European Monetary System
an index suitable for a sensible public definition. These considerations
point to using the 'headline' measure of the harmonised index of consumer
prices (or HICP) for the euro area in the definition of price stability.
Finally, the ESCB needs to build on the success of its constituent
national central banks (NCBs) in reducing inflation and achieving price
stability during the convergence process in Stage Two of EMU. Given the
current generally benign inflation outlook in the euro area that is the
product of these accomplishments, there is an understandable desire to
'lock-in' the current success in achieving price stability as well as the
apparent credibility of monetary policy, and ensure continuity with
existing central bank practice.
3. The importance of the monetary strategy for a successful start of
European monetary policy
When price stability is defined using the principles just outlined,
how should the ESCB proceed to maintain it? In achieving and maintaining
price stability - the primary objective of the Treaty - the choice of
monetary policy strategy is vital.
Within the ECB, a considerable amount of work on the monetary policy
strategy has already been completed, building to a large extent on the
substantial earlier preparatory work of the EMI. A high degree of consensus
has been reached among the NCBs and within the ECB about the main outlines
of the strategy - I will address some of these areas of agreement in a
moment. The final decision has not yet been made. But you should be
reassured that progress is being made at a good pace. I have no doubt that
we will be in a position to announce the details of the ESCB's monetary
policy strategy in good time, prior to the start of Stage Three.
Being a new institution, the European Central bank must be prepared
to come under intense scrutiny right from the start. In particular, the
international financial markets will monitor its every decision like hawks.
Facing this environment in the run-up to Monetary Union, the ESCB must
ensure that everything possible is done to make the launch of Stage Three
as tension-free as is possible. Choosing and announcing an appropriate
monetary strategy is crucial.
The monetary policy strategy is, in the first place, important for
the internal decision-making process of the ESCB - how the Governing
Council will decide on the appropriate monetary policy stance, given the
economic environment. Above all, the ESCB strategy must lead to good - that
is to say, timely and forward-looking - monetary policy decisions.
But the strategy is also of the utmost significance in communicating
with audiences outside the ESCB. It should stabilise inflation
expectations. The more the strategy helps to promote credibility and
confidence in the ESCB's monetary policy at the outset of EMU, the more
effective that policy will be - and the easier the ESCB's task of
maintaining price stability will become.
In deciding upon the appropriate monetary policy strategy, the
following aspects must be seen as essential requirements. The strategy
must:
* reinforce the ESCB's commitment to price stability, the
primary and over-riding task stipulated by the Treaty;
* it must clearly signal the anti-inflationary objectives of
the ESCB, and serve as a consistent benchmark for the
monetary policy stance; and,
* it must be transparent and explained clearly to the general
public - only then can the strategy serve as a basis for the
ESCB's accountability to the public at large.
The realisation that achievement of an optimal, non-inflationary
macroeconomic outcome may founder on the private sector's distrust has been
central to the monetary policy debate of the nineteen-eighties and
'nineties. The search for answers to the questions raised by this debate
has spawned an enormous economic literature. The keywords "time
inconsistency" and "credibility" draw forth an almost unmanageable flood of
publications that have appeared in the wake of the pioneering contributions
of Kydland / Prescott and Barro / Gordon.
The need to establish a credible and consistent monetary strategy in
the face of the well-known time inconsistency problem faced by policy
makers - the dilemma highlighted by this economic literature - is
especially important for the ESCB at the outset of Monetary Union. As a
brand new institution, the ESCB will have no track record of its own.
Building its reputation, and the associated credibility of monetary
policy, is vital. But the process of doing so is complicated by the
relatively high level of uncertainty surrounding the transition to Monetary
Union itself. The transition to Stage Three is a unique event, and will
create unique opportunities for many - but it will also create some unique
problems for monetary policy makers. At the ECB, we are addressing these
problems and are confident that the risks can be managed successfully. Many
of the difficulties we face will be overcome through our own efforts over
the coming months.
Among these problems are the difficulties involved in creating a
comprehensive and accurate database of euro area-wide statistics. Running a
single monetary policy for the euro area requires timely, reliable and
accurate euro area data. In some cases, the euro area statistics simply did
not exist until quite recently. In others, the statistics are based on new
concepts, and the properties of the data series are not yet well known. The
long runs of high quality back-data required for empirical economic
analysis may be unavailable. Those that do exist are likely to have been
constructed using some degree of estimation and judgement, possibly
rendering the econometric results produced with them questionable.
Furthermore, the regime shift associated with the adoption of the
single monetary policy may change the way expectations are formed in the
euro area, and thereby alter forward-looking economic behaviour. Monetary
policy's effects on consumption, investment, and wage bargaining - and
therefore the whole transmission mechanism of monetary policy to
developments in the price level - would be among the important economic
relationships to be affected in this way.
