Expectations, uncertainty and the design of monetary policy
Speech by José Manuel González-Páramo, Member of the Executive Board of the ECB
European Economics and Financial Centre,
London, 28 September 2006
Ladies and Gentlemen,
I would first like to thank the European Economics and Financial Centre for organising this conference and giving me the opportunity to speak in front of such a distinguished audience.
The fact that the future, or even the present for that matter, is known only with uncertainty, while most economic decisions taken by agents depend on their beliefs, either as regards their current perceptions of reality or as regards their expectations of how the future will be, plays a critical role in economics. This is particularly the case in economic policy-making and, more specifically, in the management of monetary policy.
The central bank can directly influence only short-term interest rates through its monetary policy instruments. However, consumption and investment decisions, and thus medium-term price developments, are to a large extent influenced by longer-term interest rates, which in turn depend on private expectations regarding future central bank decisions and future inflation. As a result, it is important that these developments in longer-term rates support the objective of maintaining price stability over the medium term. Stabilising the private sector’s inflation expectations becomes, therefore, a prerequisite for monetary policy to be able efficiently to achieve the objective of price stability.
Uncertainty is also a very real and relevant concern in the policy-making process of a central bank. Two major sources of uncertainty can be identified. First, there is uncertainty about data: the figures we are most interested in are available only with a lag and are subject to revision. Second, there is substantial uncertainty as regards the model of the economy we should use, the identification of the shocks affecting the economy and the transmission of monetary policy to the economy.
Taking account of inflation expectations and uncertainty has important implications for both the design and the implementation of monetary policy. In my remarks today I would like to concentrate on some of these implications and, in particular, on how these elements have been addressed by the monetary policy strategy of the European Central Bank (ECB).
Establishing credibility: The ECB’s approach
Anchoring inflation expectations requires, first, that the central bank be regarded as credible and predictable. Economic agents should be confident that the central bank will react to the various shocks affecting the economy so as to provide price stability. The greater the uncertainty, the greater the need for credibility, since anchoring inflation expectations helps to diminish uncertainty about future developments and thus contributes to the stabilising of the economy. Conversely, in an environment of considerable uncertainty, the actions of a central bank which does not enjoy a high degree of credibility may not necessarily be interpreted by agents as an indication that it is committed to its objective.
How can the central bank attain credibility among private agents?
First, by being clearly committed to a well-defined goal and by pursuing it consistently and independently of political influence. Accordingly, in the euro area the first two features of our monetary policy strategy are the fact that the ECB and the national central banks (NCBs) of the Eurosystem are fully independent, and the fact that a quantitative definition of the ECB’s primary objective – price stability – has been clearly specified. This quantitative definition (“below, but close to, 2%”) provides clear guidance for inflation expectations. At the same time, it serves the purpose of accountability, for it sets a benchmark against which the ECB’s performance in maintaining price stability can be assessed.
In addition, the European Central Bank’s definition of price stability refers to a medium-term horizon, in recognition of the fact that monetary policy can control price developments only in the medium to longer term and never over immediate horizons. By contrast with the practice typically observed in inflation-targeting regimes, the ECB has not specified a fixed time period for the achievement of its objective. There are many reasons for this decision, and some of them are indeed related to the presence of uncertainty and the need to anchor expectations.
The length of the lags with which monetary policy affects price developments is variable and uncertain. Moreover, the optimum monetary policy response always depends on the specific types of shock affecting the economy, as well as on their magnitude. A medium-term horizon allows central bankers the necessary flexibility to respond appropriately to economic shocks of a specific type. Furthermore, a medium-term perspective helps to avoid introducing unnecessary volatility into the economy and to stabilise output and employment.
The medium-term orientation is also important from the point of view of our credibility and thus helps to anchor inflation expectations. The medium-term horizon implies accepting and communicating to the public that monetary policy cannot offset short-term changes in the inflation rate caused by economic shocks such as sharp oil price increases or higher administered prices and, therefore, that short-term deviations of inflation from the definition of price stability are acceptable and do not call into question the determination and ability of the ECB to deliver price stability over the medium term.
