European Monetary System

increased cross-border competition and lower transaction costs. In this

context, we have recently experienced several initiatives aimed at creating

capital markets across national borders, such as the plans to establish

common trading platforms linking the European stock exchanges. Similar

initiatives have also been taken to establish links between national

securities settlement systems, which would facilitate the cross-border

mobilisation of securities. In the longer run, such developments will make

it possible for investors to manage their investment portfolios more

efficiently.

The Eurosystem welcomes such initiatives aimed at improving the cross-

border integration of financial markets in the euro area, and globally,

since they may result in a wider range of financial instruments on offer,

and at a lower cost, than is currently the case in the national markets.

This could lead to a virtuous circle in which the increased issuance of

instruments denominated in euro will draw the attention of international

investors to the euro area capital markets, in turn making the euro an

increasingly attractive currency for private as well as public issuers.

In fact, the experience of the first few months of the life of the

euro seems to indicate that such a positive development may already be

under way. In the first quarter of 1999, bonds denominated in euro

accounted for around 50% of the bonds issued internationally. This share is

considerably higher than the traditional aggregate share for bonds

denominated in the constituent currencies, which had been in the range of

20% to 30% in recent years. We have also seen a considerable increase in

the average size of bond issues denominated in euro, as compared with those

of bonds denominated in the former currencies, which may indicate that the

trade in euro-denominated issues is likely to become increasingly liquid.

Despite the recent developments in the euro area capital markets,

euro area companies are still mainly dependent on financing through the

banking system. Hence, there is still plenty of scope for further

development in the area of corporate financing. For example, the amount of

private bonds traded in the euro area is still very low compared with the

United States. The market capitalisation of equities is considerably lower

in most euro area countries as compared with the United States and the

United Kingdom. Likewise, the venture capital business in the euro area is

still in its infancy compared with the relatively mature venture capital

markets in the United States and the United Kingdom. Personally, I am

convinced that the introduction of the euro will also be helpful to the

development of these segments of the financial markets.

In this context, I should like to say a few words on how the

introduction of the euro may underpin the reshaping of the European banking

sector. The increased scope for securitisation will put pressure on the

European banking sector to move away from traditional retail banking

activities in favour of more advanced financial services. The European

banking industry is still segmented into relatively small national markets.

The introduction of the euro is likely to add momentum to cross-border

integration in the European banking sector. Although a considerable

consolidation of the European banking sector has taken place over the last

decade, this consolidation has so far been almost exclusively based on

mergers and acquisitions within national borders. It is only recently that

we have also started to see such deals taking place across national

borders.

I welcome this trend towards an expansion beyond national borders

with open arms, since the establishment of truly pan-European - and global

- banking groups will be instrumental in efforts to enhance competition in

the provision of financial services.

5. The Eurosystem and the equity markets

I should like to conclude my presentation today by briefly discussing

about the euro area equity markets as seen from the perspective of the

Eurosystem. It is clear that the Eurosystem has no direct control or

influence over the development of equity markets. However, the Eurosystem

acknowledges the importance of well-functioning and efficient equity

markets for the economy as a means of mobilising savings into productive

investment. Hence, efficient equity markets with transparent price

formation, high market liquidity and low transaction costs are of great

value in the capital formation process.

The existence of efficient equity markets should also reduce the risk

of the emergence of asset price bubbles, which is desirable from a monetary

policy perspective. Prior to the emergence of asset price bubbles in some

industrialised countries in the early 1990s, few central banks paid much

attention to the development of prices of equities or other assets in their

monetary policy formulation.

However, the effects of the bubble economies in the early 1990s,

notably in Japan, the United Kingdom and Scandinavia, led to an intense

debate among economists on how monetary policy could have responded better

to the situation. Some research was carried out in order to establish price

indexes that would incorporate asset prices and which could be used as

target variables or indicators within the monetary policy framework.

However, no central bank is explicitly making use of such asset price-

weighted indexes in monetary policy formulation. Nevertheless, this

development in the early 1990s made most central banks aware of the fact

that large swings in asset prices can have important effects the price

formation in the economy through its implications on real economic

developments and, in particular, financial market stability.

However, in practice it is not easy to let monetary policy actions

respond to asset price developments. Central banks have only one tool for

the implementation of monetary policy - the short-term interest rate. They

can therefore not effectively try to achieve several objectives at the same

time. It is also difficult to judge how developments in asset prices

actually feed into consumer prices, thereby making it tricky to assess the

need for the appropriate monetary policy response to their changes. This

difficulty is exacerbated by the rather high volatility of certain asset

prices, such as equities, which could result in frequent changes in policy

interest rates if the central bank were to incorporate them mechanistically

into its reaction function.

