Mar 21, 2001 - appropriate level of interest rates given the prevailing economic situation) ..... The Banca d'Italia lowered interest rates to 3.5% on 3 December ...
THE ECB’S MONETARY POLICY STRATEGY: RESPONDING TO THE CHALLENGES OF THE EARLY YEARS OF EMU
Vitor Gaspar
Klaus Masuch
Huw Pill
Director General Research
Directorate Monetary Policy
Graduate School of Business
European Central Bank
European Central Bank
Harvard University
March 2001
The views expressed in this chapter are those of the authors and do not necessarily represent the view of the European Central Bank or the Eurosystem. Thanks are due to participants in the workshops in Brussels on 5 June 2000 and 21-22 March 2001 and, in particular, to the organisers M. Buti and A. Sapir. The chapter has benefited from the comments of colleagues in the Directorates General Economics and Research of the European Central Bank. As the chapter was finalised, Huw Pill moved to Harvard University.
1.
Introduction
On 1 January 1999, responsibility for monetary policy in eleven of the Member States of the European Union (EU) passed from their respective national central banks (NCBs) to a new supranational institution, the European Central Bank (ECB). This unprecedented transfer of monetary sovereignty marked a watershed in both the process of European integration and in the history of monetary policy, as responsibility for an important instrument of economic policy passed from national control to a new, independent European institution. Given the unique character of this event, it is unsurprising that many serious challenges emerged in the transition process. With the benefit of hindsight, one can conclude that the initial challenges have been successfully overcome. Although many commentators doubted the viability of the single currency project from both macroeconomic and operational perspectives (Obstfeld, 1998; Feldstein, 1997; inter alia), the euro was introduced successfully at the beginning of January 1999 and the single monetary policy has been implemented effectively ever since. One important aspect of this success has been the high degree of credibility achieved by the ECB’s monetary policy strategy and its conduct of monetary policy. Inflation expectations have remained consistent with the primary objective of the ECB, despite the significant economic shocks – such as the increase in oil prices and the weakening of the euro exchange rate between early 1999 and Autumn 2000 – which caused headline consumer price inflation to increase to above 2%. Moreover, the operational framework for monetary policy1 has worked succesfully (Manna, et al., 2001; PerezQuirós and Rodriguez, 2001). Not only has has the operational framework permitted the ECB to signal its monetary policy intentions clearly, it has also ensured the integrity of the single monetary policy by creating a unified money market throughout the euro area. Despite these considerable successes, many challenges for monetary policy persist. The remainder of this chapter reviews the challenges facing monetary policy in the early years of Economic and Monetary Union (EMU). Such a review cannot hope to be completely comprehensive in the space available. Two particular aspects are therefore given greater attention: first, the need to develop institutional relationships within the European System of Central Banks (ESCB), which encompasses the ECB and the national central banks (NCBs) of the participating and non-participating Member States2; and second, the design of the ECB’s monetary policy strategy, which has guided policy decisions since the start of Stage Three (ECB, 1999a, 2000c; Angeloni, et al., 1999; Issing, et al., 2001). The remainder of the chapter is organised as follows. Section 2 describes the development of the institutional framework for monetary policy in Monetary Union. Section 3 describes the ECB’s monetary policy strategy and discusses the rationales for its two pillar structure. Section 4 reviews the implementation of monetary policy during the first two years of Monetary Union, focusing on the decision to lower interest rates in April 1999 as a case study of the operation of the ECB’s monetary policy strategy in practice. Section 5 provides some brief concluding remarks. 1 2
Including the payments systems connected by TARGET (the ECB’s system linking payment systems in euro area countries). The NCBs of non-participating Member States are, however, excluded from the tasks related to the single monetary policy and its implementation (see Section 2).
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2.
Institutional development
As a new institution, the ECB naturally lacked its own independent track record as a monetary policy maker. In this context, building on the experience of NCBs in the euro area (and on the successful process of macroeconomic convergence that preceded the establishment of the single currency) was seen as an essential contribution to inheriting the credibility of NCBs in the new policy regime. The ECB’s monetary policy framework therefore naturally drew on the experience of its constituent NCBs, as well as the experience of other central banks outside the euro area. The institutional framework for monetary policy created by the Maastricht Treaty In the first instance, the lessons derived from NCB experience were embodied in the design of the ECB’s legal mandate, set out by the Maastricht Treaty.3 Of course, the key elements of the Treaty are well known and have been reviewed extensively in the literature. Here only the most crucial features relevant for monetary policy are highlighted. First and foremost, the Treaty clarified that the maintenance of price stability constituted the primary objective of the ECB and the single monetary policy. This mandate reflects the underlying economic consensus that monetary policy makes its best contribution to overall economic welfare in the euro area – including the prospects for real economic growth and employment – through maintaining price stability in a credible and lasting manner (ECB, 1999a, p. 40). Second, the Treaty guaranteed the institutional independence of the ECB. The experience of the 1970s and 1980s – supported by the ensuing academic literature (e.g. Cuikermann, 1992) – pointed to the advantages of delegating responsibility for monetary policy to an independent central bank, which could then pursue price stability outside the realm of short-term politics. Third, in order to ensure the transparency and accountability of the single monetary policy, the Treaty imposed a number of reporting requirements on the ECB. The ECB must produce an Annual Report on its activities for submission to the European Council, the EU Commission and the European Parliament. This report is the subject of a plenary debate in the parliament. Moreover, each quarter, the ECB must publish a report of the ESCB’s activities. The ECB President and other members of the Executive Board can appear before the relevant committees of the European Parliament at the initiative of either side.4 These reporting requirements are among the most stringent imposed on any central bank. Nevertheless, the ECB has undertaken to exceed even these requirements. It publishes a Monthly Bulletin and orgainises a monthly press conference at which the President makes a detailed Introductory Statement describing the ECB Governing Council’s assessment of the economic situation and its implications for monetary policy. On this occasion, the President also answers questions from the assembled journalists. On a biannual basis, Eurosystem staff economic projections are published in the ECB Monthly Bulletin.
3 4
Formally the Treaty on European Union, which was later incorporated into the Treaty establishing the European Community. In practice, the President of the ECB has appeared before the Economic and Monetary Affairs committee of the European Parliament on a regular quarterly basis.
