A stability-oriented monetary policy strategy
Speech by Christian Noyer, Vice-President of the European Central Bank, at the Euro Seminar organised by PARIBAS on 8 December 1998 at the Hotel Okura in Tokyo
In only twenty-three days' time, Stage Three of Economic and Monetary Union (EMU) will commence in Europe. The introduction of the euro on 1 January 1999 will mark a tremendous achievement, the culmination of more than a decade of preparation and convergence among the eleven initial participants in the euro area. In many ways, and within a medium-term perspective, the advent of the euro is creating great opportunities for Europe and the world economy. Monetary Union is a unique opportunity to establish and maintain a zone of price stability in the euro area. Price stability is at the core of the "stability culture" that we are establishing in Europe. By fulfilling the unambiguous commitment of the Governing Council of the European Central Bank (ECB) to maintaining price stability in the euro area, we will ensure that the single monetary policy contributes as much as possible to economic welfare in a broad sense. 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 same time, fiscal authorities and general economic policies in Europe will also have a major contribution to make towards creating a unique stability culture. In this context the so-called Stability and Growth Pact, which was agreed by EU governments and aims at fostering the pursuit of disciplined fiscal policies, is a crucial element. The "stability-oriented monetary policy strategy" recently adopted by the Governing Council, and announced to the public two months ago, is at the heart of our approach. This monetary policy strategy, which I would like to explain first, is designed to ensure that the Governing Council can act in a forward-looking and pre-emptive manner, changing interest rates to contain inflationary or deflationary pressures before they become entrenched. In the second part of my speech, I should like to reflect on some of the possible implications of the introduction of the euro in the international field.
1. The ESCB's stability-oriented monetary policy strategy
The Treaty establishing the European Community assigns the European System of Central Banks (ESCB) the primary objective of maintaining price stability. In the interest of transparency and accountability, the Governing Council of the ECB has decided to publish a quantitative definition of price stability, against which its success in fulfilling the Treaty's mandate can sensibly be judged by the public. At its October meeting the Governing Council of the ECB agreed 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%". With the HICP, a specific price index is identified against which the maintenance of price stability will be assessed. It was chosen because it is both sufficiently harmonised across the different countries of the euro area at the start of Stage Three and is consistent with the public's usual focus on consumer prices. Using the index "for the euro area" highlights the fact that euro area-wide developments, rather than specific national or regional factors, will be the only determinants of decisions regarding the single monetary policy. This definition signals the aversion of the Governing Council to both inflation and deflation. The phrase "below 2%" clearly delineates the rate of inflation in the HICP deemed consistent with price stability. The wording "year-on-year increases" implies that decreases in the HICP - that is to say deflation in the measured price index - would not be considered consistent with price stability either. In this manner, the Governing Council has clearly defined its objective, which is to be maintained over the medium term. By adopting this approach we are being realistic, acknowledging that some disturbances in the price level can occur in the short run - such as those caused by changes in indirect taxes or commodity prices - that cannot be controlled by monetary policy or by the ESCB. Such factors may lead to occasional falls in the HICP, or occasional increases above 2%. These are quite normal and consistent with a meaningful definition of price stability. However, the ESCB's monetary policy will ensure that these transitory deviations from the definition do not become ingrained over the medium term. If and when we do not meet this primary objective, we are obliged to explain why that is the case and what we are going to do about this. Let me emphasise the overriding priority we attach to this objective. This priority is not only based on our legal obligations under the Treaty. It is also 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, and provides the foundation for improving growth and employment prospects in the future. In order to achieve 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 appropriate on account of the essentially monetary origins of inflation over the longer term. In parallel with the analysis of monetary growth in relation to the reference value, its strategy will also rest on a second "pillar". It 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. 