This may be no bad thing. Indeed, using the regime shift implied by
the transition to Stage Three to change both public and private sector
behaviour in favourable directions may be one of the largest gains that the
euro area can extract from Monetary Union. Nevertheless, these changes are
likely to complicate the implementation of certain important elements of a
monetary strategy, at least in the short term, as past relationships
between macroeconomic variables may break down. What is good for the euro
area economy as a whole may create some practical problems for the ESCB.
One example of this so-called 'Lucas critique' phenomenon is the
impact of current, very low rates of inflation on private behaviour. For
many countries participating in Monetary Union, there is simply no - or
only very recent - experience of how the private sector will behave in an
environment of sustained and credible low inflation. Instability in past
relationships may result, should behaviour change in this new, low
inflation environment. I have already argued that these structural changes
will benefit Europe's citizens - price stability will allow markets to work
more efficiently, thereby raising growth, and improving employment
prospects. But these changes may also complicate the ESCB's assessment of
economic and financial conditions.
These uncertainties - arising directly from the transition to Stage
Three itself - are both compounded by, and inter-related with, the broader
economic context in which Monetary Union will be established. The
increasing internationalisation of the global economy, and the current
rapid pace of technological change, have affected all sectors of the
economy, and the banking and financial systems in particular. For example,
at present there are many, inter-related innovations in the payments
system, such as:
* the introduction of TARGET (directly related to EMU itself);
* greater technological sophistication of payments mechanisms,
as use of computers and information technology becomes more
widespread and advanced;
* the additional incentive for cash-less payments that may
arise from the fact that for some time to come -
approximately three years - the new euro-denominated notes
and coin will not come into circulation. In particular,
narrow monetary aggregates might be affected by this
development; and,
* increased competition among banks and settlements systems,
arising from globalisation and the breakdown of barriers
between previously segmented national markets, which may
drive down the margins and fees charged to customers.
At the ESCB we will need to keep abreast of these developments, both
for their immediate impact on one of our "basic tasks" - promoting the
smooth operation of the payments system - and because of their broader
implications for the euro area economy. Reducing transactions costs in the
way I just described will benefit European consumers and producers - but it
may also change the indicator properties of monetary, financial and
economic variables that national central banks have looked to as guides for
monetary policy in the past.
Finally, in Monetary Union there will be some heterogeneity across
countries within the euro area. Europe's diversity is one of its greatest
assets. But this diversity is greater than is typically the case between
different regions in the same country using a single currency.
Nevertheless, the ECB Governing Council will have to concentrate on
monetary and economic developments in the euro area as a whole when
discussing and taking monetary policy decisions.
How should a monetary policy strategy be selected in this - for
monetary policy makers, at least - potentially difficult environment? The
EMI outlined a number of 'guiding principles' for the selection of a
monetary strategy by the ESCB. Foremost amongst these was the principle of
'effectiveness'. The best monetary policy strategy for the ESCB is the one
which best signals a credible and realistic commitment to, and ensures
achievement of, the primary objective of price stability.
For many commentators, this criterion points unambiguously in the
direction of so-called 'direct inflation targeting'. If monetary strategies
are to be judged according to how well they achieve price stability,
defined as a low rate of measured inflation, then advocates of inflation
targets argue an optimal strategy would surely target this low inflation
rate directly. These commentators would place explicit quantitative targets
for inflation itself at the centre of the ESCB's monetary policy strategy.
Their approach has been strongly endorsed in some academic and central
banking circles.
But, in the current circumstances, a pure 'direct inflation
targeting' strategy is too simplistic for the ESCB, and possibly even mis-
conceived. The ESCB well understands the primacy of price developments and
price stability for monetary policy making. Indeed, the Treaty's mandate is
unambiguous in this respect. We will signal our intentions on this
dimension very clearly by making a transparent public announcement of our
definition of price stability. The current low level of long-term nominal
interest rates in the euro area suggests that the financial markets, at
least, understand and believe the over-riding priority that we attach to
achieving price stability.
Regarding strategy, our choice therefore need not be governed solely
by a desire to signal our intent to maintain price stability. This has
already been well-established - by the Treaty, and by the success of the
convergence process in reducing inflation in Europe to its current low
level. Rather than signalling our intent, the strategy must constitute a
practical guide that ensures monetary policy is effective in achieving the
goal we have been set.
In this respect, there are considerable problems with using inflation
itself as the direct target within the ESCB's overall strategy. Because of
the well-known lags in the transmission mechanism of monetary policy to the
economy in general, and the price level in particular, it is impossible for
a central bank to control inflation directly. Therefore, 'inflation
targeting' in practice means 'inflation forecast targeting' where central
banks set monetary policy to keep their best forecast of inflation at the
target level deemed consistent with price stability.
