The monetary policy of the ECB: stability, transparency, accountability
Speech by Professor Otmar Issing Member of the Executive Board of the European Central Bank at the Royal Institute of International Affairs, London, 25 October 1999
Just over nine months have elapsed since the European Central Bank became fully operational. The euro is still young and it is too early now to judge the success of this ambitious European undertaking. Still, some facts stand out: the euro was launched smoothly; price stability is being maintained in the euro area; payment and settlement systems work efficiently; general economic conditions (growth, employment) are improving.
Some may argue that the European Central Bank can hardly claim merit for the price stability environment which we currently enjoy. Current price developments may not fully reflect the actions taken by the ECB, given the lags of monetary policy.y; I don't wish to dispute this view. Moreover, I know from historical and personal experience that the success of a central bank can be judged only from hard facts; which means, in this case, steady and successful performance in maintaining price stability.
Nevertheless, I believe that there are at least two ways in which the ECB can already take pride for its performance. Let me turn briefly to them.
1. The accomplishments so far
The first is that, from a technical and operational viewpoint, everything worked very well in the first months of the single monetary union. In the changeover weekend, market participants from eleven countries switched smoothly to a new and complex operating environment. The experience has shown that two decisions adopted in those days - to temporarily narrow (to 50 basis points) the "corridor" between the interest rates on the two standing facilities and to extend the closing times of the TARGET system by one hour - were useful in helping market participants to familiarise with the new environment. After just a few weeks, they appeared to have adapted to it and to well understand the monetary policy signals of the ECB. The simultaneous use of both standing facilities, intense in the first weeks, decreased considerably thereafter, and the overnight (EONIA) interest rate begun to track closely the interest rate on the main refinancing operations.
The second motive for satisfaction is the high level of credibility that the ECB appears to enjoy in the markets. Credibility is of key importance for central banks, as shown by a survey recently conducted by the former vice-president of the Fed, Alan Blinder. It is important primarily because it affects the transmission mechanism and the effectiveness of monetary policy: a high level of credibility makes disinflation less costly and helps maintaining price stability once it is attained. But what exactly is credibility for a central bank? Blinder suggests that the notion is very close to the standard dictionary definition: "the ability to have one's statements accepted as factual or one's professed motives accepted as the true ones". The ECB's motives are prescribed in the Maastricht Treaty: to maintain price stability is the primary objective. Credibility for the ECB can thus be understood to coincide with a widespread perception that price stability (in the sense of absence of either inflation or deflation) will be preserved even in the distant future.
An estimate of such risks can be extracted from the yields on long-term bonds. If one looks far enough, beyond the horizon of business cycles, changes in long-term nominal interest rates typically reflect markets' perceptions of long-term inflation risks. If the central bank is credible, long term rates will not move very far away from levels consistent with maintained prospects of price stability; they will quickly jump to higher levels if credibility is lost. If I take a look at long-term bonds denominated in euros, I can conclude that the ECB has already earned a considerable level of credibility.
I believe that this is in itself a remarkable achievement, given that the ECB is an entirely new institution. As shown in the results of Blinder's survey, academics and central bankers agree that, when it comes to establishing credibility, the most reliable route remains that of building a track record of living up to one's word. Such an option was, however, simply unavailable for the ECB at its start. Thus, the current level of credibility is mainly a result of the fact that financial markets, and the public at large, have understood the pre-commitment expressed through the announcement of the stability-oriented strategy and they believe the strategy to be appropriate to fulfil the mandate of the Treaty.
The high credibility earned by the ECB is all the more remarkable given the particularly high degree of economic uncertainty it faces.
First, the overall characteristics of the area-wide monetary policy transmission mechanism are not, and could not possibly be, well known yet. The long-run relationship between money and prices is likely to remain robust as it has proved, ubiquitously, to be in the past. However, economic behaviour at higher frequencies, in the real and the monetary domain, is much more difficult to predict and may be strongly influenced by the regime shift that accompanied the introduction of the single currency.
The second source of uncertainty relates to statistical data. Macroeconomic time series that are central to the formulation of monetary policy are often subject to substantial revisions. In the specific case of the euro-area, econometric analysis must be based in fictitious time series constructed "as if" the single currency had been in existence for many years.
2. Price stability: what is it and why do we want it?
Economists are in substantial agreement on the benefits deriving from price stability. They also broadly share the view that the best contribution that monetary policy can give to the efficient functioning of monetary economies is to ensure price stability. There is consensus that high rates of inflation are, in the long run, detrimental to growth and employment. The proposition enshrined in the Maastricht Treaty, that monetary policy should have price stability as its primary objective, is not a sign of the conservativeness of central bankers, but it follows from one of the few tenets of the economic discipline.
