The ESCB's stability-oriented monetary policy strategy
Speech by Dr. Willem F. Duisenberg, President of the European Central Bank, at the IFRI on 7 December 1998 in Paris
On 1 January 1999 - in only twenty-four days' time - Stage Three of Economic and Monetary Union (EMU) will commence in Europe. The introduction of the euro will mark a tremendous achievement, the culmination of more than a decade of preparation and convergence. But, in many ways, the greatest challenges and opportunities will still lie ahead, both for Europe and for the Europeans.
The introduction of the euro offers the great opportunity to establish and maintain price stability throughout the eleven countries that comprise the euro area. By ensuring that prices in the euro area can be kept stable over time, the European System of Central Banks (ESCB) will be laying the foundations for sustainable economic growth and improved employment prospects in Europe.
Indeed, we are already living in a de facto Monetary Union, as has been demonstrated by the coordinated move of their key interest rates by all central banks of the euro area on 3 December 1998, reflecting a consensus reached in the Governing Council on the basis of a common assessment of the economic, monetary and financial situation in the euro area. Whereas all indicators suggest a favourable broad outlook for price stability, prospects for growth for the euro area have weakened, and the international environment is still dominated by uncertainty, so that the risks appear to be predominantly on the downside. This joint reduction in interest rates has to be seen as a de facto decision on the level of interest rates with which the Eurosystem will start Stage three of Monetary Union and which it intends to maintain for the foreseeable future.
At the heart of our approach is the "stability-oriented" monetary policy strategy. The Governing Council of the European Central Bank (ECB) has adopted the broad lines two months ago and presented them to the public. Today, before explaining some further details regarding the ESCB's monetary policy strategy, I should like to describe how we interpret our mandate of maintaining price stability.
The ESCB is an institution which is independent from political interference. In a democratic society, independence has to be accompanied by accountability. The ESCB's monetary policy strategy must be clear and transparent if we are to convince the general public both of our commitment to maintain price stability and of our ability to do so. Therefore, we put much effort in the design of a sound and coherent framework that leads to consistent and effective monetary policy decisions.
Transparency regarding the ultimate objective of monetary policy is crucial for ensuring that the ESCB can be held accountable for its policies. The Maastricht Treaty entrusts the ESCB with the primary objective of maintaining price stability. It does not, however, quantify this objective or stipulate how it should be achieved. A clear definition in quantitative terms of price stability will help stabilise inflation expectations, build up the credibility of the single monetary policy of the ESCB and will thereby increase its effectiveness. The Governing Council of the ECB has, therefore, decided to publish a quantitative definition of price stability, with which the general public can sensibly judge its success in fulfilling the Treaty's mandate.
In this context, the Governing Council agreed in October that "price stability shall be defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%". The HICP is a comprehensive measure for inflation, reflecting the focus of the general public on consumer goods. It is the only harmonised price index available in the euro area.
As I have emphasised in the past, the definition we have announced reflects the aversion of the Governing Council to both inflation and deflation. The phrase "below 2%" clearly delineates the maximum rate of inflation deemed to be consistent with price stability. The wording "year-on-year increases" implies that persistent price decreases - that is to say deflation in the measured price index - would not be considered to be consistent with price stability either. We did not explicitly announce a floor for inflation, because we know that the price index may include a measurement bias of positive order, but we currently do not know its precise magnitude. One can expect, however, that the measurement bias in the HICP is smaller than for the national consumer price indices (CPIs), given the considerable effort Statisticians in the EU put in the construction of this index.
The Governing Council explicitly announced that "price stability is to be maintained over the medium term". In doing so, it also acknowledged that price levels may be temporarily distorted by short-term factors - for example, by changes in indirect taxes or commodity prices - which cannot be controlled by monetary policy or by the ESCB.
Using the index "for the euro area" highlights that area-wide developments, instead of specific national or regional factors, will be the only determinants of decisions regarding the single monetary policy. Let me emphasise the over-riding priority we attach to this objective. This priority is not only based on our legal obligations under the Treaty. It is founded in our belief - confirmed by both decades of experience and a substantial body of theoretical and empirical research - that maintaining price stability in the euro area is a pre-requisite for a sustainable and lasting improvement in the standard of living of Europe's citizens.
In addition to maintaining price stability, but without prejudice to this objective, the ESCB is required to support the general economic policies in the European Community. The choice made in the Maastricht Treaty to have price stability as the primary objective of the ESCB is based on the view that this is the best contribution monetary policy can make to the creation of conditions conducive to durable income and employment growth. Indeed, price stability is one of the longer-term conditions for the achievement of other economic policy objectives, such as sustainable economic growth and full employment. By fulfilling its primary objective of maintaining price stability, the ESCB will automatically also support the general economic policies in the European Community which are aimed at achieving the aforementioned objectives, namely non-inflationary growth and high employment.
