in the best possible scenario, i.e. when it is perfectly anticipated. The need to take price level changes into account in every kind of nominal contract is so universal that extensive resources are ultimately diverted from alternative and more productive uses. For example, at times of high inflation sellers must continuously update menus and households expend needless time and energy when they are forced to economise on liquid balances. Moreover, if the tax system is not completely indexed to changes in the price index, which is very often the case, inflation does in the end have real redistribution effects, which, in practice, entails an automatic increase in the tax burden. Finally, I should like to emphasise the fact that price stability is particularly beneficial for the political cohesion of society, because inflation (but also deflation) brings about an undemocratic redistribution of economic resources. Experience has shown that, as a rule, this hits the weakest members of society the hardest, because, for example, they maintain a higher proportion of their wealth in liquid assets.

What the monetary policy of the ESCB can do

The Treaty states that the ESCB, while having price stability as a primary objective, shall support the general economic policies in the European Community; moreover, it will operate in a such a way as to be consistent with the establishment of free and competitive markets. The Treaty therefore provides an explicit order of priority for the objectives: price stability is the first reference point for the monetary policy of the ESCB, and only within the limits of price stability can there be scope to contribute to the achievement of the other objectives of the European Community. As a consequence, the role of other Community objectives in the monetary policy of the ESCB is conditional upon the achievement of the overriding target of price stability. The high unemployment rate in Europe represents the main concern of economic policy-makers. I should like to stress that the ESCB shares these concerns and will do its utmost to help find a solution to this problem. That said, however, we should realise that what monetary policy is able to contribute to economic policy and the reduction of unemployment, is the achievement of price stability. I have already explained the benefits of price stability for society and the reasons which underlie this conviction in some detail. By creating optimal conditions for a sustainable and strong pace of economic activity, price stability will ultimately spur employment growth and foster higher living standards. Moreover, in specific circumstances, if production, inflation and employment all move in the same direction, monetary policy can play a role in stabilising output and employment growth, without endangering price stability. However, this role is very limited, because the high unemployment rate in Europe is far more the consequence of structural rigidities within the European labour and product markets than a result of adverse cyclical developments. The solution is thus to be found, above all, in structural reforms. The European unemployment rate has, indeed, been high and stable over the business cycles in the past decade. However, over the same period, unemployment was significantly reduced in those EU countries which succeeded in creating better-functioning labour and product markets, which allowed wages and prices to adjust when economic conditions changed. A clear example can be found in the Netherlands, where a substantial reduction in unemployment has been effected in recent years by reforming the labour market, while following the same monetary policy as Germany, where the unemployment rate is still close to 10%. The ESCB is also concerned with the variability of real output and the associated fluctuations in employment, which could be considered to be an undesired consequence of an excessive control of price developments. In this respect, the medium-term orientation of the monetary policy of the ESCB should help to avoid excessive fluctuations in real economic activity. Given the fact that the ESCB does not aim to stabilise every short-term deviation of price developments from the predetermined path of price stability, it contributes to the stabilisation of economic activity around its long-run potential growth path. I should like to add, however, that the room for manoeuvre of monetary policy and the degree of success in terms of maintaining price stability crucially depend on the support of sound fiscal policies and responsible wage settlements in the euro area.

The links with other economic policies

I should now like to address the way in which the economic environment and the economic policies of both the Community and the governments of Member States will affect the functioning of monetary policy. A monetary policy reaction to inflationary pressures and the uprooting of inflationary expectations may cause short-run fluctuations in real output. Flexible and competitive goods and labour markets, however, would soften this trade-off, thereby allowing central banks to attain the goal of price stability with less serious adverse consequences for real output. The establishment of free and competitive markets for labour, goods and services would facilitate to a large extent the functioning of monetary policy in the euro area. At the limit, it is conceivable that if markets were to operate without friction, the control of inflation by a central bank could be exercised with a negligible impact on real output. Market flexibility may also help to reduce regional asymmetries in the effects of the single monetary policy. The monetary policy of the ESCB will be geared towards the euro area as a whole and will not be able to take into account purely national or regional developments. Moreover, the cyclical positions of participating countries will not completely converge at the start of Stage Three, although, with the single currency in place, some national differences may disappear over time. In the past, asymmetric shocks across European countries were sometimes dealt with via movements in the exchange rates. In the EMU environment, which is characterised by a single and uniform monetary policy aimed at maintaining price stability in the euro area as a whole, the required adjustments will have to stem from fiscal policies and national prices and wages, in addition to mobility of labour and capital. For this reason, the ESCB will follow closely, and contribute to, the debate on the reform of European wage-setting mechanisms. Sound economic reasoning recommends that wages should reflect the differentials in productivity; otherwise inflation and unemployment could result. Budgetary policies also play a major role in conditioning monetary policy. Sound budgetary policies enhance the credibility of monetary policy by preventing inflationary pressures due to an excessive stimulation of domestic demand. Furthermore, fiscal discipline exerts a downward influence on the risk premia embedded in nominal long-term interest rates. Moreover, given the requirements of the Stability and Growth Pact, a budgetary position which is close to balance or in surplus in normal conditions may allow scope for reaction to unforeseen regional or local shocks that could bring about heavy real output losses. This would also contribute to alleviating the possible asymmetric impact of monetary policy actions on single countries.

