The monetary policy of the European Central Bank
Speech by Eugenio Domingo Solans Member of the Executive Board of the European Central Bank during the "Working Breakfast" at the Permanent Seminar on 4 December 1998 in Madrid
It was with immense pleasure that I accepted the invitation to take part in this event, organised by Euroforum. In view of the prestigious nature of Euroforum, the professional standing of its President, Eduardo Bueno, Professor at the Universidad Autónoma de Madrid and consultant to the Banco de España (there is a great deal of similarity between our respective professional histories) and, above all, the value I have attached to his friendship over the past thirty years, there was no question as to whether to agree to join you for this working breakfast. I have been asked to keep my presentation brief in order to allow as much time as possible for discussion. Therefore I will try to put forward a few ideas on the monetary policy of the European Central Bank (ECB) which I can develop during subsequent discussions. During the discussion period please feel free to raise any questions on other aspects of the ECB's operations.
The three fundamental principles underlying the monetary policy
As in the case of any other central bank, the ECB's monetary policy is based on three fundamental principles: setting the objectives to be achieved, establishing the most appropriate strategy for accomplishing these objectives and, finally, selecting the best instruments for implementing its chosen strategy. While the Governing Council of the ECB is responsible for formulating its monetary policy, both the Executive Board of the ECB and the national central banks are involved in its application and therefore this constitutes one of the tasks allotted to the European System of Central Banks (ESCB) as a whole. Objectives, strategies and instruments therefore form the three main elements which enable us to establish the precise point within the range of monetary policy possibilities which should constitute the ECB's policy: its precise altitude, longitude and depth.
The ECB's monetary policy objectives
We did not have to think long and hard to define the ECB's monetary policy objectives and, generally speaking, those of the ESCB. This had been done for us by the Treaty on European Union in which, under Article 105, it is stated that "the primary objective of the ESCB shall be to maintain price stability" which, on a more practical level, the ECB has defined as a year-on-year increase in the harmonised index of consumer prices (HICP) for the euro area of below 2%, which it seeks to maintain in the medium term. "Without prejudice to the objective of price stability", continues the aforementioned Article 105 of the Treaty, "the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2". If you refer to the aforementioned Article 2 of the so-called Treaty of Maastricht, you will find that sustainable and non-inflationary growth, together with a high level of employment and social protection, are among its aims. The ECB, then, must prioritise those of its activities which promote the objective of stability and, without prejudice to this approach, it will contribute, indirectly and to the extent possible, to economic growth and increased employment. Is this approach in any way contradictory? Absolutely not. The best contribution the ECB can make to promoting investment and thus to generating economic growth and increased employment is precisely by providing a framework for price stabilisation. The worst path that the ECB could follow would be to implement a lax economic policy which claimed to be directly creating jobs. In fact, in the medium term price stability will encourage efficient investment, sustainable growth and employment. This is because stability prevents price distortions, that is to say any distortion of the mechanism which guides decision-makers in the markets, and thus favours an improved allocation of resources. When stability is achieved, prices are more transparent, which promotes competition and therefore efficiency. Moreover, if economic agents have positive expectations with regard to stability, the risk premium element of long-term of interest rates will fall, promoting investment and lasting consumption. In this respect, it should be remembered that one of the clearest inflation forecast indicators is an increasingly steep maturity-related asset yield curve. Finally, stability promotes growth and employment insofar as it allows resources to be channelled into productive activity. Inflation, on the other hand, merely encourages speculative investment with the aim of safeguarding funds against monetary deterioration. As we saw earlier, the aims set out in Article 2 of the Maastricht Treaty also include social safeguards. In this context, therefore, it can be said that inflation is the most unjust of all taxes, because it attacks personal income and assets while distorting certain public redistribution mechanisms such as, for instance, progressive taxation scales. In other words, stability is not just important for economic efficiency but also for social justice, since it provides economic conditions which benefit the weakest and most vulnerable members of society. An appropriate ECB monetary policy is a necessary condition but will not, in itself, enable us to achieve stability. National taxation policies geared to satisfying the objectives of the Stability and Growth Pact, together with several supply-side policies leaning towards liberalisation and flexibility, are also necessary to enable us to avoid the persistent need for measures to combat inflation. We must avoid the temptation to reinterpret the Stability and Growth Pact by introducing "golden rules" of dubious legality, based on the false theoretical foundations of the so-called "ultra-rationality hypothesis" which, in the past, claimed to justify increased taxation pressure and which now calls for increased public spending in terms of investment. Let's not beat about the bush: taxation policy has only one golden rule, which consists in maintaining a long-term budgetary balance on the economic horizon. In connection with the ECB's objectives, it should also be noted that it is difficult or even impossible to meet two separate targets simultaneously using only a single monetary policy. This applies when dealing with the concept of fixing fluctuation bands for the rate of exchange between the euro and the US dollar. In this case, the exchange rate objective could conflict with the price stability concept and the ECB would then fail in its primary objective. We must not forget, with regard to this issue, that combining linked exchange rates, the free circulation of capital and monetary autonomy is not, to be quite blunt, sustainable. It is precisely this which is the raison d'être of the ECB as the single monetary authority in an economic area which has irrevocably fixed exchange rates (a single currency) and freely circulating capital (a single market). To conclude this section, let me stress that it is essential for the ECB to make it absolutely clear that its main objective is stability. If, as some would suggest (for instance in the Modigliani manifesto), the ECB were to directly target employment, this would adversely affect the credibility of its monetary policy and thus have an impact not only on inflation but also, paradoxically, on employment. The direct targeting of employment objectives by a central bank is counterproductive.