Moreover, by emphasising that price stability is to be maintained in the medium term ensures that the appropriate forward-looking and medium-term orientation is imparted to monetary policy. This will ensure that policy responses to threats to price stability are measured and deliberate. Such actions will not introduce unnecessary instability into the economy, while nevertheless ensuring that price stability is maintained.
However, it should be noted that, unless it enjoys the support of sound budgetary policies and responsible wage behaviour, the maintenance of price stability will be more difficult and thereby overall economic welfare will be reduced. That is why I attach great importance to the so-called Stability and Growth Pact, in which European governments agreed to reduce government deficits to close to balance or even to create a surplus in the medium term.
In this context, it should be emphasised that the European unemployment problem is mainly of a structural nature. Monetary policy cannot solve this problem. It can only contribute to creating the conditions needed to solve the problem by maintaining price stability. The main solution to the unemployment problem has to be provided by structural reforms aimed at making European goods, services and labour markets operate more flexibly.
Let me now turn to the two main elements of the ESCB's stability-oriented monetary policy strategy. The Governing Council of the ECB has chosen a distinct monetary policy strategy, one that reflects the special circumstances existing at present as well as those in the foreseeable future. Given a natural desire to build on the success of national central banks (NCBs) in the euro area prior to Stage Three, the strategy ensures as much continuity as possible with the existing strategies of NCBs. At the same time, the chosen strategy gives due consideration to the unique situation created by the transition to Monetary Union.
Given these specific circumstances, the Governing Council has decided that it would not be wise to define a single intermediate target for the ESCB's monetary policy to which it would react in an almost mechanistic manner.
In accordance with the announced definition of price stability, the ESCB has adopted a stability-oriented monetary policy strategy, which rests on two "pillars". The first pillar is a prominent role for money. This is deemed to be important on account of the basically monetary origins of inflation over the longer term. In indication of the prominent role it attaches to money in the formulation of its monetary policy, the Governing Council of the ECB has announced a quantitative reference value for monetary growth at its last meeting.
In parallel with the analysis of monetary growth in relation to the reference value, its strategy will also rest on a second "pillar". This will consist of a broadly-based assessment both of the outlook regarding price developments and of the risks to price stability in the euro area as a whole.
As I have just indicated, there is a wide consensus that the development of the price level is a monetary phenomenon in the medium to long term. The historical experience of central banks in- and outside Europe clearly demonstrates that it is essential, for the success of monetary policy, to carry out a thorough analysis of monetary aggregates and the information they contain. In particular, empirical evidence shows that increases in prices are relatively closely linked to rates of money growth in excess of the real growth capacity of the economy over the medium-term. Consequently, monetary developments can reveal useful information about future price developments and thereby offer an important compass for the conduct of monetary policy. Therefore, it is absolutely essential for any central bank that has the task of keeping prices stable to analyse and monitor developments of monetary aggregates closely.
It is against this background that the Governing Council decided to announce a reference value for monetary growth, which is consistent with - and serves the achievement of - price stability. The Governing Council will regularly and thoroughly analyse the relationship between actual monetary growth and this pre-announced reference value. Wherever monetary growth deviates from the reference value, an explanation will be sought. If this explanation indicates a threat to price stability, monetary policy will react accordingly in order to address this threat. However, interest rates will not be changed in a mechanistic fashion in an attempt to correct deviations of money growth from the reference value over the short term. That is why we do not speak of a target for monetary growth, but rather of a reference value.
In this context, the Governing Council of the ECB, a week ago, agreed on three important issues. First, the specific definition of a broad monetary aggregate for which the reference value will be announced. Second, whether a single figure or a range will be chosen for the reference value. Third, the precise level of the first reference value for monetary growth.
In selecting the precise definition of the monetary aggregate that effectively serves the function of a reference value, both empirical and conceptual considerations were taken into account. Empirical economic studies have investigated the properties of various euro area-wide monetary aggregates, in particular in terms of their long-run stability and leading indicator properties. From the conceptual point of view it was considered of great importance to include also those assets in the monetary aggregate, which have a high degree of substitutability with narrower definitions of money. As most short-term money market instruments are close substitutes for more traditional bank deposits, it was decided to select the broadest of the available definitions. The reference value will, therefore, refer to M3 in a relatively broad definition, which includes in addition to currency in circulation and deposits also repos, money market paper, short-term debt securities issued and units or shares of money market funds.
