24 February 1999 (ORGANISATIONAL UNIT) (safe date)
The Monetary Policy Strategy of the ECB[*]
Ignazio Angeloni, Vítor Gaspar and Oreste Tristani
DG Research, European Central Bank
“The man of system (...) is often so enamoured with the supposed beauty of his own ideal plan of government, that he cannot suffer the smallest deviation from any part of it. (...) He seems to imagine that he can arrange the elements of a great society with as much ease as the hand arranges different pieces upon a chessboard. He does not consider that the pieces upon the chess board have no other principle of motion besides that which the hand impresses upon them; but that, in the great chess board of human society, every single piece has a principle of motion of its own, altogether different from that which the legislature may choose to impress upon it” (Smith, 1759).
1 Introduction
Monetary policy is an ongoing process, whose implications can only be understood in conjunction with the broad economic context and with the goals that policy itself is trying to achieve. Like chess moves acquire meaning in succession, as part of the player’s overall game plan, so sequences of policy actions are linked together with the underlying circumstances and goals by a rigorous, though flexible, logical thread. From Lucas’ early contributions we learned that specific monetary policy actions have different impacts on economic agents depending on the overall policy framework according to which they are conducted. It is the monetary policy strategy—in short, the framework that a central bank uses to translate relevant information into actions and to publicly explain such actions—that really matters when it comes to affecting market expectations and, indirectly, economic behaviour and outcomes.
From this perspective, the European Central Bank (ECB) actually started “making policy” (specifically, explaining the strategy it intended to adopt) well before January 4, 1999. As early as in 1997, the European Monetary Institute (EMI) published substantive anticipations of the broad lines of the ECB operational framework and of other aspects of the strategy.[1] After its creation, in mid-1998, the ECB proceeded to gradually unveil further details, alongside the process of internal elaboration: key press releases and statements by the ECB President on this subject bear the dates of October 13, December 1, December 22, 1998.[2]
The ECB strategy is, just like the sections of the EU Treaty that deal with monetary policy, the result of a collective intellectual effort, combining many diverse experiences and influences into an overall consistent set. Looking for its antecedents, at least three sources of influence come to mind. First, the strategy reflects, and contributes to promote, the fundamental principles that have guided the process of European economic integration. Second, the strategy clearly bears the mark of recent monetary and economic history and the policy experience of the last decades, in particular the high levels of inflation recorded since the late sixties. Thirdly, the strategy also draws intellectual inspiration from the developments of economic theory in the same period, which in turn are closely connected with that economic history. The rest of the paper will deal mostly with the latter aspect, while presenting the ECB’s monetary policy strategy. It is thus perhaps not pointless to make a brief reference here to the firs two.
From the spirit of the European integration, the ECB monetary policy strategy embodies the notion of one money as a component of a single market—for goods, labour, capital—operating under open and free competition. The link is most evident if we consider the strategy in a broad sense, to include the operational framework of monetary policy and the architecture of the payment system. Many aspects of this overall framework are intended to preserve or enhance the efficiency of the area-wide money and financial market. A few examples: the structure of the TARGET system is designed to facilitate that uniform monetary conditions prevail in the euro area. This is a requirement equally essential for monetary policy as it is for facilitating a level playing field in the single financial market. All key features of the payment system and of the eligible collateral reflect a constant attention to avoiding market segmentations and promoting a high degree of capital mobility in the area. More broadly, all monetary policy instruments are intended to operate indirectly, in a market friendly way. The overall result is at least as consistent with free and competitive markets as the overall framework formerly used by any participating central bank. Moreover, in accordance with the principle of subsidiarity, all operational tasks in the conduct of monetary policy are, wherever possible, delegated to National Central Banks (NCBs).
An even stronger link exists between the ECB strategy and our recent economic and monetary history. The birth of the ECB coincides, not by chance, with the end of a 30-year period of global monetary instability characterised by high inflation. The “era of instability” started with excessive expansion of nominal demand in the US in the sixties, associated with the Vietnam war build-up and government spending in general. From 1968 until the final break up in 1973 the Bretton Woods System was clearly under strain. The impact on inflation was exacerbated by the first oil shock,[3] which occurred against the background of an already overheated aggregate demand. In the subsequent propagation mechanism, a prominent role was played by domestic factors, notably, the structural characteristics of goods and labour markets and the stance of monetary and fiscal policies. The outcome took the forms of economic recession, high inflation and unemployment, currency instability and misalignments, persistent public deficits, high and volatile interest rates. Europe still bears in its high level of unemployment a painful mark of that period.[4] Through this phase, the old monetary order, built on fixed exchange rates and anchored to gold via the dollar, was transformed into a multipolar system of purely fiat monies, where the credibility of central banks in the maintenance of price stability is the only anchor. It thus seems natural that the ECB strategy was designed in such a way to incorporate all elements that, in light of this experience, could contribute to preserve the newly regained monetary stability.