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The relationship between the ECB and the NCBs At a more practical level, the ECB hoped to retain and inherit the credibility and experience of the NCBs by maintaining and further developing strong institutional relationships with them. As is well known, the body collectively responsible for monetary policy decisions in the euro area is the Governing Council of the ECB, which consists of the President and Vice-President of the ECB, the remaining four members of the ECB’s Executive Board and the Governors of the NCBs of the Members States which have adopted the euro as their currency. The NCB Governors are members of the Governing Council as individuals, not as representatives of their institution or their country. They are bound by the Treaty to pursue the primary objective of the ECB at the area-wide level, rather than follow national objectives or represent national interests. The Executive Board of the ECB is responsible “for the preparation of meetings of the Governing Council” (Article 12.2 of the Statutes of the ECB). The Executive Board is also responsible for implementation of monetary policy decisions taken by the Governing Council. Although the ECB itself has the capacity to undertake monetary policy operations, in practice most operations are implemented in a decentralised (but nonetheless fully harmonised) manner by the NCBs, on the instructions of the Executive Board. The General Council of the ECB (of which the President and the Vice-President of the ECB and the Governors of the NCBs of all EU Member States, regardless of whether they have adopted the euro as their currency, are members) deals with issues relevant to the entire ESCB, but has no responsibility for the single monetary policy. In order to more clearly identify those institutions which are directly involved in the single monetary policy, the term “Eurosystem” was introduced by the Governing Council as a label to cover the ECB and the NCBs of those countries which have adopted the euro (see Chart 1). For the task of preparing the meetings of the Governing Council, the Executive Board relies on material prepared by the ECB staff. In addition, the knowledge of NCBs’ experts is captured by a system of Eurosystem or ESCB committees, which can give advice to the Executive Board and thereby to the Governing Council. The membership of these committees consists of experts delegates from the NCBs and the ECB, and may vary according to the topic being discussed (with the delegates of non-particpating NCBs invited to a subset of the meetings).5 There are currently thirteen such committees which deal with all aspects of the ESCB’s work.6 Many of the committees are supported by working groups and task forces which deal with specific aspects of the committee’s mandate. In the context of the single monetary policy, the Monetary Policy Committee (MPC) is of particular note. The MPC provides expert input to the ECB staff and the Executive Board (and thereby, indirectly, to the Governing Council and the General Council) on various technical aspects of the conduct of the single monetary policy, e.g. the design and implementation of the monetary policy strategy; the analytical tools and indicators underlying monetary policy decisions; and, the functioning of the operational framework for monetary policy. One aspect of the MPC’s work is to co-ordinate the production and finalisation of the macroeconomic 5
6
These Committees are set up by the Eurosystem. They are not mandated by the Treaty. The Banking Supervision Committee also includes representatives of the banking supervisory authorities which in several EU countries are institutions other than the central bank. The full list of committees is: accounting and monetary income; banking supervision; banknotes; budget; external communications; information technology; internal auditors; international relations; legal; market operations; monetary policy; payment and settlement systems; and, statistics.
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projections for the euro area prepared collectively by the staff of the Eurosystem (see Section 3 below). However, discussions of, or the provision of advice on, current monetary policy decisions (i.e. on the appropriate level of interest rates given the prevailing economic situation) are outside the scope of the MPC’s mandate. While the ESCB committees are mandated to assist the Governing Council in their area of expertise, their relationship with the Governing Council respects the Executive Board’s prerogatives with regard to the preparation of Governing Council meetings. Therefore, material prepared by the committees – including, for example, the macroeconomic projections co-ordinated by the MPC – are submitted to the Governing Council via the Executive Board. These projections thus have a similar status to briefing material prepared by ECB staff members for meetings of the Governing Council, which is also submitted via the Executive Board. In other words, the committees are not intended to pre-discuss – still less pre-agree – policy issues. Rather they should provide advice on technical background questions. As such, all material prepared by the committees has the status of input into the proceedings and policy discussions of the Governing Council. The relationship between the ECB and other policy making institutions The ECB and the Eurosystem do not operate in an institutional vacuum. While fully respecting the independence of the ECB and the primacy of the objective of price stability, the Treaty recognises this by requiring that “without prejudice to the primary objective of price stability, 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”. These objectives of the Community include (inter alia) “sustainable and non-inflationary growth” and “a high level of employment”. The Maastricht Treaty provides a fundamentally sound allocation of objectives and policy instruments between the monetary and other policy authorities in Europe. It provides for a clear division of responsibilities among policy making institutions which – by providing the proper incentives – enhances the credibility of all policies, as well as increasing their transparency and facilitating accountability. While the responsibility for maintaining price stability in the euro area over the medium term (and for the monetary policy instruments required to do so) lies exclusively with the ECB, national structural and fiscal policies (and the behaviour of the social partners in wage bargaining and price setting) are responsible for enhancing the prospects for sustainable growth in real activity and employment. Moreover, fiscal authorities are required to achieve budgets close to balance or in surplus over the medium term, in the context of the Stability and Growth Pact. If all parties respect the fundamental allocation of these responsibilities and act accordingly, success with regard to the objectives of all policy areas concerned would be the natural outcome of individual policy choices. Clearly, an open and frank exchange of views and information among policy makers helps to ensure that all concerned parties are well informed when taking their policy decisions. The ECB engages fully in this dialogue. First, by announcing its monetary policy strategy (discussed below), the ECB has provided a clear quantitative definition of the primary objective of monetary policy and an honest description of the framework within which policy decisions are formulated. 5
Second, through a broad variety of communication channels – such as the regular monthly press conference, the ECB Monthly Bulletin and testimony of members of the Executive Board at the European Parliament – the ECB explains in detail its assessment of the prevailing economic situation and its monetary policy decisions, including the economic rationale on which they are based. Third, the ECB participates in a range of official fora at the euro area, EU and international levels which permit an intense exchange of views with other policy making bodies. In the European context, the ECB partipates in the Eurogroup and ECOFIN and has membership of the Economic and Finance Committee (EFC) and Economic Policy Committee (EPC). In all such meetings, the independence of the ECB is fully respected. Transparency in the design and conduct of the ECB’s monetary policy allows national governments and other policymakers in the euro area to design and implement the fiscal and labour market policies for which they are responsible in a manner that takes into account interdependencies of these policies with the single monetary policy. Given the information provided by the ECB, national governments and other relevant policy making authorities know that monetary policy will respond to fiscal, structural and wage policies (as well as to all other developments) in a manner which serves to maintain price stability over the medium term. Obviously, monetary policy has to respond to a very broad range of developments beyond the policy choices made by other institutions in order to address risks to price stability. One implication of this complexity is that the Eurosystem cannot engage in any ex ante policy co-ordination, for example by agreeing to condition monetary policy actions on certain current or prospective fiscal and structural policies or wage developments. Such co-ordination might hinder the Eurosystem's prompt response to threats to price stability arising from other sources, thereby endangering the primary objective. If the markets come to expect that the Eurosystem's policy would be constrained by some form of ex ante co-ordination, this would reduce the credibility – and thereby the effectiveness and success – of the single monetary policy. Ex ante co-ordination would also decrease accountability and reduce the transparency of the policy framework for the public. This might risk the creation of an environment where individual policy making institutions could focus policy on short-term considerations with potentially adverse consequences for all policy areas over the medium term. Attempts to co-ordinate policies ex ante so as to achieve a certain “policy mix” between monetary and fiscal policy only serves to confuse the specific roles and mandates of these policies, often making them sub-optimal, less transparent and accountable, and potentially destabilising for the economy as a whole. 3.
