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Review of the quantitative reference value for monetary growth

5 December 2002

Review of the reference value

At its meeting on 5 December 2002 the Governing Council reviewed the reference value for monetary growth. It decided to reconfirm the existing value, namely an annual growth rate of 4½% for the broad aggregate M3.

This decision was taken on the grounds that the current evidence continues to support the assumptions underlying the first derivation of the reference value in December 1998, namely those for trend potential growth in the range of 2–2½% per annum and for a trend decline in M3 income velocity of ½–1% per annum in the euro area.

With regard to the assumption of trend potential growth, the Governing Council considers that there is no evidence that structural changes have taken place in the euro area which would warrant a revision of this assumption underlying the reference value. The attainment of higher potential growth in the euro area, which is urgently needed, remains conditional on further progress in structural reforms, especially in the labour and goods markets. Against this background, the Governing Council will continue to monitor the evidence with regard to developments in productivity growth in the euro area, and the ECB's monetary policy will take such evidence into account as appropriate.

With regard to the assumption for the trend in M3 income velocity, the available evidence confirms that it continues to be valid.

The Governing Council will undertake the next review of the reference value in December 2003.

Background: the ECB's monetary policy strategy and the reference value

The Governing Council wishes to recall the following features of the reference value and its role in the ECB's monetary policy strategy.

  1. Under its first pillar, the monetary policy strategy of the ECB assigns a prominent role to money in reflection of the fundamentally monetary origins of inflation over the medium to longer-term horizons. The close association between money and prices over the medium term, one of the fundamental principles in economics, suggests that the analysis of persistent trends in money is crucial for any central bank aiming at maintaining price stability. Exploiting the information content in monetary and credit aggregates helps the central bank to look beyond the transitory impact of various shocks and to maintain a medium-term orientation in monetary policy. This also matches the Governing Council's experience that since the start of Stage Three of Economic and Monetary Union the analysis of monetary developments in general, and of M3 in particular, has provided very useful input for assessing the economic situation and taking monetary policy decisions. Moreover, historical experience shows that episodes of asset price overvaluations have tended to be accompanied by strong money and credit growth. The analysis of monetary and credit aggregates can help to identify the build-up of financial imbalances which may in turn have implications for price stability.
  2. In order to signal this prominent role of money to the public, in October 1998 the Governing Council decided to announce a reference value for the growth rate of a broad monetary aggregate. In December 1998, the Governing Council announced the first reference value of 4½% for the annual growth rate of the broad monetary aggregate M3. Several studies have provided empirical evidence confirming that the condition for announcing a reference value, namely the stability of money demand, is satisfied for the euro area. Furthermore, studies have shown that M3 has good leading indicator properties for future price developments over medium-term horizons.
  3. The reference value is derived in a way that is consistent with – and serves the achievement of – price stability. The derivation of the reference value is, therefore, based on the ECB's definition of price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. To be consistent with the medium-term orientation of the ECB's monetary policy strategy, the reference value is derived using the assumptions for the medium-term trend in M3 income velocity and trend potential growth. At its meeting on 5 December 2002, the Governing Council reassessed and confirmed the assumptions underlying the derivation of the reference value, namely that over the medium term:
    1. M3 income velocity declines at a trend rate in the range of ½% to 1% per annum, and
    2. potential output grows at a trend rate between 2% and 2½% per annum.
    Taking account of the definition of price stability and these last two assumptions, the Governing Council decided to reconfirm the existing reference value for monetary growth, namely an annual growth rate of M3 of 4½%. The Governing Council will continue to monitor monetary developments in relation to the reference value on the basis of a three-month moving average of annual growth rates and continue to focus its assessment of the liquidity conditions in the euro area on the analysis of the persistent deviations from the reference value and of the underlying reasons for such deviations.
  4. The Governing Council wishes to stress that the reference value for monetary growth is a medium-term concept which is based on medium-term assumptions for the development of its fundamental determinants. In general, short-run movements in money may be difficult to interpret and may stem from a number of temporary factors which do not necessarily have implications for future price developments. For this reason, the Governing Council already made it clear in 1998 that the announcement of the reference value does not entail a commitment on the part of the ECB to correct mechanistically deviations of monetary growth from the reference value. Rather, the reference value, by making explicit what is the rate of growth of money that is considered to be consistent with the maintenance of price stability over the medium term, is a key tool for monetary analysis. It provides monetary policy with a "compass" which ensures that the central bank, while responding to the variety of shocks affecting the economy over time, does not lose sight of the fact that over a sufficiently extended period of time the rate of growth of money must be consistent with its price stability objective.
  5. The analysis of the deviations of annual M3 growth from the reference value represents an important element in the evaluation of monetary developments and their implications for future price stability. However, monetary analysis is not limited to this evaluation. Other monetary indicators (such as M1 and loans to the private sector) also contain significant information. Furthermore, it is important to take into account past deviations of M3 growth from the reference value, in order to come to a broadly based assessment of the liquidity conditions in the euro area. Finally, developments in M3 need to be analysed in conjunction with other, non-monetary indicators (e.g. GDP, prices, interest rates and other financial market indicators) in order to understand the nature of the shocks affecting monetary developments and to extract best the indications for future price developments.
  6. Against this background, the experience of high M3 growth over the past one and a half years has to be assessed in the context of large portfolio re-allocations by the euro area non-MFI private sector triggered by the high level of uncertainty and distress in financial markets and notably by the unprecedented decline in stock prices over the past two years. These exceptional developments have prompted non-MFI residents in the euro area to reduce their holdings of relatively risky assets such as shares and increase their demand for relatively liquid and low-risk assets included in M3. The protracted phase of financial uncertainty has caused some signs of instability in the short-term dynamics of M3 in recent periods, as captured by available money demand models for the euro area. However, the reference value is a medium-term concept and should therefore not be assessed on the basis of short periods of time. In this respect, given the exceptional nature of recent stock market developments in terms of their size and duration, events such as those of the past two years would not be expected to occur regularly. In addition, and more importantly, there are at present no signs of structural breaks or changes in the long-run fundamental relationship between money and prices in the euro area which underlies the derivation of the reference value. Nevertheless, it will be necessary in the future to continue to monitor closely the stability of this long-run relationship in the euro area.
  7. Owing to the current economic and financial market uncertainty, the interpretation of monetary developments is at present more difficult than under normal circumstances. In particular, it is uncertain when a normalisation of the situation in financial markets will occur. At the current juncture, the protracted strong monetary dynamics, which are also reinforced by the low opportunity cost of holding money, have led to an accumulation of substantial liquidity in the euro area. Given the current circumstances of relatively weak economic activity, this situation is not seen as signalling risks to price stability in the near future.
  8. The Governing Council also wishes to recall that the ECB's monetary policy strategy uses two pillars in order to assess the risks to future price stability. The monetary analysis always has to be seen in conjunction with the second pillar of the ECB's monetary policy strategy, which uses other economic and financial indicators for the evaluation of the risks to price stability. This diversified approach to the analysis stimulates the cross-checking of information, thereby reducing the risks of policy-related mistakes in an uncertain environment.

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