Prolonged monetary instability characterised all main international currencies after the beginning of the seventies. Central banks had a key role in bringing inflation back under control, often through a painful disinflationary process. The emphasis that is found in the Treaty on the independence of the ECB and on the mandate to preserve price stability as an overriding objective bears the mark of the inflationary experience of those years. I should not be seen as biased if I also mention in this context the track record of the Bundesbank on the basis of its statute.
However, price stability is not defined in the Treaty. In order to provide an anchor for agents' expectations, the Governing Council decided to give a clear definition of price stability in the euro area: a year-on-year increase in the Harmonised Index of Consumer Prices of below 2 percent. The definition is symmetric, ruling out both inflation and deflation. Given the imperfect control of monetary policy over inflation due to the existence of "long and variable lags" in its transmission mechanism, price stability is to be achieved over the medium term.
The framework adopted to achieve this objective is the stability-oriented monetary policy strategy. The strategy is of great importance for a central bank, since it represents both a conceptual structure for the policy-making process and a vehicle for communicating with the public. The ECB strategy announced last October is the result of careful analyses and thorough discussions, and it has been devised in such a way as to suit the special character of the ECB: in particular, the uncertainties generated by the transition to the single currency and the lack of a track record for the new institution. One of the guiding principles in the selection of the strategy has been to express continuity with the best performing NCBs in the Eurosystem. One doesn't change a winning team! As far as the definition of price stability is concerned, a clear element of continuity is expressed by the upper limit of 2 percent: this is the value that was adopted as a goal by the main European central banks before Stage III.
3. How to achieve price stability: two "pillars"
The stability-oriented monetary policy strategy comprises two pillars. First, a prominent role for money, in relation to which a quantitative reference value of 4½ percent for the rate of growth of M3 was announced in December; second, a comprehensive assessment of the outlook for price developments and risks to price stability. The strategy aims to take stock of the advances of recent economic research on optimal monetary policy, without loosing sight of a few fundamental principles that have been known for a long time in the discipline.
The importance of monetary aggregates stems from the relationship that exists between money and prices over the medium term, the relevant horizon for monetary policy. On the basis of available data, the relationship appears to be sufficiently stable in the euro area. However, it needs to be monitored very carefully, since a structural break in behavioural relations may occur. Bank of Canada's former Governor Gerry Bouey is reported to have said: "We didn't abandon monetary aggregates, they abandoned us". But M3 has not yet abandoned us, in Europe. As long as this "fidelity" prevails, the ECB must, and will, continue to monitor the information it provides.
The emphasis attributed to the analysis of monetary aggregates in the stability-oriented strategy is also consistent with the principle of continuity within what is now the euro area. The way the information coming from monetary aggregates is used at the ECB is, however, different from the past, in particular different from the model of the Bundesbank. The special characteristics of the euro area had to be taken into account. Hence the "reference value", rather than a target range, for the rate of growth of the M3 monetary aggregate.
As the second pillar, and jointly with the analysis of monetary aggregates, a comprehensive assessment of future expected developments of prices and of general economic conditions is also conducted, focusing both on likely future paths and on the balance of risks. The broadly-based assessment has sometimes been confused with the forecast carried out by the central banks adopting an "inflation targeting" strategy. It is, however, broader in scope than an inflation forecast, since it brings together the information content of such a large number of indicators that it cannot be summarised, if not arbitrarily, in a single number or chart.
One of the many variables considered in the assessment of the prospects for price stability is the exchange rate. In this respect I must stress that the ECB has no target or favoured level of the exchange rate of the euro - either bilateral or on a trade-weighted basis - for policy purposes. The depreciation of the euro in the first months of this year has given rise to a debate over whether this approach can or cannot be assimilated to an attitude of "benign neglect". That debate is essentially misplaced. There could be no neglect of exchange rate developments because exchange rate changes can, if sustained, have an important impact on price stability. There is, however, no special role for the exchange rate in the stability-oriented strategy outside that embodied in the broadly-based assessment.
4. A "hidden" pillar: communication
Since the start of Stage III, we at the ECB have tried hard to clarify the main characteristics of the strategy and operating procedures of the new institution. This implied a constant communication effort, carried out, inter alia, through the official publications of the ECB. Each month since January 1999, the Monthly Bulletin has provided in-depth accounts of the characteristics of the euro-area economy and of the other tools that are currently an integral part of our policy analysis. Special effort has been devoted to the description of some key variables, such as money and credit aggregates. Ad-hoc articles have provided comprehensive descriptions of the institutional set-up of the Eurosystem, explaining how the information is pooled and evaluated with participating NCBs in the relevant Committees, and then filtered to the Governing Council. The characteristics of the decision making process have been thoroughly described. Finally, the ECB's reading of current economic and financial developments - that is an account of the way information processing is performed in practice - can be found in the Monthly Bulletin, together with the assessment of the future prospects for, and risks to, price stability and with explanations of the policy decisions.