The ECB’s monetary policy strategy
Monetary policy always faces an environment of considerable and varied uncertainty. In order to maintain price stability, monetary policy decisions must take these uncertainties into account. In the context of the euro area, one important aspect of the Governing Council’s approach to meeting this challenge was the announcement, in October 1998, of the ECB’s stability-oriented monetary policy strategy (ECB, 1999a, 2000c; Angeloni, et al., 1999; Issing et al., 2001). The introduction of the euro changed – and continues to change – economic behaviour and institutional structure in the euro area. The effects of monetary policy on financial markets, consumption, investment and 6
wage bargaining have been among the important economic relationships affected by this regime shift. Therefore, especially in the early years of Monetary Union, the ECB faces considerable – and to some extent “special” – uncertainties beyond those always confronted by central banks, about (inter alia) the reliability of available economic indicators, the structure of the euro area economy and the transmission mechanism of the single monetary policy.7 A large academic literature has addressed the question of how monetary policy should be conducted in an uncertain environment (surveys are provided in ECB (2001) and Angeloni, et al. (2000)). This literature – together with the practical experience of central banks in general, and those in the euro area in particular – has informed the design of the ECB’s strategy, and thus the implementation of the single monetary policy, in several respects. Addressing strategic uncertainty Much of the uncertainty facing monetary policy makers in unavoidable. Knowledge of the structure of the euro area economy is inevitably imperfect and economic data are always subject to measurement error. In this environment, it is crucial that monetary policy itself does not become an independent source of additional uncertainty. If the public and financial markets do not understand the objectives, instruments and decision making framework for monetary policy, extra and avoidable uncertainty is introduced into the economy. One can envisage a complicated (and potentially costly) interaction between the central bank and the public, where, when making forward-looking economic decisions, each party has to take into account its uncertainty regarding the framework for decision making used by the other party. Drawing from the game theory literature, this type of uncertainty can be labelled strategic uncertainty. The ECB’s public (and relatively detailed) announcement of its strategy is an attempt to address and contain strategic uncertainty. Announcement of the strategy is intended to clarify and explain how monetary policy decisions are taken. In this respect, the strategy serves two main roles. First, the strategy structures the internal decision making process. In particular, it ensures that the Governing Council receives all the information and analysis that it requires to formulate monetary policy decisions which serve the maintenance of price stability. Given the complexities and uncertainties surrounding the structure of the euro area economy, the range of information and analysis required is potentially extremely broad. It is therefore always desirable to adopt a full information approach, which aims to ensure that all available data and all relevant approaches and models are used efficiently in the analysis underlying monetary policy decisions. To render this body of analysis manageable, a framework which simplifies and structures information is necessary. The ECB’s strategy chooses to organise analysis into two categories – one where money plays a prominent role, the other encompassing the more diverse set of remaining approaches. This is the framework within which the internal discussion of monetary policy takes place. Second, the strategy provides a consistent and coherent framework for the presentation of monetary policy decisions and their economic rationale to the public. Again, given the complexity of monetary policy making, making such communication intelligible to the public inevitably requires an element of simplification.
7
See Issing (2000a) for an open account of the uncertainties associated with the introduction of the euro from a policy-makers’ perspective.
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Viewed as an attempt to contain strategic uncertainty, the ECB’s strategy should bolster the credibility and predictability of the single monetary policy. Both aspects serve to reduce the uncertainty faced by the public and thus (indirectly) by policy makers themselves. The ECB’s definition of price stability In order to bolster credibility, the ECB has provided a quantitative definition of its primary objective, namely price stability. Price stability was defined as an annual increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%. Neither prolonged inflation nor deflation is deemed consistent with this definition. The ECB affirmed that, in line with its Treaty mandate, monetary policy decisions would focus on this overriding objective. The definition of price stability provides an anchor for inflation expectations and therefore serves to reduce uncertainty about price developments over the longer term. In terms of the academic literature, the ECB’s announcement of its definition of price stability can be seen as tantamount to the adoption of what Svensson has called a “target rule”, i.e. the ECB has provided the public with a clear quantification of the objective of monetary policy. A forward-looking, medium-term oriented and full information approach to monetary policy making In order to improve the predictability of the single monetary policy, the ECB has provided a detailed description of how it arrives at monetary policy decisions which serve the maintenance of price stability. This decision-making process – and thus the design of the strategy – recognises various structural features of the euro area economy. In particular, it acknowledges the long and variable lags in the transmission of monetary policy actions to the price level. These lags have two important implications. First, monetary policy is ill suited to fine-tuning short-term developments in the price level. The uncertainties surrounding the timing and magnitude of the impact of monetary policy actions on the price level are simply too great. Therefore, the Governing Council has stated that price stability is to be maintained over the medium term. Second, since monetary policy actions will affect price developments with a time lag, the assessment of risks to price stability must be forward-looking, so that the policy choices made today are appropriate to address future threats to price stability when the lags in transmission unwind. The need for robustness and a diversified approach to the analysis underlying monetary policy decisions The design of the strategy recognises that any specific economic framework – although it may capture some important features of the euro area economy – is incomplete in some respects and certainly does not capture the full complexity of the transmission process. The appropriate monetary policy response to a threat to price stability will depend on the nature of that threat. In order to identify the nature of an economic shock which poses risks to price stability, one needs to evaluate and cross-check a number of variables. Evaluating a single variable in isolation implies that only one type of shock can be discriminated, whereas evaluating all variables together allows the richest assessment of the prevailing economic situation and shocks to be made.8 For this reason, the ECB’s strategy does not attempt to partition the available economic data and information. The strategy explicitly takes into account different 8
Intuitively, in order to distinguish two types of economic shock, an observer must evaluate at least two economic indicators which behave differently in response to the incidence of each of the shocks.
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approaches or “views of the world”, rather than relying on a single indicator or framework of analysis. Obviously, data are evaluated in an integrated manner, exploiting all relevant information. By diversifying across analytical frameworks rather than relying on a single and inevitably incomplete approach the risk of major policy errors is reduced. For simplicity, this principle can be labelled “robustness”.9 A desire for robustness implies a need to take a diversified approach to guide policy judgements (ECB, 2000c; Engert and Selody, 1998). In implementing such an approach in practice, the ECB decided to adopt a monetary policy strategy with a two pillar structure, which can be rationalised as a framework which accommodates the need to use a diverse set of analyses in the face of uncertainty about the “true” model of the economy (cf. Selody, 2001). One pillar represents a set of analytical approaches which assign an important role to monetary and credit aggregates either as indicators of future price developments or as important structural variables within the inflation process. The other pillar represents an alternative set of analytical tools which focus on the interaction between supply and demand and/or cost pressures as determinants of price developments, and thereby emphasise other economic and financial indicators. The two pilar structure of the ECB’s strategy is one way of organising the full information approach required for monetary policy, which – in addition to analysing all the available data – also encompasses a variety of different economic models, tools and analytical frameworks. While this description – as is the case with the strategies of other central banks – falls short of providing a complete quantitative “instrument rule” for the single monetary policy,10 it nevertheless offers a detailed insight into the process by which monetary policy decisions are made which complements the quantification of the objective of monetary policy provided by the definition of price stability. The prominent role for money The prominent role assigned to money in the ECB’s strategy reflects the monetary origins of inflation over the medium to longer term. One of the most remarkable empirical regularities in macroeconomics is the ubiquitous long-run relationship between the price level and the money stock.11 In the literature, a broad consensus exists that any well-specified model of a monetary economy should exhibit this feature. On both empirical and theoretical grounds, this provides ample justification for assigning money an important role in monetary policy making, as reflected in the practice of leading central banks (Pill, 2001). This conclusion is particularly apposite for the euro area. In contrast to other countries where monetary developments during recent decades have been rather erratic, in the euro area the available evidence continues to point to the existence of a stable relationship between broad monetary aggregates – in particular M3 – and price developments over the longer term (Coenen and Vega, 1999; Brand and Cassola, 2000). Moreover, M3 and other monetary and credit aggregates appear to possess good leading indicator properties for future price developments, especially at medium-term horizons (Gerlach and Svensson, 2000; Nicoletti Altimari, 2001; Trecroci and Vega, 2000).