Accountability and transparency of the monetary policy of the ESCB

Allow me now to return to the issues of democratic accountability and transparency. The Treaty contains several provisions which ensure the accountability of the ESCB. First, it states that the ECB is required to disclose to the European Community institutions (the Council of the European Union, the European Commission and the European Parliament) an annual report on the ESCB's monetary policy. Moreover, as President of the ECB, I am required to present the report to the European Parliament and to take part in the subsequent debate. As I have announced before, I shall attend the hearings at the European Parliament at least four times per year to discuss the activities of the ESCB. The Parliament has the right to ask the members of the Executive Board to provide answers to specific questions. Finally, representatives of the European Commission and of the ECOFIN Council participate in the meetings of the Governing Council of the ECB and thus monitor the preparation of monetary policy decisions. Broadly speaking, the issue of the transparency of monetary policy is very important at the start of Stage Three, given that the ESCB is a new institution and the public is not accustomed to evaluating its behaviour. The monetary policy of the ESCB will be transparent in fulfilling its overriding objective of maintaining price stability, as stated explicitly in the mandate of the Treaty; it will also be held accountable in reaching its main goal. The ESCB has also gone beyond the Treaty requirements. Since the summer, a routine of holding a monthly press conference has been established, in which I and the Vice-President of the ECB report on the decisions taken by the Governing Council of the ECB and disclose and explain the underlying arguments. My introductory statements at these press conferences are and will continue to be published without delay. Moreover, as from January 1999 the ECB will provide the public with a Monthly Bulletin containing a detailed analysis of the economic situation that led to the monetary policy decisions. Furthermore, my colleagues on the Executive Board of the ECB and myself intend to be very active in giving speeches which deal with all issues of relevance for the conduct of monetary policy. I am convinced that the Governors of the national central banks will be glad to perform the same role for national audiences. Furthermore, the publication of working and occasional paper series will further clarify the "economic model" that underpins the ESCB's reasoning and behaviour and stimulate the debate on relevant technical and policy issues. I should also like to emphasise that the ESCB does not see communication as a one-way street. On the contrary, I think that we would greatly benefit from a frequent exchange of opinions and ideas with social partners and the public at large.

Relationship with other European Community institutions

The relationship between the ESCB and other European institutions is explicitly mentioned in the Treaty. There is considerable scope for collaboration and exchange of views with other European institutions. However, the ESCB is independent in its pursuit of price stability. I have already mentioned my reports to the European Parliament, which represent an example of the democratic accountability of monetary policy. Furthermore, as President of the ECB, I shall be invited to the ECOFIN Council meetings whenever issues of relevance to the ESCB come under discussion. As I mentioned earlier the President of the ECOFIN-Council and a member of the Commission may participate, without having the right to vote, in meetings of the Governing Council of the ECB. Finally, I should like to mention that I am also invited to the newly established informal Euro-11 Council meetings.


The main contribution of EMU to the welfare of the people will be the maintenance of price stability. Our conviction and hope is that the economic performance of the euro area will benefit significantly from price stability. This will also ultimately facilitate the achievement of the objectives which underpin the general economic policies of the European Community and the individual governments at the national level. Moreover, both the support of the social partners and the adoption of behaviour consistent with the maintenance of price stability are of extreme importance to a successful start of EMU.

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