As a result of our communication effort, financial markets and the public appear to have understood the principles of the stability-oriented strategy and the ECB's commitment to price stability in the medium term. But some academics are not satisfied. The ECB cannot be considered "transparent", they say, unless it discloses its economic forecasts, and publishes detailed, attributed minutes of the Governing Council meetings.
Let me first comment on the issue of economic forecasts. Some academics' exclusive focus on published forecasts is based on a fundamental misconception: that a unique internal forecast exists, i.e. that the large amount of information analysed by a central bank can be summarised in precise mathematical terms, once the related uncertainty has been adequately conveyed. The underlying assumption is that economic relationships reveal themselves to central banks in a perfectly transparent, although probabilistic, way.
I am afraid that reality is more complex than this, and it is inherently opaque to policy makers and the public alike. Both face a signal extraction problem in conditions of high uncertainty. The additional pieces of information known by the central bank are themselves the result of a complex and somewhat informal elaboration process and cannot be simply "disclosed" by releasing numbers, observed or expected as they may be. Ultimately, policy decisions are the results of a complex evaluation of raw evidence, theoretical reasoning, empirical results - including various econometric forecasts - and judgmental inputs coming from personal interpretations of reality. This is why central banking has sometimes been described as an art and this is why the set of information that leads to policy decisions can simply not be summarised in a few numbers or charts. This does not, of course, exclude that the ECB in the future might publish forecasts.
When it comes to communication to the public, the most transparent, although admittedly still imperfect, representation of this complex decision making process can only be a discussion of the plausibility of the information provided by all available indicators, including econometric models, as described through a combination of words, arguments and figures. Monetary policy is about economics and non-economists often feel frustrated at the lack of uncontroversial results one finds in this discipline and at the frequent reference to the "on the one hand ... on the other hand" formula. How can economists expect central bankers to be single-handed?
It is important to stress that forecast figures should not be understood as an exhaustive, coherent and yet simple way of presenting all the components of, e.g., an assessment of the outlook for future price stability. Such a presentation is simply impossible to achieve given the degree of uncertainty central banks face, as the Bank of England itself never stops to clarify when explaining its fan charts. As John Vickers has argued, attempting to organise all relevant information around a single inflation forecast may be one possible, and sensible, way of structuring the release of information. However, forecast figures will ultimately remain a simplified and necessarily incomplete summary of all the quantitative analyses and judgmental inputs that contribute to form the assessment of the prospects for price stability in a central bank. In the case of the ECB, an extensive discussions of these prospects can already be found in each Monthly Bulletin. I therefore maintain that, whatever the score currently attributed to the ECB in terms of transparency, it would not be significantly modified by the publication of an internal forecast.
The second issue that is often raised relates to the publications of the minutes and voting records of the meetings of the Governing Council. At the monthly press conference given in the ECB, President Duisenberg summarises and explains the decisions of the Governing Council and the reasoning behind them. Moreover, the President and the Vice-President are available for extensive questioning, transcripts of which are made available on the ECB Web site. I regard this practice as highly transparent, as highly as it is conceivable for the summary of a debate which takes place within closed doors.
As to the publication of individual voting records, I have already argued that this practice would seriously undermine the functioning of the Governing Council. In the context of the Eurosystem, it would subject NCB Governors to national and other pressures and would be detrimental to a frank and constructive exchange.
Does the lack of publication of individual voting records undermine the accountability of the ECB? I believe that the answer is no. According to Mervyn King et al., "Accountability refers to the need to justify and accept responsibility for decisions taken". In this light, the ECB's announcement of a numerical definition of price stability should also be interpreted as an attempt to give a specific benchmark against which to assess its performance: the consistency of observed inflation with this objective can be judged, over time, by any observer, based on the HICP figures released by Eurostat. The ECB will then be clearly seen to be, or not to be, fulfilling the requirements of the Treaty and its own stated strategy.
The channels for accountability of the ECB defined by the Treaty are the reporting requirements to the European Parliament, the Council of Ministers and the Commission, which take the form of an annual report and quarterly reports. The President of the ECB presents these reports to, and discusses them in, the relevant committee of the European Parliament, which can also question other members of the ECB's Executive Board. Potential deviations of actual inflation from the path deemed consistent with price stability have to be accounted for in these fora.
Three main factors have contributed to make the initial months of the life of the ECB quite successful. The favourable initial economic conditions inherited from participating NCBs; a painstaking preparatory work, carried on by the Eurosystem as a whole; and finally, the high level of credibility earned so far, a remarkable characteristic for a newly established institution.
A decisive contribution to earn credibility has been given by the announcement of the stability-oriented monetary policy strategy, which has proved a suitable and efficient framework for policy decisions in the newly created economic area. It also appears to have been understood as such, by financial markets and the public at large.
The work of the ECB continues. Credibility has to be maintained and strenghtened through a track record of good performance. The ECB will continue to make its best effort to adequately implement the stability-oriented strategy and to explain how it is applied in practice to determine policy decisions.