The ECB's monetary policy strategy
A strategy is a combination of criteria and procedures which allow decisions to be taken in order to achieve a monetary policy objective. This decision-making process can be based on inflation forecasts which depend on the behaviour of a relevant monetary variable or, more simply, on the "pegging" of exchange rates to a stable currency. This last strategy is ideal for more open economies, encompassed by a specific monetary zone, such as, for instance, the Netherlands and Germany. However, this would not be suitable for a much larger but relatively closed economic space such as the euro area. I believe that it is a mistake to try to exaggerate the polarity of the inflation strategy and the monetary strategy. These are quite clearly separate strategies but they are not in any way opposed, incompatible or irreconcilable. Certainly, some aspects of each of these strategies should be combined, resulting in another, completely separate and valid strategy. This is what the ECB has done and it now needs to give the end product a name which does not merely describe the desired objective ("the stability-orientated monetary policy strategy"). There are two components to the ECB's monetary policy strategy. The first, more practical and visible component consists in a quantitative reference to the growth of the money supply as defined by the broad M3 aggregate. Taking into account the quantitative definition of stability, economic growth and realistic hypotheses on money circulation rates, this monetary reference has initially been set at 4 1/2%. The second component of the ECB's monetary strategy, a more general and enveloping one, is the estimation of inflation forecasts and risks for price stability in view of changes in a group of significant variables, all of which are related to the euro area as a whole. Some examples of these significant variables are credit, long-term interest rates, prices of raw materials, import prices, wages and public spending deficits. Inflation is a monetary phenomenon. When the rate at which the money supply grows is greater than the nominal potential rate of growth of an economy, in the medium term this will generate inflation. In other words, the medium-term inflation rate is indicative of excessive monetary expansion in relation to economic growth. Growth in the money supply therefore provides the best early warning of inflation and monetary control is the best monetary policy strategy. The virtues of the first component of the ECB monetary strategy are, when all is said and done, well known. If it worked, this alone would be sufficient. In practice, however, things are never so simple. Inflation forecasting and control cannot rely solely on a monetary aggregate because of doubts as to whether or not this monetary aggregate can be controlled and is stable and meaningful. If a narrow definition of money, such as M1, is adopted, controllability can be achieved in that, through the monetary policy instrument, it is possible to have a greater impact on its evolution, but this is offset by the loss of stability and significance. If it is decided to opt for a broad monetary aggregate, such as M3 or M4, the money demand function becomes more stable and clearly more significant, in that a greater correlation can be achieved between exchange rates, providing a better explanation of changes in nominal costs and inflation, in return for some loss of control. Despite this, doubts persist. In practice, these will, of course, increase when national currencies are replaced with the euro; then the need for the second part of the monetary policy strategy will become obvious.
The ESCB monetary policy tool
The wide range of instruments available to the ESCB for the implementation of the euro area monetary policy has been established with reference to two fundamental criteria: efficiency and neutrality. These instruments can be separated into three categories, related to open market operations, standing facilities and minimum reserves. The ESCB's instruments and procedures do not differ significantly from those traditionally used by the Banco de España and with which you are all familiar. This means that I only need to highlight a few differences. In addition, I should add that over recent weeks the Banco de España has introduced changes aimed at facilitating a smooth transition. With regard to open market operations, the frequency and maturity of the main re-financing operation has become that of a weekly auction of loans with a maturity of two weeks, and an interest rate which is either announced in advance (fixed rate auction) or announced later as the result of offers received (variable rate auction). There will also be monthly auctions for three-month loans which will always be of the variable rate type in order to avoid sending signals to the market. Fine-tuning will be carried out in exceptional circumstances between two regular auctions and, finally, the structural liquidity demand can be influenced by means of open market transactions which consist in the direct purchase and sale of securities or the issuance of debt certificates. Standing credit and deposit facilities will supply or absorb overnight liquidity, without the imposition of any other restrictions on their use by institutions other than the provision of guarantees or collateral. Both types of interest on standing facilities constitute a strip or corridor which will contain short-term market interest rate swings and provide a structure for monetary policy trends. This means that they will play an important role in terms of providing signals, a role also fulfilled by the Banco de España but in a less predetermined and formalised manner. As far as guarantees for all these transactions are concerned, it should be stated that acceptable collateral may take the form of either a public instrument or a private instrument, provided that these are of a suitable nature, according to the neutrality principle applied to the public sector and to the private sector. The minimum reserves will be equal to 2% of book liabilities calculated on the basis of a monthly average, will be subject to a minimum exempt level of EUR 100,000 and - this being the most important point underlining the main difference compared with the current position in Spain - will be remunerated in line with market rates. The averaging provision will allow us to absorb liquidity shocks without recourse to standing facilities. Such a minimum reserves will constitute a useful tool for restricting the volatile nature of monetary market interests rates, for reducing the need for fine-tuning and for tightening up the system's liquidity, thereby enhancing the effectiveness of the monetary policy. Its remuneration in line with the market will not only reduce money demand elasticity with regard to interest rates but also offer neutrality to euro area banks as compared with those in other countries which do not use such a tool.
Although inevitably in a simplified form, I hope that this statement on the aims, strategy and instruments of the euro area monetary policy has provided some basic information on the central core of the ECB's operations and that it can be used as a starting-point for our discussions. Thank you for listening; during the discussion period, I shall be pleased to elaborate on the issues raised or examine any others which you think may be of interest.