In order to best serve its primary objective of medium-term price stability, the ECB has chosen a full-information approach which rests on two pillars: an economic analysis and a monetary analysis. The two-pillar approach uses both economic and monetary analysis to produce complementary pictures which can be cross-checked against each other and which together provide a comprehensive assessment of the current risks to price stability. There is, again, also an element of model uncertainty reflected in this choice, as the analytical underpinnings of the two analyses rest to some extent on different paradigms. This allows the signals coming from the two analyses to be cross-checked and therefore avoids relying too much on any particular model.
Furthermore, there is one feature of our monetary policy that plays a particularly crucial role in maintaining credibility and thus anchoring inflation expectations: communication. A central bank which does not succeed in communicating the principles underlying its monetary policy and is perceived as acting in a non-systematic, discretionary manner will, over time, endanger its reputation.
The central bank’s communication should therefore ensure that markets understand both the systematic responses of monetary policy to economic developments and the current assessment of the central bank. Successful central bank communication supports predictability and correct price formation in financial markets, contributes to the efficient allocation of funds and reduces uncertainty about future interest rates. A reasonable understanding of the monetary policy strategy among the public helps to guide price and wage-setting behaviour in a manner consistent with the objectives of the central bank.
In the case of the ECB, it was understood at an early stage that external communication would be of the essence. In this respect, the publication of the key elements of the monetary policy strategy in October 1998 and the communication of the details of its clarification in 2003 constituted in themselves a major step towards monetary policy transparency. In the practical implementation of our communication we make use of a wide range of channels. I will mention only two of these here. First, there is the press conference after the first Governing Council meeting in each month. The introductory statement at the press conference is a key element in our communication, as it conveys the collective view of the ECB’s Governing Council on the monetary policy stance in real time. Second, there is the ECB’s Monthly Bulletin, which is published one week after the press conference. It gives a more detailed explanation of the analysis behind the monetary policy decisions, as well as regularly reporting on information collected by the ECB, such as the bank lending survey or the Survey of Professional Forecasters. Importantly, it also includes the ECB’s quarterly staff projections, an advance copy of which is published immediately after the press conference following the Governing Council meeting. The Monthly Bulletin also contains articles providing insights into the principles governing our policy.
It is this combination of a full and transparent presentation of the monetary policy concept and strategy, a precise arithmetic definition of price stability, and detailed explanations of the ECB’s assessment every month which allows market participants not only to have an intimate understanding of our policy and the way it is implemented, but also, more importantly, to correctly predict our decisions, having had the possibility of analysing all pertinent information and data.
Credibility and activism
Of course, those elements need to be reflected in the consistent management of our main monetary policy instrument: interest rates. Let me now turn to this issue.
From a theoretical point of view, when inflation expectations are well anchored around the inflation objective of the central bank, the evolution of inflation over time is influenced more by the numerical objective of policy than by the history of inflation itself. In this context, wage and price-setters treat inflationary shocks as transitory and assume that the central bank will take all necessary steps to bring inflation back to the target level in the medium term.
In principle, well-anchored inflation expectations may afford the central bank more flexibility to respond to economic disturbances, at least as long as economic agents are confident that this flexibility will not be misused to depart permanently from the inflation objective. In order to reach that degree of credibility, one policy option might be to apply simple rules, since these have the advantage of making policy more predictable, which can facilitate the expectation formation process. In the presence of uncertainty, the challenge is then to find a rule that works well in the different models of the economy considered. Since many models “agree” that inflation is undesirable and that monetary policy can contribute to keeping it under control, it is not surprising that a robust rule that raises interest rates more than one for one with inflation delivers a robust outcome. This is the cornerstone of the “Taylor rule”, as advocated by Taylor (1993). The second component of that rule consists of a response to the output gap, such that when GDP rises above potential, interest rates should rise.
One downside to this approach is, however, that if it is applied in a rigid fashion, which may be necessary for the rule to be credible, it will sometimes ignore information that the central banker perceives as being relevant for predicting future risks to price stability. In addition, in the real world, information does not arrive in the stylised way commonly assumed in most models: often shocks reveal themselves only gradually, rather than appearing at a quarterly or any other given frequency.