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10 11
A policy is said to possess the property of “robustness” if it delivers “reasonable” outcomes across a broad set of possible models of the economy (Blanchard and Fisher, 1989; Bryant, et al., 1993; McCallum, 1999). This should be distinguished from “robustness” in the sense of robust control (Hansen and Sargent, 2001; Onatski and Stock, 2000). i.e. a complete description of the contingent responses of short-term interest rates to developments in economic indicators. Lucas (1995); McCandless and Weber (1995).
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The prominent role assigned to money in the ECB’s strategy has been signalled by the announcement of a reference value for the annual growth rate of the broad monetary aggregate M3. In December 1998 the Governing Council set the reference value at 4½%, a value confirmed in both December 1999 and December 2000. The announcement of the reference value represents a visible public commitment on the part of the Governing Council thoroughly to analyse and explain monetary developments and their implications for monetary policy decisions. This explanation appears regularly in the commentary section of the ECB’s Monthly Bulletin. Analysis under the first pillar is geared to extracting the information in monetary developments that is relevant for identifying and assessing risks to future price stability. In so doing, the first pillar relies on a variety of macroeocnomic models of the euro area which accord monetary developments an important role either in the transmission process or as an indicator variable for future price developments. Although comparisons of annual M3 growth with the reference value provide a starting point, a broad range of other analytical tools are also employed (cf. Masuch, et al., 2001). Deviations of M3 growth from the reference value do not mechanically trigger interest rate changes. Rather such deviations are the catalyst for further analysis, first searching for the causes of such deviations and then assessing the implications for future price developments and thus monetary policy. Therefore, the reference value for M3 is not an intermediate monetary target. The ECB does not attempt to control monetary growth in the short term so as to hit the reference value at a specific horizon. Rather the reference value acts as an analytical and presentational tool which constitutes an important benchmark for assessing risks to price stability. Analysis of other economic and financial indicators To take appropriate decisions, the Governing Council needs to have a comprehensive understanding of the prevailing economic situation and be aware of the specific nature of the economic disturbances which threaten price stability. While inflation is ultimately a monetary phenomenon, monetary developments may, at least in the short term, not always be the only, or even the most useful, guide for assessing those disturbances which pose risks to price stability. A monetary policy aimed at the maintenance of price stability must therefore rely on analysis of a broader range of indicator variables. Consequently, in parallel with the analysis of monetary developments, the ECB also evaluates a wide range of other economic and financial indicators (the so-called second pillar) in making its broadly based assessment of the risks to price stability in the euro area. Analysis under the second pillar therefore complements the monetary analysis undertaken under the first pillar, by revealing the influence of a host of factors that can affect price developments in the short to medium run, but which are not necessarily captured by the monetary data. This analysis is typically centred on the effects of interactions between supply and demand and/or cost pressures on pricing behaviour. Developments in financial market indicators and asset prices are also closely monitored, as well as a host of domestic and external factors (including the impact of changes in indirect taxes, of the fluctuations in the exchange rate and international commodity prices, etc.). The information made available for the meetings of the Governing Council derived from this broad range of economic indicators is regularly reviewed in the commentary of the ECB Monthly Bulletin. 10
Macroeconomic forecasts and projections also play an important role in the second pillar of the ECB’s strategy. Given that the range of relevant indicators under the second pillar is potentially very broad, there is a need to structure and summarise this information, to facilitate the analysis of risks to price stability. A forecast procedure offers a convenient analytical tool for organising a large body of information in a systematic way which respects basic economic relationships and accounting identities. In particular, as mentioned in Section 2, Eurosystem staff produce a set of macroeconomic projections in a regular exercise co-ordinated by the MPC which constitutes an important input into the policy making process. The word “projection” (rather than “forecast”) has been adopted in order to signal that the published projections are the results of a scenario based on a set of underlying technical assumptions, including the assumption of unchanged monetary policy. The MPC conducts two macroeconomic projection exercises per year, one in the Spring and one in the Autumn. Given the close involvement of the MPC, these projections involve a great interaction between the ECB and NCB staff experts. As such, these projections represent the output of a collective endeavour, which encompasses a large body of information and expertise collected and situated throughout the euro area. The macroeconomic projections produced in the context of the exercises co-ordinated by the MPC are based on a number of inputs. First, the analytical framework used to produce these projections embodies a variety of macroeconometric frameworks and models of the euro area. These include an area-wide model (Fagan, et al., 2001) and a multi-country model.12 NCB models of individual countries are also employed, with the results being aggregated at the euro area level in a consistent way. (The models used for these projections emphasise the role of supply and demand interactions and/or cost pressures as determinants of inflation, and do not accord an important role to money.) Second, the projections produced by these models are influenced and adjusted using the technical assessments of staff experts both at the ECB and at the NCBs. Introducing such adjustments is standard forecasting practice and a necessary component of an effective procedure for producing such projections. As this description of the procedures makes clear, the Eurosystem staff projections are based on the technical expertise of the members of the MPC and the staff of the ECB and the NCBs. As such, these projections are an input into the policy making process – they do not embody the policy judgement of members of the Governing Council. The process by which the Eurosystem staff projections are produced is therefore consistent with the institutional framework described in Section 2, and recognises the distinction between the staff’s role of providing input into the Governing Council’s deliberations and the Governing Council’s Treatybased responsibility for taking monetary policy decisions. Since December 2000, the ECB has published macroeconomic projections in its Monthly Bulletin. Projections are published for HICP inflation and the growth rate of real GDP and its components. These projections have a two-year horizon. In order to reflect accurately the degree of uncertainty attached to such projection exercises, the projections are published in the form of ranges, based upon the average absolute errors made in previous national central bank and Eurosystem projections. In the Monthly Bulletin, the projections are accompanied by a short text describing their main features.
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These models allow for sticky prices and wages so that output in the short run responds to demand shocks. The specification is such that in the long run the models have a well-defined steady-state with a clear link to underlying economic theory. However, the short-run dynamics reflect ‘ad hoc’ specifications estimated on the basis of historical data (see Fagan et al., 2001).