Announcing a specific rate of monetary growth as the reference value rather than a range supports the view that the Governing Council will not react 'mechanistically' to deviations from the reference value. Movements of monetary growth within a range might be interpreted as not requiring a monetary policy reaction, even when the information they reveal about the disturbance to the economy suggest a serious threat to price stability. Rather monetary policy will respond to the information revealed by the deviation so as to maintain price stability over the medium term.
Deviations of current monetary growth from the reference value would, under normal circumstances, signal risks to price stability in the medium term. To achieve this, the reference value is derived in a manner consistent with the ESCB's announced definition of price stability. Furthermore, the reference value for monetary growth takes into account the trend of real GDP growth over the medium term, as well as the trend changes in the velocity of circulation. An approach using trend growth over some past period strengthens the medium-term orientation of the monetary policy strategy. At the same time, it adds some employment and income stabilising elements.
In setting the actual reference value for monetary growth, the Governing Council has taken account of these factors. First, the Governing Council is committed to maintain price stability on its published definition. This requires increases in the HICP for the euro area of "below 2 %". Second, the Governing Council takes the view that a figure in the range of 2 % to 2 1/2 % per annum for the trend growth of real GDP in the euro area appears to be reasonable. Third, the uncertainties concerning short-term developments in velocity linked to the start of Stage Three have led the Governing Council to assume that the medium-term trend decline in velocity lies in the approximate range of 1/2 % and 1 % each year. This range encompasses the historical experience of the last twenty years. Based on these considerations, the Governing Council decided to set the first reference value for monetary growth at 4 1/2 %.
The Governing Council of the ECB will monitor monetary developments against this reference value on the basis of latest three-month moving averages of the monthly year-on-year growth rates for M3. This will ensure that erratic monthly outturns in the data owing to data revisions do not unduly distort the information contained in the aggregate.
Although monetary data contain information which is vital for monetary policy decision-making, monetary developments alone will not constitute a complete summary of all the economic information necessary to take appropriate policy decisions. There is a clear need for the Governing Council to look at a wide range of other economic and financial indicators. This assessment will comprise a systematic analysis of all the other information on the economic and financial situation, ensuring that the Governing Council is as well informed as possible when making its monetary policy decisions.
While it is true that accurate forecasts can contribute to the success of an appropriately forward-looking monetary policy, the ESCB should not be judged on, or held accountable for, the accuracy of its internal forecasts. Rather, its performance in maintaining price stability in the medium term - should be used by the public to judge the success of the ESCB's policies. Consequently, publication of a forecast is only deemed important in so far as it helps to achieve price stability, through increasing the clarity and transparency of the policy-making process.
Relying on a single forecast that attempts to summarise all the information available from a wide range of indicators would be misguided. The Governing Council will not want to be presented with a single number to which it will have to react mechanistically, if at all. In contrast, the Governing Council will want to know the economic reasons behind the projected risks to price stability. The appropriate monetary policy response to a threat to price stability will depend on the nature of the threat. The Governing Council can only understand the nature of the risk if it is presented with a full set of data. From these data, it can attempt - with the help of various staff analysis - to identify the nature of the disturbance to price stability. Having identified the threat, an appropriate policy response can be selected and implemented.
The Governing Council will inform the public regularly about its assessment of the monetary, economic and financial situation in the euro area. Moreover, when policy decisions are made, the reasoning behind specific decisions - including the economic rationale on which judgements have been made - will be communicated to the public immediately after the meeting at which they have been taken. By presenting the analysis that is actually driving policy decisions, the ESCB will be transparent, since this analysis is informative about policy changes and since the presentation to the public will reflect the type of discussion I anticipate occurring in the Governing Council itself.
On the basis of the strategy I have just outlined, the Governing Council will regularly inform the public about its specific monetary policy decisions. The Governing Council will meet every fortnight. The first meeting in every month will immediately be followed by a press conference. The ECB will frequently issue press releases after meetings of the Governing Council, without delay, and will regularly publish a monthly bulletin as well as an annual report. We shall also regularly explain our policies in speeches and interviews, and I have already announced my acceptance of invitations to present them to the European Parliament at least four times a year.
The ESCB's monetary policy strategy must be clear and transparent if we are to convince the public of our commitment to maintain price stability and our ability to do so. We must be seen to be operating in a solid and coherent framework that leads to consistent and effective monetary policy decisions. Given the uncertainties that we face at the outset of Stage Three and taking into account the particular circumstances of the euro area, the chosen approach is more likely to produce good policy decisions than an almost automatic response based on specific rules defined in relation to an inflation or an intermediate monetary target. The stability-oriented monetary policy strategy adopted by the ECB Governing Council offers precisely this framework. Having respected the principle of transparency, I am confident that this strategy will be successful. By maintaining price stability in the euro area, the ESCB will then lay a necessary foundation for Europe's future economic stability and prosperity.