One possible response is to ensure that policy itself is gradual. Recent literature has indeed shown that some degree of inertia in the policy instrument can be beneficial to the economy. Inertia in monetary policy reduces the risk of having to quickly reverse policy decisions, something most central bankers are keen to avoid, as policy reversals are fairly challenging from the point of view of communication. It also increases the leverage of the policy rate as regards medium and longer-term market rates, as markets come to expect that a given stance or rate cycle will generally be maintained for some time. Furthermore, a gradualist approach to monetary policy could reduce the likelihood of financial market disruptions and diminish the probability of large monetary policy mistakes in an uncertain environment. Finally, an established reputation for conducting policy in a gradual manner would be particularly beneficial in the face of major risks, such as an outbreak of deflationary fears. Private sector expectations that the central bank will remove in a gradual manner the monetary policy stimulus engineered to counteract such fears would in itself exert a stabilising effect, thus reducing the likelihood of the zero lower-bound constraint on nominal interest rates hampering the central bank’s attempt to stabilise inflation and inflation expectations.
The gradualist approach to policy has some support among academics and policy-makers, but also encounters some criticism in the literature. A possible negative side effect of the gradualist policy is that the central bank risks falling “behind the curve”. In other words, if the economy starts to pick up and inflation increases, a monetary policy response that is too slow might prolong the inflation spell, thereby creating the need for an even stronger correction in the future. In the event that inflation is a persistent phenomenon, this can be costly, since the return to a situation of price stability will take longer.
Moreover, we should take into account the fact that the way in which monetary policy should react to economic developments depends not only on how well-anchored inflation expectations are or the degree of uncertainty present, but also on the degree of rigidity in the economy and the nature of the shocks the economy is facing. Assuming that inflation expectations are well-anchored, if the economy has rigid adjustment mechanisms, for example, monetary policy can be more gradual and focused on the medium term when confronting a cost-push shock, since, first, the policy response to the inflationary shock will be less persistent because the inflationary consequences of the shock will be more promptly reabsorbed in the first place, and second, a change in the nominal policy rate will have a stronger impact on the real rate. This type of monetary policy reaction might also be advisable if the economy is more prone to supply shocks, at least to the extent that these types of shock yield more transitory effects on inflation.
Against this background, we can draw the following conclusions with regard to the euro area economy.
First, the degree of uncertainty facing the European Central Bank is arguably much greater than that facing other, more established central banks. Monetary Union is a new regime, and we currently have only around eight years of data covering Stage Three of Economic and Monetary Union at our disposal for model estimation and analysis.
Second, the euro area seems to have experienced demand shocks of a smaller magnitude than those observed in the United States, for example, but to have witnessed more frequent negative supply shocks. This finding is confirmed by comparative analyses of the euro area and the US economy on the basis of structural models (Smets and Wouters, 2005). Given that unfavourable supply shocks tend to move inflation counter-cyclically at times of weak economic activity, the mixture of shocks that has hit the euro area over the last few years implies that the macroeconomic environment has been particularly challenging for monetary policy.
Third, prices in the euro area are more rigid. The average duration of a consumer price spell is 13 months, with 11 months for producers. In the United States, comparable figures indicate durations of less than seven months and slightly more than eight months respectively (Bils and Klenow, 2005; Dhyne et al, 2005).
Finally, inflation persistence in the euro area is low by international standards, meaning that inflation has a tendency to return to its long-run level relatively quickly. The half-life of the effect of a shock to inflation is considerably less than one year, which is close to the figure obtained for the United States.
What are the consequences of this environment from the point of view of monetary policy decisions?
Monetary policy and the economy: The track record
To answer this question, let’s have a look at the monetary policy decisions of the ECB, going back almost as far as its inception.
In early 2001, for example, the ECB began an easing cycle. At the time, on the back of significant adverse supply shocks and relatively strong wage dynamics, inflation rates were high. However, we also saw an upcoming worsening of the outlook for economic activity, as indicated by the rapid decline in several confidence measures. This reduced both the risks to inflation coming from wages and inflationary pressures more generally. While the information coming from monetary trends was, in our assessment, consistent with price stability over the medium term, we took the view that the upward inflationary pressures were of a temporary nature and warranted looking beyond the shocks that had caused them to emerge. We held the view, with it looking increasingly unlikely that the recovery would materialise soon, that a protracted period of weak economic activity would eventually facilitate a downward adjustment in price and wage-setting behaviour. The easing cycle, which we readily initiated, comprised a cumulative decline in the policy rate of 275 basis points over two years, reducing the policy rate to 2%. With hindsight, there is no doubt that the judgement of the Governing Council was appropriate in assigning considerable weight to the decrease in inflationary pressures stemming from the downside risks to economic activity. And there is also no doubt that the resolute action of the ECB, based on its own inflationary analysis, not only allowed inflation and inflationary expectations to be stabilised, but also helped to forestall a much deeper slowdown in the economy.