11
The role of the Eurosystem staff economic projections in the ECB’s monetary policy making is much more nuanced than some textbook descriptions of monetary policy would imply. The projections are seen as one component of the analysis undertaken under the second pillar of the ECB’s strategy, not as an exhaustive summary statistic of information about the outlook for price developments, still less a sufficient statistic for monetary policy decisions. When interpreting the projections published by the ECB, one should keep their important, but nonetheless limited, role in mind. In particular, it is important to emphasise that the Governing Council does not use its staff projections as the sole or main tool for organising and communicating its assessment of the economic situation. Rather the Governing Council evaluates these projections alongside – and compares them with – the information revealed by the first pillar and other pieces of information and forms of analysis from the second pillar. Taking monetary policy decisions on the basis of analysis organised in the two pillar framework Ultimately, the Governing Council has to come to an interest rate decision on the basis of its collective overall assessment of the economic situation and risks to price stability. This decision will draw on all the available information, not just that reflected in the staff projection and/or the deviation of M3 growth from the reference value. The two pillar structure of the ECB’s strategy facilitates this decision making process in a number of ways. First, by presenting distinct, yet complementary, forms of analysis to members of the Governing Council, the two pillar approach encourages a discussion of issues from a variety of perspectives. In practice, this is the mechanism by which the two pillar approach makes the final decision more robust. Second, the two pillar structure focuses discussion directly on the interest rate decision itself – which is where the Governing Council’s responsibility lies – rather than requiring first agreement about either the appropriate interpretation of monetary developments or a single euro area inflation forecast. Given uncertainty about the structure of the economy and the most appropriate model, reaching such agreements may anyhow be difficult in a Council with 18 members. The two pillar structure of the ECB’s strategy is often misunderstood by external observers as implying multiple targets for monetary policy. However, as the preceding discussion makes clear, the maintenance of price stability in the euro area is the only target (more formally, the “primary objective”) of the single monetary policy. Both pillars of the strategy should be understood as instrumental in facilitating the achievement of this ultimate objective. The first pillar is therefore not a “monetary target” and the second pillar is not an “inflation target” or an “inflation forecast”. Rather, when taken together, the two pillars of the strategy form a forward-looking framework which simplifies and organises the presentation and analysis of the information relevant for monetary policy making, in order to facilitate the Governing Council’s assessment of risks to price stability and selection of the appropriate monetary policy responses to them (see Chart 2). 4. The ECB’s strategy in practice For almost all of 1999 and 2000, measures of private long-term inflation expectations have fallen inside the range that the ECB has deemed compatible with the maintenance of price stability over the medium term (see, for example, the “break-even” inflation rates derived from French price level indexed bonds shown in 12
Chart 3, noting that their interpretation is subject to a number of caveats). Furthermore, the markets seem to have been able to anticipate the ECB’s monetary policy decisions in a broadly accurate way, suggesting that the ECB’s policy framework has been well understood. This may be illustrated using either the three-month Euribor futures contract or the Eonia swap curve (Gaspar, et al., 2001).13 Against this background of success, this section uses the Governing Council’s decision to cut interest rate in April 1999 as an example of how the ECB’s monetary policy strategy has worked in practice (see Issing (2000b, 2001) for a more comprehensive account of the conduct of the ECB’s monetary policy strategy during the first year). Some background: Developments in late 1998 When the main elements of the ECB’s stability-oriented monetary policy strategy were announced on 13 October 1998 (ECB, 1998), euro area inflation, as measured by the change in the Harmonised Index of Consumer Prices (HICP), was only 0.9% (see Chart 4). Inflation expectations were also low. In 1998, M3 had been growing steadily at annual rates fluctuating between 4.4 and 4.9%. During late 1998, in the aftermath of the Asian and Russian financial crises, the prospects for world growth were being revised down. The turmoil in financial markets led to concerns about the emergence of a possible credit crunch in the US. In the Autumn the Federal Open Market Committee (FOMC) of the Federal Reserve System decided to lower interest rates. Overall developments in the euro area and the world economy were consistent with the maintenance of inflation rates at very low levels. In early December the NCBs in the euro area decided to reduce their interest rates to 3%. This was done in a concerted manner,14 with the decisions announced after the meeting of the ECB Governing Council on 3 December. On 22 December, the Governing Council confirmed that this rate would apply at the start of Stage Three, demonstrating it was already the de facto decision-maker, even before formally assuming responsibility for the conduct of the single monetary policy.15 At the beginning of 1999 the level of nominal interest rates in the euro area was the lowest since World War II. The short-term real interest rate, measured by the three-month money market rate minus current HICP inflation, moved below 2% – lower than at any time during the 1990s. The situation in early 1999: Analysis and assessment of monetary developments M3 growth at the start of 1999 was slightly above the reference value (see Chart 5). The January data showed a significant increase in overnight deposits, which was only partially corrected in February. Overall, the threemonth moving average of annual M3 growth rates for the period December 1998 – February 1999 (the latest observation available to the Governing Council when it took the decision to cut interest rates at the start of April) was 5.1%. It was also notable that credit to the private sector was growing relatively fast, at an annual rate of approximately 10%.
13
14 15
In ECB (2000b) it is argued that changes in market interest rates under certain circumstances would lead rather than follow monetary policy decisions. The Banca d’Italia lowered interest rates to 3.5% on 3 December 1998 and to 3% later in the month. The Governing Council also announced that the rate on the deposit facility would be 2%, while the marginal refinancing rate was set at 4.5%. A narrower corridor would apply during the first weeks. The first open-market operation – a two-week fixed rate repo tender at 3% – took place on January 4, 1999.
13
Some external commentators have erroneously interpreted the first pillar in a narrow fashion, focusing solely on the short-term deviation of M3 growth from the reference value. Since the latest M3 growth data available in early April 1999 were slightly above the reference value of 4½%, it was argued that the signal offered by this indicator at that time was – at least prima facie – one of modest upward risks to price stability. However, as has been emphasised in Section 3, this narrow interpretation is at odds with the more broadly defined scope of monetary analysis under the first pillar that is implied by the ECB’s strategy. A more detailed investigation suggested that, in early April 1999, there were several reasons not to be too concerned about potential upside risks to price stability signalled by the monetary data. First the deviation of monetary growth from the reference value was, at that stage, neither substantial nor prolonged, and thus did not fulfil the conditions explicitly mentioned by the ECB (1999a, b) as a condition for signalling risks to price stability. Second, a number of special factors associated with the transition to Stage Three may help to explain the increase in M3 growth. For example, liquidity preference may have increased because of the uncertainties arising from the regime shift to the single monetary policy. Moreover, changes in the statistical reporting or minimum reserve systems may also have played some role. Third, the moderation of monetary growth in February 1999 was consistent with the view that strong M3 growth in January was temporary and associated with transitional factors. The magnitude and persistence of such effects was difficult to ascertain in the first few months of Stage Three. On these bases, the Governing Council had good reason to exercise caution in the interpretation of monetary data and not to regard monetary developments in early 1999 as implying upward risks to price stability.16 The situation in early 1999: Analysis and assessment of other economic and financial indicators In late 1998 and the early months of 1999, the consensus macroeconomic forecast for euro area real economic growth in 1998 and 1999 was revised downwards (see Chart 6a). Forecast real GDP growth in 1999 was revised down from almost 3% to only slightly above 2%. These downward revisions were mirrored in the forecasts produced by international organisations and were broadly consistent with the ECB’s analysis of the most likely scenario. Available data for 1998 also pointed to a slowdown in the growth of real economic activity (see Chart 7). At the same time, the available projections for inflation one or two years ahead still fell comfortably within the “increases ... below 2%” range deemed consistent with price stability by the ECB. Yet such forecasts had over-predicted inflation developments in the recent past and showed a clear pattern of downward revision. For example, as clearly indicated in Chart 6b, the consensus forecasts for headline inflation in 1999 had been revised down from the 2% foreseen in March 1998 to a rate of just 1% expected in March 1999. In part, both the over-prediction and the downward revisions were a consequence of an unanticipated decline in international oil prices, which (in US dollar terms) fell by almost 50% from January 1997 until February 1999. Analysis of macroeconomic forecasts was supported by the independent assessment of financial market expectations embedded in financial yields and spreads. In particular, the so-called break-even inflation rate
16
This point was made in the Press Conferences and the Montly Bulletin issued during the first quarter of 1999.