The ECB strategy includes elements drawn from the strategies of the most successful central banks. First, and most fundamentally, the commitment to price stability as a primary policy goal. Second, the emphasis on monetary aggregates, that reflects the role that quantitative targets played in curbing inflation both in the US and Europe. Third, an awareness of the potential for instability in money demand. That suggests a role for money as a reference value rather than a target. Finally, the role assigned to a transparent, broadly based assessment of the outlook for, and the risks to, price stability, an element that has recently become central to the inflation targeting strategies adopted by some central banks. In the ECB strategy, these elements coexist and are intended to operate synergetically, in a flexible and forward looking manner.
The last, but not least important, reference point in the design of the strategy is represented by the macroeconomic and monetary literature, and especially the advances of the last three decades. These advances were closely related to the aforementioned period of monetary instability and can be seen as attempts to find ways to overcome the inflationary phase and to build the monetary policy credibility which is necessary to achieve a more orderly monetary system. Specifically, we refer to: in the earlier years, rational expectations, the critique of the inflation-unemployment trade-off, the analyses of the costs of inflation, the time inconsistency literature, the debate on rules vs. discretion; more recently, the role assigned to institutional design with a view to enhancing central bank independence, the theory and practice of inflation targeting, the literature on monetary policy rules and on the conduct of policy under uncertainty. In the ECB monetary policy strategy, the elements produced by these debates are purposefully reflected and summarised, as will be discussed in the remainder of the paper.
Before starting our review of the analytical underpinnings of the ECB strategy, a caveat is in order: we have deliberately chosen not to discuss here the relationship between monetary policy and financial stability. This important question has attracted considerable attention in recent times, often from critics of the EU Treaty and of the strategy itself.[5] However, given that the focus of this paper is mainly on the links between the ECB strategy and the macro-monetary literature, a thorough consideration of the financial stability issues would have brought us considerably far from our line of argument. More importantly, contrary to the views recently expressed by some observers, we are convinced that the “monetary framework” we discuss here—taken to include, again, the operational side—in no way constrains the “financial stability framework” of the euro area, or its future evolution. There are four key elements in that framework: the information exchange between national supervisory agencies and the ECB; the effectiveness of the emergency liquidity-providing instruments; the cross-country sharing of the related costs; the international (i.e., extra euro area) dimension of supervisory co-ordination. The single monetary policy has no implications for any of these elements. It does not enhance, nor prevents, the effective flow of supervisory information in the system. It allows for a multiplicity of instruments to be used to assist illiquid financial institutions. It imposes no constraint on cost sharing. Finally, it has no implications whatever for cross-border supervisory co-ordination.
The paper is organised as follows. In section 2, we discuss reasons for adopting a new and original strategy. Each following section covers one building block of the overall framework for the stability-oriented monetary policy strategy. Section 3 deals with the definition of price stability, that is crucial for a precise understanding of the final goal of monetary policy. Section 4 describes the role of money in the strategy. Section 5 presents the broadly based assessment of the outlook for price developments and risks to price stability. Section 6 briefly presents the operational framework and section 7 concludes with a concise summary of money market developments during the first month of operation of the single monetary policy.
2 Why a new strategy
As a key component of communication policy, the explanation of the monetary policy strategy is, for every central bank, an ongoing process. New elements are occasionally added, which modify, at the margin, the existing set of public knowledge about the central bank framework. The recent monetary history shows relatively few occasions where central banks have felt the need to announce, at one single point in time, radical changes in their strategies, to quickly affect market expectations or, more often in recent times, to adjust to changes in the institutional position of the central bank itself. Examples are the change of operational targets by the Fed in October 1979 or the approach taken by the Bank of England and other central banks adopting inflation targeting.
The announcement of the strategy of the ECB clearly represents another example of these relatively infrequent changes decided by central banks. As such, however, it differs markedly from other ones previously occurred in two key respects: the circumstances of the change and its intrinsic nature.
The circumstances—that is the external conditions prevailing when the change takes place—are much more favourable than the ones faced by other central banks in the recent past. While the latter were sometimes “forced” to modify their monetary policy strategy in order to curb rising inflation expectation, for example after the abandonment of an exchange rate targeting regime, the ECB has been established in a period of current and expected price stability. Consequently, the ECB finds itself in a position in which there is no urgency to give a signal of a renewed anti-inflationary determination with respect to the behaviour of the participating NCBs. On the contrary, the ECB is quite content to provide a signal of continuity with respect to the past, in order to inherit the anti-inflationary credibility earned by the participating NCB with the best track record. Thus, there is no need to underline the adoption of the new strategy through a communication device suitable for financial markets audiences and for the general public. The discussion of policy decisions and the analysis of current macroeconomic conditions can continue to take place in official publications, such as periodic Bulletins, that have traditionally been used by central banks to these ends.
This decision is in contrast with that taken by other central banks that have recently changed strategy. These banks have felt the need to distance themselves from the past and, consequently, to mark the change of the strategy with the creation of new communication means: an example are the so-called inflation reports. Since this decision was, in many instances, accompanied by a renewed emphasis on transparency, it has been argued that the inflation report constitutes in itself a means to enhance transparency. However, no economic reason appears to be involved in the choice of the name of the publication in which the central bank explains its policy choices. Hence, we would argue that the emphasis often put in the academic literature on the need to publish a separate report on inflation is misplaced.