Between 2003 and 2004, when the forecasts of all major institutions, including the central scenarios of our projections, pointed to accelerating economic growth in the euro area over the following years, a mechanistic policy response would have led to the start of a tightening cycle. However, this did not occur, because the downward risks to the recovery were accorded considerable weight in our decision-making process. Ex post, this turned out to be the right decision. An early tightening of our monetary policy would probably have led to a policy reversal, which could have damaged our reputation. In parallel, our communication, explaining our decisions and emphasising our permanent commitment to the objective of price stability, allowed inflation expectations to remain well-anchored.
At the end of 2005, after two and a half years of maintaining rates at historically low levels, the Governing Council decided to increase ECB interest rates by 25 basis points. During the second half of 2005, as hard data and survey indicators pointed in the direction of strengthening economic activity, it was seen as likely that headline inflation rates, after rising to levels significantly in excess of 2%, could remain above or at 2% in 2006 and 2007, and monetary analysis continued to point to upside risks to price stability over the medium term because of the ample liquidity that had accumulated in the economy. Under these circumstances, waiting for the materialisation of data confirming the strengthening of economic activity and the risks to price stability would have damaged our credibility and could have required stronger tightening in the medium term. On this occasion, our communication strategy needed to be accompanied by policy action in order to keep medium to long-term inflation expectations in the euro area solidly anchored at levels consistent with price stability.
The decision taken in December 2005 did not pre-commit the ECB to a series of interest rate increases, but rather confirmed the ECB’s readiness to act as needed. Close monitoring of the risks to price stability on the basis of new information would guide future decisions. Within this framework, in March, June and August 2006 we again decided to increase the key ECB rates by 25 basis points. On the basis of available information at that time, inflation was likely to remain above 2% in the short run. Looking further ahead, changes in taxes and oil prices are expected to significantly affect inflation in 2006 and 2007, while there was also likely to be an upward impact from the indirect effects of past oil prices in the context of the stronger growth rates expected over the coming quarters. These elements, together with risks of further increases in oil prices and stronger wage and price developments owing to second-round effects, necessitated our decision. In addition, strong monetary and credit growth in an environment of ample liquidity continued to point to risks to price stability.
All in all, since 1 January 1999 the ECB has changed its policy rate 19 times. Over the same period the Federal Reserve System has almost double the number of changes. These figures cannot, however, be taken as evidence of a systematic difference in the degree of activism at the two central banks. While their monetary policy strategies do exhibit some differences, the available empirical evidence shows the euro area and the United States having a similar degree of interest rate smoothing and ascribes the different patterns of interest rate developments for the two central banks to differences in the size and nature of shocks, even considering such differences to be more important than the respective degrees of flexibility in the two economies (Sahuc and Smets, 2006; Christiano, Motto and Rostagno, 2006). In view of the unfavourable “supply-side” shocks that have hit the euro area, and the understanding that a central bank operating in a relatively rigid economy is – by comparison with a more flexible economy – able to deliver the same amount of support to macroeconomic conditions by adjusting its policy instrument in more moderate steps, the monetary policy stimulus put in place by the ECB in the first few years of the millennium has been considerable.
Credibility and predictability
Having talked about the implications of the importance of inflation expectations both in terms of the central bank’s transparency and external communication, and in terms of the optimal degree of activism, I’d now like to briefly consider how successful the euro area’s monetary policy strategy and implementation has been in anchoring inflation expectations and establishing the ECB’s credibility and predictability.