But recognition of this need for forecasts in an inflation targeting
strategy immediately raises practical difficulties. In the uncertain
environment likely to exist at the outset of Monetary Union, forecasting
inflation will be very difficult, not least for the conceptual, empirical
and practical reasons I outlined a moment ago. Forecasting models estimated
using historic data may not offer a reliable guide to the behaviour of the
euro area economy under Monetary Union. Forecast uncertainty is likely to
be relatively large, possibly rendering the whole inflation targeting
strategy ineffective.
To address these uncertainties, a large element of judgement would
have to be introduced into the forecasting process, in order to allow for
the regime shifts and structural and institutional changes that are a
seemingly inevitable consequence of EMU. Simply relying on historic
relationships to forecast future developments is unlikely to prove accurate
or effective. While introducing judgmental adjustments into forecasts in
these circumstances would be both appropriate and necessary, such
adjustments are likely to compromise the transparency of the inflation
forecasts and, thus, of any inflation targeting strategy. Using judgement
may prevent outside observers from readily assessing the reliability and
robustness of the inflation forecasting procedures used by the ESCB.
I see a distinct bias in the academic discussion of the comparative
advantages of inflation targeting and monetary targeting. With good reason,
many arguments are presented against the ESCB adopting a monetary target.
But proponents of inflation targeting seem to forget that, in the current
context, most of these arguments could also be used against inflation
targeting. Above all, I have not seen any attempt thus far - even if only a
tentative one - to explain how the ESCB should deal with the specific
difficulties involved in making an inflation forecast at the outset of
Monetary Union that could be used as the centrepiece of an inflation
targeting strategy.
In many respects, a strategy giving a prominent role to monetary
aggregates has considerable advantages over direct inflation targeting.
Monetary aggregates are published. They are clearly not subject to various
kinds of 'judgmental manipulation' by policy makers or central bank staff
that might be possible with inflation forecasts. To the extent that policy
makers wish to depart from the signals offered by monetary growth because
of 'special factors' or 'distortions' to the data - including those
distortions arising from the transition to Monetary Union itself - they
will have to do so in a public, clear and transparent manner.
Moreover, a strategy that assigns a prominent role to the monetary
aggregates emphasises the responsibility of the ESCB for the monetary
impulses to inflation, which a central bank can control more readily than
inflation itself. These monetary impulses are the most important
determinants of inflation in the medium term, while various other factors,
such as terms of trade or indirect tax shocks, may influence the price
level over shorter horizons.
In the light of these considerations, it was agreed at the EMI that,
regardless of the final choice of the monetary policy strategy, monetary
aggregates would be accorded a prominent role in the overall monetary
framework adopted by the ESCB.
However, the EMI also noted that certain technical pre-conditions
would have to be met before this 'prominent role' could be translated into
an explicit, publicly announced monetary target, guideline, benchmark or
monitoring range. Specifically, such targets or ranges would only be
meaningful guides to monetary policy if the relationship between money and
prices - as encapsulated in a 'demand for money' equation - was expected to
remain sufficiently stable.
In this regard, several existing empirical studies point towards the
stability of the demand for euro area-wide monetary aggregates. However,
these studies are necessarily only preliminary. The reliability of these
results in the face of the uncertainties raised by the transition to Stage
Three is unknown. Future shifts in the velocity of money are certainly
possible - perhaps even likely. They cannot be predicted with certainty.
Moreover, it is not clear whether those aggregates that have the best
results in terms of stability are sufficiently controllable in the short-
term with the policy instruments available to the ESCB. In these
circumstances, relying on a pure strategy of strict monetary targeting is
simply too risky.
Against this background, the ESCB will have to design a monetary
policy strategy of its own. The chosen strategy will show as much as
possible continuity with the successful strategies that participating NCBs
conducted in the Stage Two. At the same time the ESCB's strategy will take
into account to the extent needed the unique situation created by the
introduction of the euro.
4. The new monetary policy instruments and procedures for the euro
area
Having a well-designed monetary strategy is vital. But we must also
be able to implement it successfully at an operational level. What
instruments are available to implement this strategy?
The ECB will have a complete set of monetary policy instruments at
its disposal. These instruments have been selected on the basis of their
efficiency for transmitting monetary policy and their neutrality across
market participants.
Three types of instruments are available to the ESCB: open market
operations, standing facilities and a minimum reserve system. I will
briefly present these instruments in the remainder of my speech.
4.1 Open market operations
Open market operations include, first, a weekly main refinancing
operation, which will take the form of a reverse repurchase transaction
with a maturity of two weeks. The main refinancing operation will be based
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