14
implicit in a comparison of the yields on nominal and price level indexed French government bonds also remained consistent with the definition of price stability (see Chart 3).17 As discussed in Section 3, rather than relying solely on inflation forecasts, monetary policy decisions require an assessment of the nature of shock hitting the euro area economy. Moreover, the projections themselves are based on assumptions for certain variables, such as the nominal exchange rate of the euro, international commodity prices and prospects for global economic growth, which can change rapidly, rendering projections quickly outdated. Developments in these variables therefore need to be closely monitored independently of the forecast exercise. During the early months of 1999, several such variables changed course in a previously unexpected manner. First, the euro exchange rate against the US dollar and other international currencies, having peaked in late 1998, began to depreciate (see Chart 8). Second, international oil prices, having fallen almost continuously from 1997 (as noted above), rose strongly after February 1999. However, there were several reasons not to attach too great a weight to these developments in the overall monetary policy assessment made in April 1999. In particular, at that time, they were both relatively short-lived and could be interpreted as representing an unwinding of previous (possibly unsustainable) developments. Moreover, the overall economic situation of declining business confidence and weakening economic activity suggested that the danger of second-round effects was modest. This latter conclusion was supported by wage and cost indicators, which pointed towards continued wage moderation in the euro area. Moreover, the consensus macroeconomic forecasts made in late 1998 and early 1999 – which foresaw a gradual pick-up in economic activity in the euro area through 1999 – were, to some extent, conditional on an increase in world economic growth. However, the Japanese data for the last quarter of 1998 still showed recession and deflation. Economic recession in Russia was expected to deepen. The Brazilian crisis risked contagion which could impair the functioning of the global financial markets, thereby heightening uncertainty. The overall judgement was that risks to the world economy were tilted to the downside. These risks could conceivably spread into the euro area if they were to affect consumer or business confidence significantly. The Governing Council’s decision to lower interest rates In early April 1999 the Governing Council decided to cut interest rates by 50 basis points, reducing the rate on the Eurosystem’s main refinancing operation to 2.5% (cf. Chart 9). This decision was based on a through analysis of the available economic information organised in the two pillar framework of the ECB’s monetary policy strategy. In large part, the decision was a response to changes in the balance of risks to price stability in the euro area which – in the absence of an interest rate change – were seen at that time as lying “mainly on the downside.” The ECB explained the policy move “as a
17
Note however that this break-even inflation rate implicitly includes financial market participants’ expectations regarding the future course of monetary policy, in contrast to the internal Eurosystem staff projections which are based on the assumption of unchanged short-term interest rates. This inconsistency is one reason why financial market expectations have to be analysed independently and thus accounts, in part, for why the Eurosystem staff forecasts can only be part of the input provided to the Governing Council’s decision making process coming from the second pillar.
15
precautionary measure to preserve price stability in the medium term and, in doing so, contribute to better exploiting the growth potential of the euro area economy” (see ECB, 2000).18 Viewing the Governing Council’s decision against the background of the ECB’s strategy One must first recognise that the April 1999 interest rate decision did not mechanically follow from deviations of M3 growth from the ECB’s reference value. The thorough monetary analysis undertaken at the time suggested that monetary developments could not be considered a risk to future price stability. Moreover, the April decision does not appear mechanically linked to deviations of inflation projections from the ECB’s definition of price stability. Assuming that the Eurosystem staff projections for medium-term inflation were broadly in line with the consensus projections shown in Chart 6b, these would have implied an evolution of inflation rates within the range deemed compatible with price stability. As noted in Section 3, the ECB’s monetary policy strategy does not imply a mechanical link between monetary growth or staff economic projections and interest rate decisions. A thorough assessment of the nature of the economic shocks and the related risks to price stability is carried out, drawing on a broad range of indicators and analytical tools. Given the uncertainty in the international environment the and weakening of economic activity in the euro area, in early 1999 this assessment inter alia focused on the likelihood of further declines in inflation. With headline HICP inflation as low as 0.8% in December 1998 through February 1999 (the last three observations available at the time of the interest rate decision), there was a certain risk, related, in part, to the possibility of further negative shocks to economic growth or confidence in the euro area, that inflation could move outside the range compatible with price stability.19 This risk may have been highlighted by the pattern of headline inflation forecast revisions portrayed in Chart 6b. In such a situation, a precautionary policy move was prudent and – in explicitly eschewing mechanistic reaction to forecasts – fully consistent with the ECB’s monetary policy strategy. When taking monetary policy decisions, the ECB naturally has to consider contingent policy responses to future previously unanticipated shocks or small-probability (but potentially very important) events (see Gaspar, 2001). Such contingent responses are not embodied in macroeconomic forecasts or projections, which are normally based on the assumption of unchanged short-term interest rates. In the context of the April 1999 decision, one could argue that a decision to lower interest rates addressed downside risks to future price stability which – should they have become manifest and entrenched – may have proved difficult to reverse if the April decision to lower interest rates had been delayed. There was no risk at the time that inflation could move lastingly above 2%. Any potential future upside risks to price stability (e.g. resulting from a further increase in oil and other import prices in the context of a significant strengthening of real growth) could have been addressed by later – but possibly more aggressive – interest rate rises should they come to dominate the future overall assessment. Viewed in this light, the Governing Council’s decision to lower interest rates “as a precautionary measure” in April 1999 could be seen as an attempt to insure the euro area against potential deflationary risks, partly by 18
19
In its Annual Report (p. 9), the ECB (2000) further stated: “… in an environment where current inflation rates were significantly below the upper limit of the Eurosystem’s definition of price stability and in view of downward pressures on future price developments associated with a weakening of economic activity, the Governing Council decided on 8 April to reduce the main refinancing rate by 50 basis points to 2.5%.” This is all the more relevant given the possibility of a small positive measurement bias in the HICP.