As regards the anchoring of inflation expectations, evidence can be gained from financial markets and economic surveys. A key indicator of the ECB’s monetary policy comes from expectations of inflation implied by the differences between the returns on index-linked and nominal bonds and inflation-linked swap rates. When looking at these market prices, however, one has to bear in mind that the spread between these nominal and real yields not only measures market participants’ inflation expectations, but also includes the inflation uncertainty risk premium required by investors as compensation for the risk of a loss in purchasing power. Keeping this in mind, and also looking at various measures of long-term inflation expectations in the euro area, such as Consensus Forecasts and the ECB’s Survey of Professional Forecasters, one can say that long-term inflation expectations have been pretty well anchored by the ECB’s quantitative definition of price stability since the introduction of the euro.
As regards the predictability of monetary policy, policy moves have been well anticipated by money markets. Recent studies by academics have confirmed that the predictability of the ECB is at the highest level among major central banks. Investors have indeed become more confident in their forecasts of future short-term interest rate developments prior to ECB monetary policy announcements. Bond market indicators paint essentially the same picture. Implied bond market volatility in the euro area is currently close to its lowest level since January 1999 (ECB, 2006).
Looking more closely at the results provided by the literature, it can be seen that between 1 January 1999 and 12 December 2005, out of a total of 120 days on which Governing Council meetings were held, financial markets were surprised on only eight occasions. The greatest surprise was registered on 17 September 2001, when the ECB lowered interest rates at an unscheduled meeting as a response to the exceptional events of 11 September 2001. The surprises are split more or less evenly between days when the policy rate was changed and days when it was not. All surprises on days when no changes were made to policy rates were followed by a change in policy rates a month later, suggesting that these surprises were related to the precise timing of the decisions. It is also likely that some of the surprises were related to the size of the change in policy rates. This is particularly true for surprises occurring within longer periods of gradual policy tightening or loosening (for example in early 2000 and early 2003 respectively). Finally, the largest surprises occurred during the first three years of Monetary Union, indicating that the short-term predictability of the ECB has increased over time. This evidence may reflect the fact that financial markets have gradually learned about the ECB’s monetary policy framework and communication.
Evidence also suggests that the volatility of long-term bond futures prices increases around the time that the ECB makes its monetary policy announcements and holds its press conferences, suggesting that both of these events contain information that is relevant to bond markets. However, the increase in volatility is relatively muted and short-lived, which is consistent with the interpretation that the ECB’s decisions and communication have, on the whole, been predictable.
Let me now conclude. In my speech today I have discussed the implications of inflation expectations and uncertainty for monetary policy. The response of the Eurosystem to the challenges created by these factors is a combination of a clear and well-defined monetary policy strategy, the consistent implementation of this strategy when taking monetary policy decisions and the transparent communication of both the strategy and those decisions. Judging by developments in long-term inflation expectations, which have been pretty well anchored by the ECB’s quantitative definition of price stability since the introduction of the euro, and the high degree of predictability of our monetary policy, we can qualify our policy as a real success. However, this does not mean that there is any room for complacency. Continued alertness is key to preserving credibility.
Bils, M. and P. Klenow (2005), “Some evidence on the importance of sticky prices”, Journal of Political Economy 112.
Christiano, L., R. Motto and M. Rostagno (2006), “Shocks, Structures or Policies? A Comparison of the Euro Area and the US”, Journal of Economic Dynamics and Control (forthcoming).
Dhyne, E., L. Alvarez, H. Le Bihan, G. Veronese, D. Dias, J. Hoffmann, N. Jonker, P. Lünnemann, F. Rumler and J. Vilmunen (2005), “Price-setting in the euro area: some stylised facts from individual consumer price data”, ECB Working Paper No 524.
ECB (2006), “The predictability of the ECB’s monetary policy”, Monthly Bulletin, January.
Sahuc, J.G. and F. Smets (2006), “Differences in interest rate policy at the ECB and the Fed: an investigation with a medium-scale DSGE model”, mimeo, European Central Bank.
Smets, F. and R. Wouters (2005), “Comparing shocks and frictions in US and euro area business cycles: a Bayesian DGSE approach”, Journal of Applied Econometrics 20, No 1, pp. 161-183.
Taylor, J. (1993), “Discretion versus policy rules in practice”, Carnegie-Rochester Conference Series on Public Policy 39, 195-214.