In this respect, the present situation in the United States, as well

as in several European countries, is interesting: equity prices have risen

rapidly for an extended period but consumer prices remain very subdued and

there are, so far, no signs that there is going to be a spill-over from

asset price developments into consumer price inflation.

Against the background of the rather unclear relationship between

asset price developments and consumer price inflation, the development of

equity prices does not have a prominent role in the formulation of the

Eurosystem's monetary policy. This notwithstanding, the Eurosystem closely

monitors the prices of equities and other assets within its broadly based

assessment of economic developments in the euro area, which forms the

second pillar of its monetary policy strategy. The Eurosystem will

therefore remain vigilant in order to detect any influence from asset

prices, through their impact on real economic developments and financial

market stability, on the formation of consumer prices.

***

THE MONETARY POLICY OF THE EUROPEAN CENTRAL BANK

Speech by Eugenio Domingo Solans

Member of the Executive Board of the European Central Bank

during the "Working Breakfast" at the Permanent Seminar

on 4 December 1998 in Madrid

Introduction

It was with immense pleasure that I accepted the invitation to take

part in this event, organised by Euroforum. In view of the prestigious

nature of Euroforum, the professional standing of its MESTER PROGRAM OF

MARKETING WEEK AT.DOCl[pic][?]\- -#President, Eduardo Bueno, Professor at

the Universidad Autуnoma de Madrid and consultant to the Banco de Espaсa

(there is a great deal of similarity between our respective professional

histories) and, above all, the value I have attached to his friendship over

the past thirty years, there was no question as to whether to agree to join

you for this working breakfast.

I have been asked to keep my presentation brief in order to allow as

much time as possible for discussion. Therefore I will try to put forward a

few ideas on the monetary policy of the European Central Bank (ECB) which I

can develop during subsequent discussions. During the discussion period

please feel free to raise any questions on other aspects of the ECB's

operations.

The three fundamental principles underlying the monetary policy

As in the case of any other central bank, the ECB's monetary policy

is based on three fundamental principles: setting the objectives to be

achieved, establishing the most appropriate strategy for accomplishing

these objectives and, finally, selecting the best instruments for

implementing its chosen strategy.

While the Governing Council of the ECB is responsible for formulating

its monetary policy, both the Executive Board of the ECB and the national

central banks are involved in its application and therefore this

constitutes one of the tasks allotted to the European System of Central

Banks (ESCB) as a whole.

Objectives, strategies and instruments therefore form the three main

elements which enable us to establish the precise point within the range of

monetary policy possibilities which should constitute the ECB's policy: its

precise altitude, longitude and depth.

The ECB's monetary policy objectives

We did not have to think long and hard to define the ECB's monetary

policy objectives and, generally speaking, those of the ESCB. This had been

done for us by the Treaty on European Union in which, under Article 105, it

is stated that "the primary objective of the ESCB shall be to maintain

price stability" which, on a more practical level, the ECB has defined as a

year-on-year increase in the harmonised index of consumer prices (HICP) for

the euro area of below 2%, which it seeks to maintain in the medium term.

"Without prejudice to the objective of price stability", continues the

aforementioned Article 105 of the Treaty, "the ESCB shall support the

general economic policies in the Community with a view to contributing to

the achievement of the objectives of the Community as laid down in Article

2".

If you refer to the aforementioned Article 2 of the so-called Treaty

of Maastricht, you will find that sustainable and non-inflationary growth,

together with a high level of employment and social protection, are among

its aims.

The ECB, then, must prioritise those of its activities which promote

the objective of stability and, without prejudice to this approach, it will

contribute, indirectly and to the extent possible, to economic growth and

increased employment.

Is this approach in any way contradictory? Absolutely not. The best

contribution the ECB can make to promoting investment and thus to

generating economic growth and increased employment is precisely by

providing a framework for price stabilisation. The worst path that the ECB

could follow would be to implement a lax economic policy which claimed to

be directly creating jobs.

In fact, in the medium term price stability will encourage efficient

investment, sustainable growth and employment. This is because stability

prevents price distortions, that is to say any distortion of the mechanism

which guides decision-makers in the markets, and thus favours an improved

allocation of resources. When stability is achieved, prices are more

transparent, which promotes competition and therefore efficiency.

Moreover, if economic agents have positive expectations with regard

to stability, the risk premium element of long-term of interest rates will

fall, promoting investment and lasting consumption. In this respect, it

should be remembered that one of the clearest inflation forecast indicators

is an increasingly steep maturity-related asset yield curve.

Finally, stability promotes growth and employment insofar as it

allows resources to be channelled into productive activity. Inflation, on

the other hand, merely encourages speculative investment with the aim of

safeguarding funds against monetary deterioration.