16
helping to reduce uncertainty about future economic developments and thereby contributing positively to the confidence in the economy. Acting in a pre-emptive manner to potential serious downside risks to price stability is a forward-looking response to the particular nature of economic shocks and the related risks to price stability prevailing in early 1999. It may be viewed as an example of a robust monetary policy response in the sense of Hansen and Sargent (2001). Obviously, one characteristic of such a precautionary move is that it could always be reversed if the downside risks against which precautions were taken were not to materialise and/or were sufficiently addressed by the policy move. Indeed, the ECB had signalled at the time of the move that the likelihood that policy interest rates would go down further was rather small. This episode provides one example that illustrates why the ECB was well-advised not to adopt an inflation forecast targeting approach.20 Such an approach would entail linking monetary policy decisions mechanically to deviations of a central inflation forecast from the quantified inflation objective. November 1999 The April policy move could be reversed in November 1999, once new information showed that the global economic situation had stabilised, the downside risks to price stability no longer prevailed and the balance of risks “had been progressively moving to the upside” (ECB, 2000). As regards monetary developments, Chart 5 illustrates the gradual increase in monetary growth during the summer of 1999. By November 1999, the deviation of M3 growth from the reference value could be interpreted as being indicative of emerging upward pressures on price developments. Detailed analyses of M3 and its components and counterparts– involving a variety of economic and econometric tools –supported this view. The signals which could be drawn from monetary developments were supported and complemented by analysis of other economic and financial indicators under the second pillar. Headline HICP started to rise in spring 1999 and stood at 1.2 % in September 1999 and it was expected to further increase in the short-term mainly related to higher energy prices (Chart 4). GDP growth had stabilised in the second quarter and then recovered in the third quarter of 1999 (Chart 7). The downside scenarios regarding global economic growth which had been entertained in the first quarter of 1999 had also diminished in importance in the overall assessment, given signs of economic stabilisation in Asia and continued strong expansion in the United States. By November 1999 the depreciation of the euro against other international currencies (Chart 8) and the increase of international oil prices had both become cumulatively larger and more prolonged. The direct impact of these developments was already tending to raise short-term euro area inflation forecasts and projections, while – against a background of recovering economic growth – the risk that they could lead to inflationary second-round effects through wage bargaining had increased. The information analysed and presented in the context of the two pillars of the ECB’s strategy therefore readily lent itself to the interpretation that downside risks to price stability had diminished and the balance of risks had shifted to the upside. Thus, the level of ECB interest rates which resulted from the cut in April 1999
20
Other objections to inflation forecast targeting are not discussed here. Regarding the role of staff macroeconomic projections in the ECB’s strategy, see ECB 2000c.
17
was no longer justified and consequently the Governing Council decided to increase these rates by 50 basis points on 4 November 1999. 5. Concluding remarks on transparency and communication This chapter has outlined how the ECB has responded to the considerable challenges facing monetary policy in the early years of EMU. It has emphasised two aspects. First, it has discussed institutional development and, in particular, measures designed to incorporate the expertise located in NCBs into the overall, necessarily area-wide assessment of economic data underlying monetary policy decisions. Second, it has described the ECB’s monetary policy strategy and how this has been used in the difficult circumstances facing the ECB in early 1999. One theme of the chapter – and of the design of the ECB’s monetary policy strategy – has been the need to address the considerable uncertainties surrounding the transmission of monetary policy in the euro area. This need has manifested itself in the two pillar framework within which monetary policy decisions are formulated. This framework encourages a diversified approach to the analysis and assessment of the full information set of economic data and information relevant for monetary policy decisions. This full information approach – construed in a broad sense to include a variety of economic models and analytical tools – is intended to lead to better and more robust policy advice and guidance for the Governing Council. Of course, the two pillar framework is more complex than alternative monetary policy strategies. However, this complexity is an accurate and honest reflection of the challenges facing central banks, compounded in the case of the ECB by the special uncertainties associated with the introduction of the euro. One measure of the transparency of monetary policy is the extent to which the external aspect of the strategy (i.e. the presentation of decisions and their rationale to the public) corresponds to the internal decisionmaking process. In other words, a transparent central bank will report and explain its monetary policy decisions to the public on the basis of the same framework within which those decisions are taken internally. In this respect – and contrary to the impression one might obtain from recent academic criticism of the ECB – the ECB’s approach is very transparent, since the presentation of policy decisions to the public is based on the same two pillar framework used to provide input for Governing Council discussions (ECB, 2000c). In contrast to approaches adopted elsewhere and/or in the past, the ECB has not attempted to present its policy decisions as if they followed mechanically from developments in M3 growth or inflation forecasts. By presenting policy decisions to the public in a manner which corresponds closely to the internal decision making procedure, the ECB should ultimately provide a clearer, more transparent and more predictable policy-making framework, although investment during a learning phase is undoubtedly required. The ECB’s overall performance should be judged in terms of its primary objective, namely the maintenance of price stability over the medium term. Because of the lags in monetary transmission to the price level, it remains too early to make a comprehensive assessment of the success of the ECB’s strategy. However, two broad conclusions can be drawn. First, the information available from long-term bond yields and inflation forecasts made in the private sector suggests that inflation expectations remain in line with the ECB’s definition of price stability. The credibility of the single monetary policy has therefore not been questioned in this respect. Second, in the face of the considerable uncertainties posed by the transition to Stage Three of 18
Monetary Union and a number of major economic shocks since 1998, the ECB has, in the view of most observers, avoided major policy errors. Given the magnitude of the original challenges, this has to be regarded as a significant achievement.
19