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. Overall, this strategy ensures the greatest possible continuity with successful monetary strategies pursued in the euro area countries in the past. Nevertheless, it is an approach that reflects the special circumstances faced by the ESCB at the start of Stage Three. This strategy underlines the strong commitment of the Governing Council of the ECB to its primary objective and should facilitate the achievement of this overriding goal. It will also ensure the transparency of the ESCB's decision-making and its accountability. Based on its strategy, the Governing Council of the ECB will inform the public regularly and in detail about its assessment of the monetary, economic and financial situation in the euro area and the reasoning behind specific policy decisions. As I have already indicated, there is a broad 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 Europe and beyond clearly demonstrates that it is essential 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 provide useful information about future price developments and thereby offer an important compass for the conduct of monetary policy. Against this background, it is absolutely essential for any central bank that has the task of keeping prices stable to analyse and monitor developments in monetary aggregates closely. By way of an indication of the prominent role it attaches to money in the formulation of its monetary policy, the Governing Council of the ECB announced a quantitative reference value for monetary growth at its meeting on 1 December 1998. The reference value has two key features. First, it has been derived in a manner that is consistent with - and directed at achieving - price stability. Second, it has been constructed such that, in the absence of special factors or other distortions, deviations of monetary growth from the reference value will signal risks to price stability. In the future, the relationship between actual monetary growth and the pre-announced reference value will be regularly and thoroughly analysed by the Governing Council. Where deviations emerge, an explanation will be sought. If such an explanation points towards a threat to price stability, monetary policy will react appropriately, but not in a mechanistic manner, in order to counter this threat. In contrast to a conventional monetary targeting regime, the ESCB is not, however, committed to correcting deviations of money growth from the reference value over the short term. One week ago the Governing Council of the ECB 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; and 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 a conceptual point of view it was considered of great importance also to include in the monetary aggregate those assets which have a high degree of substitutability with narrower definitions of money. The reference value will, therefore, refer to a relatively broad definition of M3, which, in addition to currency in circulation and deposits, also includes repos, money market paper, short-term debt securities issued and units or shares of money market funds. In setting the reference value for monetary growth, the Governing Council has taken account of various factors and emphasised its medium-term orientation. First, the Governing Council is committed to maintaining price stability according to 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 in 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 approximately within a range of 1/2% and 1% each year. This range reflects historical experience over the last twenty years. On the basis of these considerations, the Governing Council decided to set the reference value for monetary growth at 4 1/2%. The Governing Council has decided to announce a specific reference rate for monetary growth, rather than a range. The Council believes that announcing a reference range may be falsely interpreted as implying that interest rates would be changed automatically if the boundaries of the range were exceeded. This interpretation would not be consistent with the concept of a reference value, which - as emphasised in the announcement of the ESCB's stability-oriented monetary policy strategy in October 1998 - does not imply a commitment to mechanistically correct any deviation of monetary growth from the reference value over the short term. The Governing Council of the ECB will monitor monetary developments against this reference value on the basis of the 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 the monetary data contain information vital for monetary policy-making, monetary developments alone will not, of course, constitute a complete summary of all the economic information necessary to take appropriate policy decisions. In the ESCB's stability-oriented monetary policy strategy, money is accorded a prominent - but not an exclusive - role. There is a clear need for the Governing Council to look at a wide range of other economic and financial indicators. Consequently, as I have pointed out, a broadly-based assessment of the outlook for price developments and the risks to price stability in the euro area aims at systematically analysing all the other available information about the economic and financial situation both within and beyond the euro area. However, the stability-oriented monetary strategy does not include the regular publication of inflation forecasts, for the following reasons. 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 the definition of price stability is important, as it helps to anchor inflation expectations, by increasing the clarity and transparency of the ultimate objective of the ESCB. The ESCB aims at defining price stability according to its announced quantitative definition. A credible commitment to this definition should provide the main anchor for inflation expectations, rather than an uncertain inflation forecast. In fact, it is not always transparent and appropriate to publish a forecast for future inflation, which might deviate, on the one hand, from the ESCB's definition of price stability and, on the other, from the actual outturn. In certain cases the publication of forecasts may even destabilise expectations and price developments, in particular as the forecasts are normally conditional and reflect some of the risks and uncertainties prevailing at the time.