As we saw earlier, the aims set out in Article 2 of the Maastricht

Treaty also include social safeguards. In this context, therefore, it can

be said that inflation is the most unjust of all taxes, because it attacks

personal income and assets while distorting certain public redistribution

mechanisms such as, for instance, progressive taxation scales.

In other words, stability is not just important for economic

efficiency but also for social justice, since it provides economic

conditions which benefit the weakest and most vulnerable members of

society.

An appropriate ECB monetary policy is a necessary condition but will

not, in itself, enable us to achieve stability. National taxation policies

geared to satisfying the objectives of the Stability and Growth Pact,

together with several supply-side policies leaning towards liberalisation

and flexibility, are also necessary to enable us to avoid the persistent

need for measures to combat inflation.

We must avoid the temptation to reinterpret the Stability and Growth

Pact by introducing "golden rules" of dubious legality, based on the false

theoretical foundations of the so-called "ultra-rationality hypothesis"

which, in the past, claimed to justify increased taxation pressure and

which now calls for increased public spending in terms of investment. Let's

not beat about the bush: taxation policy has only one golden rule, which

consists in maintaining a long-term budgetary balance on the economic

horizon.

In connection with the ECB's objectives, it should also be noted that

it is difficult or even impossible to meet two separate targets

simultaneously using only a single monetary policy. This applies when

dealing with the concept of fixing fluctuation bands for the rate of

exchange between the euro and the US dollar. In this case, the exchange

rate objective could conflict with the price stability concept and the ECB

would then fail in its primary objective. We must not forget, with regard

to this issue, that combining linked exchange rates, the free circulation

of capital and monetary autonomy is not, to be quite blunt, sustainable. It

is precisely this which is the raison d'кtre of the ECB as the single

monetary authority in an economic area which has irrevocably fixed exchange

rates (a single currency) and freely circulating capital (a single market).

To conclude this section, let me stress that it is essential for the

ECB to make it absolutely clear that its main objective is stability. If,

as some would suggest (for instance in the Modigliani manifesto), the ECB

were to directly target employment, this would adversely affect the

credibility of its monetary policy and thus have an impact not only on

inflation but also, paradoxically, on employment. The direct targeting of

employment objectives by a central bank is counterproductive.

The ECB's monetary policy strategy

A strategy is a combination of criteria and procedures which allow

decisions to be taken in order to achieve a monetary policy objective. This

decision-making process can be based on inflation forecasts which depend on

the behaviour of a relevant monetary variable or, more simply, on the

"pegging" of exchange rates to a stable currency. This last strategy is

ideal for more open economies, encompassed by a specific monetary zone,

such as, for instance, the Netherlands and Germany. However, this would not

be suitable for a much larger but relatively closed economic space such as

the euro area.

I believe that it is a mistake to try to exaggerate the polarity of

the inflation strategy and the monetary strategy. These are quite clearly

separate strategies but they are not in any way opposed, incompatible or

irreconcilable. Certainly, some aspects of each of these strategies should

be combined, resulting in another, completely separate and valid strategy.

This is what the ECB has done and it now needs to give the end product a

name which does not merely describe the desired objective ("the stability-

orientated monetary policy strategy").

There are two components to the ECB's monetary policy strategy. The

first, more practical and visible component consists in a quantitative

reference to the growth of the money supply as defined by the broad M3

aggregate. Taking into account the quantitative definition of stability,

economic growth and realistic hypotheses on money circulation rates, this

monetary reference has initially been set at 4 1/2%.

The second component of the ECB's monetary strategy, a more general

and enveloping one, is the estimation of inflation forecasts and risks for

price stability in view of changes in a group of significant variables, all

of which are related to the euro area as a whole. Some examples of these

significant variables are credit, long-term interest rates, prices of raw

materials, import prices, wages and public spending deficits.

Inflation is a monetary phenomenon. When the rate at which the money

supply grows is greater than the nominal potential rate of growth of an

economy, in the medium term this will generate inflation. In other words,

the medium-term inflation rate is indicative of excessive monetary

expansion in relation to economic growth. Growth in the money supply

therefore provides the best early warning of inflation and monetary control

is the best monetary policy strategy. The virtues of the first component of

the ECB monetary strategy are, when all is said and done, well known. If it

worked, this alone would be sufficient.

In practice, however, things are never so simple. Inflation

forecasting and control cannot rely solely on a monetary aggregate because

of doubts as to whether or not this monetary aggregate can be controlled

and is stable and meaningful. If a narrow definition of money, such as M1,

is adopted, controllability can be achieved in that, through the monetary

policy instrument, it is possible to have a greater impact on its

evolution, but this is offset by the loss of stability and significance. If

it is decided to opt for a broad monetary aggregate, such as M3 or M4, the

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