References Angeloni, I., V. Gaspar and O. Tristani (1999), “The Monetary Policy Strategy of the ECB”, in D. Cobham and G. Zis (eds.) From EMS to EMU, London: MacMillan. Angeloni, I., F. Smets and A. Weber (2000), Monetary Policy Making Under Uncertainty, Frankfurt: European Central Bank / Centre for Financial Studies. Blanchard, O.J. and S. Fisher (1989), Lectures on Macroeconomics, Cambridge, MA: MIT Press. Brand, C. and N. Cassola (2000), “A Money Demand System for Euro Area M3”, ECB Working Paper No. 39. Bryant, R.C., P. Hooper and C.L. Mann (1993), Evaluating Policy Regimes: New Research in Empirical Macroeconomics, Washington, DC: Brookings Institution. Coenen, G. and J-L. Vega (1999), “The Demand for Euro Area M3”, ECB Working Paper No. 6. Cukiermann, A. (1992), Central Bank Strategy, Credibility, and Independence: Theory and Evidence, Cambridge, MA: MIT Press. ECB (1998), “A Stability-oriented Monetary Policy Strategy for the ESCB”, ECB Press Release, 13 October. ECB (1999a), “The Stability-oriented Monetary Policy Strategy of the Eurosystem”, ECB Monthly Bulletin (January). ECB (1999b), “Euro Area Monetary Aggregates and their role in the Eurosystem’s Monetary Policy Strategy”, ECB Monthly Bulletin (February). ECB (2000a), Annual Report 1999, Frankfurt: European Central Bank. ECB (2000b), “Monetary Policy Transmission in the Euro Area”, ECB Monthly Bulletin (July). ECB (2000c), “The Two Pillars of the ECB’s Monetary Policy Strategy”, ECB Monthly Bulletin (November). ECB (2001). “Monetary Policy Making Under Uncertainty”, ECB Monthly Bulletin (January). Engert, W. and J. Selody (1998), “Uncertainty and Multiple Paradigms of the Transmission Mechanism”, Bank of Canada Working Paper No. 98/7. Fagan, G., J. Henry and R. Mestre (2001), “An Area-wide Model (AWM) for the Euro Area”, ECB Working Paper No. 42. Feldstein, M. (1997), “EMU and International Conflict”, Foreign Affairs, 76 (6): 60-76. Gaspar, V. (2001), “The role of monetary policy under low inflation”, in The Role of Monetary Policy Under Low Inflation: Deflationary Shocks and Policy Responses, Institute of Monetary and Economic Studies, Bank of Japan, reprinted in Monetary and Economic Studies, Special Edition, 19 (5-1). Gaspar, V. G. Perez-Quirós and J. Sicilia (2001), “The ECB’s Monetary Policy Strategy and the Money Market”, ECB, work in progress. Gerlach, S. and L.E.O. Svensson (2000), “Money and Inflation in the Euro Area: A Case for Monetary Indicators?”, mimeo. Hansen, L. and T.J. Sargent (2001), “Avoiding Misspecification in Macroeconomic Theory” in The Role of Monetary Policy Under Low Inflation: Deflationary Shocks and Policy Responses, Institute of Monetary and Economic Studies, Bank of Japan, reprinted in Monetary and Economic Studies, Special Edition, 19 (5-1). Issing, O. (2000a), “The Monetary Policy of the ECB in a World of Uncertainty” in I. Angeloni, F. Smets and A. Weber (eds.) Monetary policy making under uncertainty, Frankfurt: European Central Bank / Centre for Financial Studies. Issing, O. (2000b), “The ECB’s Monetary Policy: Experience after the First Year”, Journal of Policy Modelling, 22: 325343. Issing, O. (2001), “The Monetary Policy of the ECB.” Journal of Asian Economics, forthcoming. Issing, O., V. Gaspar, I. Angeloni and O. Tristani (2001), Monetary Policy in the Euro Area: Strategy and Decision-Making at the European Central Bank, Cambridge: Cambridge University Press, forthcoming. Lucas, R.E. (1995), “Nobel lecture: Monetary Neutrality”, Journal of Political Economy, 104 (4): 661-82. Manna, M., H. Pill and G. Quirós (2001), “The Eurosystem’s Operational Framework in the Context of the ECB’s Monetary Policy Strategy”, International Finance, forthcoming. Masuch, K., H. Pill and C. Willeke (2001), “Frameworks and Tools of Monetary Analysis” in H-J. Klöckers (ed.) Monetary analysis: Tools and applications, Frankfurt: European Central Bank. McCallum, B. (1999), “Issues in the Design of Monetary Policy Rules” in J. Taylor and M. Woodford (eds.), Handbook of Macroeconomics, Amsterdam: North-Holland. McCandless, G.T. and W.E. Weber (1995), “Some Monetary Facts”, Federal Reserve Bank of Minneapolis Quarterly Review, 19: 529-38. 20
Nicoletti Altimari, S. (2000), “The Leading Indicator Properties of Money in the Euro Area”, ECB, mimeo. Obstfeld, M. (1998), “EMU: Ready or Not?” Princeton Essays in International Finance No. 209. Onatski, A. and J. Stock (2000), “Robust Monetary Policy Under Model Uncertainty in a Small Model of the US Economy”. NBER Working Paper No. 7490. Perez-Quirós, G. and H. Rodriguez (2000), “The Daily Market for Funds in Europe: Has Something Changed with the EMU?”. Paper presented at the ECB conference ‘The operational framework of the Eurosystem and financial markets’, Frankfurt, May 2000. Pill, H. (2001), “Monetary Analysis: Tools and Applications” in H-J. Klöckers (ed.) Monetary analysis: Tools and applications, Frankfurt: European Central Bank. Selody, J. (2001), “Uncertainty and Multiple Paradigms” in H-J. Klöckers (ed.) Monetary analysis: Tools and applications, Frankfurt: European Central Bank. Trecroci, C. and J-L. Vega (2000), “The Information Content of M3 for Future Inflation”, ECB Working Paper No. 33.
21
Chart 1
Institutional development within the Eurosystem
Chart 1a
Decision making bodies
Other members of the Executive Board Governing Council President and Vice President of the ECB Executive Board Governors of the NCBs of the participating Member States
General Council
Governors of the NCBs of the non-participating Member States
22
Chart 1b
Relationship between the ECB and the NCBs
General Council
Governing Council
ECB Executive Board Analysis prepared by ECB staff submitted via the ECB Executive Board
Technical analysis by ESCB committees submitted via the ECB Executive Board
European Central Bank
Eurosystem
NCBs of the participating Member States
ESCB committees e.g. Monetary Policy Committee; International Relations Committee, etc. Participation in ESCB committees varies according to matter being discussed
NCBs of the non-participating Member States
European System of Central Banks (ESCB)
23
Chart 2
Stylised characterisation of the ECB’s monetary policy strategy
Primary objective of price stability
Governing Council systematically combines all information in order to take monetary policy decisions
First Pillar
Second Pillar
Analysis according a prominent role to money (signalled by the reference value for M3 growth)
crosschecking
Analysis focused on a wide range of other economic and financial indicators
Economic information
24
Chart 3
Break-even inflation rates implied by the yield on 10-year price level indexed French Treasury bonds (percent per annum)
3
2
upper boundary of ECB's definition of price stability
1
0 9/ 3/ 6/ 9/ 3/ 6/ 9/ 12 12 12 15 15 15 15 15 15 15 /1 /1 /1 /1 /1 /1 /1 /2 /2 /2 5/ 5/ 5/ 99 99 99 99 00 00 00 19 19 20 8 9 9 9 0 0 0 98 99 00
25
Chart 4
Harmonised index of consumer prices (percent per annum)
3
Upper bound of the ECB's definition of price stability
2.5 2 1.5 1 0.5 0
Oct.2000
Jul.2000
Apr.2000
Jan.2000
Oct.1999
Jul.1999
Apr.1999
Jan.1999
Oct.1998
Jul.1998
Apr.1998
Jan.1998
26
Chart 5
Monetary developments
(annual percentage change)
12 10
Loans
8 M3 6 Reference value
4 2 0
Jul.2000
Jan.2000
Jul.1999
Jan.1999
Jul.1998
Jan.1998
27
Chart 6
Revisions to consensus macroeconomic forecasts for the euro area (annual percentage change)
Chart 6a
Revisions to consensus forecasts of real GDP growth in the euro area
3.5
1998
1999
2000
3
2.5
2
1.5
1
0.5
0 A p r.1 9 9 8 A ug.1 9 9 8 D ec .1 9 9 8
M a y .1 9 9 8 Se p .1 9 9 8
Jan .1 9 9 9 M a y .1 9 9 9 Sep .1 9 9 9
M ay .1 9 9 9 Sep .1 9 9 9
Jan .2 0 0 0
28
Chart 6
Revisions to consensus macroeconomic forecasts for the euro area
(annual percentage change)
Chart 6b
Revisions to consensus forecasts of inflation in the euro area
2
1998
1999
2000
1 .5
1
0 .5
0 A pr.1 9 9 8
A u g.1 9 9 8
D ec.1 9 9 8
M a y.1 9 9 8
S ep.1 9 9 8
J a n.1 9 9 9
M a y.1 9 9 9
S ep.1 9 9 9
M a y.1 9 9 9
S ep.1 9 9 9
Ja n.2 0 0 0
29
Chart 7
Gross domestic product (annual percentage change)
4 3.5 3 2.5 2 1.5 1 0.5 0 00Q3
00Q1
99Q3
99Q1
98Q3
98Q1
30
Chart 8
Euro exchange rate
(dollars per euro)
1.2 1.15 1.1 1.05 1 0.95 0.9 0.85 0.8 Jul.2000
Jan.2000
Jul.1999
Jan.1999
Jul.1998
Jan.1998
31
Chart 9
Interest rates
(percent per annum)
10-year government bond yield
6 5.5 5 4.5 4 3.5 3 2.5
3-month interest rate
2 Jul.2000
Jan.2000
Jul.1999
Jan.1999
Jul.1998
Jan.1998
32