2. The international role of the euro
Let me now turn to the international role of the euro. The euro will be the currency of an economic area, which will roughly equal the United States in terms of both its economic strength and its degree of macroeconomic openness. However, the size of an economy and external trade volume alone are not always perfect indicators of the international importance of a currency. According to most measures, for example, the US dollar is of greater international importance than the relative size of the US economy would suggest. It is clear that the European Central Bank - which represents not only an equally large economic area with an equally large population (of 300 million), but also a currency which will increasingly circulate outside the euro area - will have an important international role to play. The international role of a currency is a complex phenomenon. There are many uses for a currency in an international context. On the official side, these include its use as an anchor for exchange rate pegs, for holding foreign exchange reserves and as a vehicle currency for foreign exchange interventions. On the private side, these include its use as a quotation and vehicle currency for international trade, as the currency of denomination for financial assets and as a substitute currency in circulation abroad. The introduction of the euro will also have consequences for economies abroad and for the international capital markets. For the euro, this means that there are several areas in which it could play a significant role. In the near future, such a role obviously seems to be more likely in areas where global currency diversification is desired, and less likely where global standardisation on the use of a single currency has occurred. In this context, it should be stressed that the euro will inherit the international role of all the currencies participating in the euro area, for instance the Deutsche Mark and the French franc. For short-term instruments, we anticipate a deep and liquid European money market, which will ensure very similar short-term interest rates for comparable instruments and credit risks. Until 1 January 1999, we will see further convergence of short-term interest rates to narrow spreads among Member States of the euro area, because of the irrevocable fixing of exchange rates, which will cause such differences to disappear within the euro area. Developments in this market segment will also be strengthened by the ESCB's operational framework for open market operations, which will be based primarily on reverse transactions and the implementation of the new payment system called TARGET (the Trans-European Automated Real-time Gross settlement Express Transfer system) in all participating countries. In this context the role of the euro vis-à-vis so-called third currencies, such as the Japanese yen and the US dollar, will receive increasing public attention. The ESCB will take a neutral stance. It will neither promote nor hinder the development of the euro as an international currency. The ESCB will accept the international role of the euro as it develops through market forces. There will be no deliberate policy of challenging third currencies. However, by being successful in maintaining price stability, the ESCB will also automatically foster the role of the euro as an international currency. We are not currently participating in a formal exchange rate arrangement with third countries outside the EU, for instance with the United States, and we consider it very likely that this situation will remain the same for the foreseeable future. Moreover, the European Ministers of Finance have agreed only to issue so-called orientations for exchange rate policy in exceptional circumstances, such as a clear and sustained misalignment of the euro. Experience of fixed exchange rates supports the view that target zones are vulnerable to speculative capital movements and could become inconsistent with the primary objective of price stability. In its monetary policy strategy, the ESCB, therefore, does not specify a target or target zones for the exchange rate of the euro. This follows from our clear mandate to maintain price stability. The exchange rate will mainly be an outcome of the economic process and of economic and monetary policies. The lack of a formal exchange rate target does not imply that the exchange rate of the euro will be unstable or volatile. Let me stress that price stability in the euro area is the best contribution the ESCB can make to a stable international monetary system and an externally stable euro. The Governing Council cannot therefore conduct an exchange rate policy separate from its monetary policy strategy. Rather, the monetary policy strategy comprises a thorough analysis of exchange rate developments. The effective exchange rate of the euro area will be a key indicator within the stability-oriented monetary policy strategy of the ESCB. Based on its monetary strategy, the ESCB will be able to conduct a successful monetary policy, which takes into account the development of the exchange rate of the euro in an appropriate manner, as one of the determinants of price developments in the euro area.
The success of EMU and of the single currency will clearly depend on the establishment of a stability culture in Europe. This will facilitate the conduct of the stability-oriented monetary policy over the coming years and in particular support economic policies in achieving high international standards in terms of economic growth and employment. To the extent that the ESCB is successful in maintaining price stability, it will also foster the use of the euro as an international currency and contribute to its stability. I am convinced that the euro will follow a long European tradition of stable currencies. Its success will not come overnight. But over the coming years, stable prices in the euro area are likely to guarantee that it is widely used by Europeans and international investors.