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Summary of “The ECB and the euro - the first five years”

by Professor Otmar Issing, Member of the Executive Board of the European Central Bank
Mais lecture, delivered at the Cass Business School, London, 12 May 2004

The European Central Bank (ECB) has now been conducting monetary policy for over five years. Historically, the situation is unique: one currency – and one central bank – but at the same time, 12 countries and governments. It is not surprising that there was considerable scepticism as to whether a single monetary policy for so many countries with differing economic structures and independent government policies could be successful. Observers considered a whole range of different scenarios, from regarding the euro as a panacea for all of Europe’s economic ills to anticipating the collapse of the single currency.

Against the background of these concerns, and in the light of the experience gained over these first five years, it is time to take stock. The ECB has without doubt been successful in fulfilling its mandate to maintain price stability. What have been the factors underlying this success?

The mandate to maintain price stability, as enshrined in the Maastricht Treaty has, of course, been of paramount importance. The political independence of the ECB provides a solid institutional framework for the pursuit of that primary objective. A significant part of the success is certainly also attributable to the ECB’s monetary policy strategy.

As a new institution, the ECB was not able to rely on a track record of past successes. It was therefore particularly important to commit to a publicly announced monetary policy strategy which would provide a framework for internal analysis and decision-making in pursuit of the stated objective. A purely discretionary approach was not an option. In particular, the strategy had to serve the purpose of establishing a solid anchor for inflation expectations and set a benchmark which the public could use to hold the ECB accountable. At the same time, the strategy had to be robust and flexible enough to enable the ECB to meet the specific challenges faced by the single monetary policy.

Such challenges were created by the high degree of uncertainty regarding the transmission mechanism and the possibility of structural breaks resulting from the launch of the single currency. Knowledge about the transmission of monetary policy impulses to inflation and economic activity was very limited, as was the availability of timely and harmonised macroeconomic data.

The ECB was acutely aware of this situation. In 1998, it announced a strategy that took account of these concerns. The strategy was based on fundamental theoretical considerations and empirical knowledge, as well as on decades of policy experience acquired by the national central banks.

In May 2003, in the light of the experience acquired in its first five years, the ECB conducted an evaluation of its monetary policy strategy. As a result, the main elements of the strategy were confirmed. The upper ceiling on the definition of price stability has remained at 2%. At the same time, the Governing Council clarified that it would seek to achieve an inflation rate below, but close to, 2% over the medium term. It also confirmed that its assessment of risks to price stability would continue to be based on two complementary perspectives: an economic and a monetary analysis – the two pillars of the strategy. The monetary analysis thereby serves as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications arising from the economic analysis.

In view of the specific challenges posed by the nature of the new currency area, the ECB, when developing its strategy in 1998, decided on a new approach. It chose neither a monetary targeting nor inflation targeting strategy, and with good reason. A focus on a simple indicator or a single analytical approach, be it a monetary aggregate or an inflation forecast, would not have done justice to the uncertainties faced by the ECB. The two pillars provide an appropriate framework for bringing together and cross-checking different analytical approaches and making systematic use of all information relevant to decision-making.

The advantages of this approach are increasingly being recognised, not least from the perspective of the relationship between monetary and credit developments and asset prices. The monetary policy strategy proved itself under the specific conditions prevailing in the euro area at the start of Monetary Union and has remained superior to the alternatives beyond that initial phase.

The ECB has gained a high level of credibility. Notwithstanding the substantial and prolonged price shocks witnessed between 1999 and 2001, long-term inflation expectations have been anchored at stable levels consistent with the definition of price stability. However, despite the achievements in the area of price stability, macroeconomic conditions in the euro area remain unsatisfactory: High unemployment, weak economic growth and growing public deficits clearly indicate the need for urgent structural reforms.

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