Yves Mersch: Monetary policy-making in the euro area
Speech by Mr Yves Mersch, Governor of the Central Bank of Luxembourg, on the occasion of the
Annual Meetings of the ACIIA (Association of Certified International Investment Analysts) and the
EFFAS (the European Federation of Financial Analysts Societies), Luxembourg, 28 June 2006.
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Ladies and Gentlemen,
It is a pleasure for me to be here again today and to address such a distinguished audience of highly
qualified professionals and specialists from the financial sector. Your work in developing financial skills
and promoting professionalism and knowledge is commendable. It is also important for this financial
centre.
The topic I have been asked to cover today is extremely broad. I will start by briefly outlining the
institutional framework, strategy and objective of the Eurosystem. Subsequently, I will address what
seems to be a permanent feature of central banking, and perhaps also of human destiny, namely the
need to take decisions in an uncertain environment and based on imperfect knowledge.
1. Essential features of the Eurosystem's monetary policy
•
Central Bank independence
Crucial to this novel framework are the concepts of central bank independence and the
assignment of a clear mandate to the ECB and the Eurosystem. The movement towards
central bank independence is not limited to the euro area. Based on the experience gained
during the inflation-prone period ranging from approximately the mid-1960s to the
mid1980s, a broad consensus emerged that price stability is the responsibility of the central
bank, at least over the medium term, and that fighting inflation is best ensured by an
independent central bank.
•
The Eurosystem's mandate
The Treaty is equally unequivocal when it comes to the ESCB's primary objective, which,
according to article 105, "...is to maintain price stability". It is only "Without prejudice to the
objective of price stability," that "...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."
Summarising, one can therefore state that the independence of the ECB and the NCBs of
the Eurosystem is particularly strong, as it is enshrined in an EU Treaty and therefore far
more complex to modify than a national act of legislation. Similarly, the primary objective of
the Eurosystem is clearly defined. By contrast, certain other central banks have to meet
several objectives, including e.g. employment.
• The Eurosystem's definition of price stability
The Treaty did not define the concept of price stability and in October 1998, the Governing
Council of the ECB announced the following definition:
"Price stability shall be defined as a year-on-year increase in the HICP for the euro area of
below 2%. Price stability is to be maintained over the medium term."
Every word in this definition is important and I would like to highlight the following points:
- The ECB is one of the few central banks to have quantified its inflation objective.
This contributes to anchoring expectations and makes it easier for the public at
large and for financial markets to judge how the Eurosystem is delivering on its
mandate.
- By setting the upper bound for inflation above zero, the ECB takes into account the
possibility of measured inflation overstating true inflation as a result of small but
positive measurement errors. Such errors may, e.g., arise if prices are not
adequately adjusted for changes in quality. Moreover, a zero inflation rate for the
Eurosystem as a whole would necessarily entail that if some euro area Member
States experienced positive inflation rates, this would have to be compensated by
deflation in other euro area Member States.
- Headline inflation, rather than some core inflation concept is taken into
consideration. Oil prices are high largely due to demand effects from countries
which at the same moment provide the euro area with low import prices and
pressure on wages. Eliminating therefore oil from the price index would risk
creating a downward pressure to the true inflationary pressures.
- Headline inflation is measured by means of an index of consumer prices whose
statistical methodology has been harmonised for all EU Member States. This
Harmonised Index of Consumer Prices, or HICP, is compiled by Eurostat.
- This definition makes clear that in implementing its monetary policy, the Governing
Council does not look at individual countries, but at the euro area as a whole.
- Finally, in order to avoid a hectic and possibly pro-cyclical monetary policy, the
ECB explicitly states that price stability has to be maintained over the medium
term. This reflects the fact that monetary policy affects price developments with
significant and variable time lags and that an economy is continuously subject to
large unforeseeable shocks.
In May 2003, after more than four years of conducting monetary policy, the ECB undertook a
thorough evaluation of its monetary policy strategy and, while confirming its initial price
definition, it clarified its position by stating that "...it will aim to maintain inflation rates close to
2% over the medium term ". The goal is thus to keep inflation rates below, but close to 2%,
emphasising that the ECB wishes to provide a sufficient safety margin against the risks of
deflation.
•
The Eurosystem's two-pillar strategy
The Eurosystem analyses the risks to price stability from two analytical perspectives,
economic analysis and monetary analysis, which together constitute its two-pillar strategy.
The main purpose of this two-pillar strategy is to analyse all relevant information and to
cross-check it from two different analytical points of view.
The economic analysis focuses on real activity and the interplay of supply and demand in the
goods, services and factor markets in order to assess the short to medium-term
determinants of price developments.
The monetary analysis focuses on a longer-term horizon, analysing the long-run link
between money and prices.
With these two analyses, the ECB covers the entire chronological spectrum. The monetary
analysis mainly serves as a means of cross-checking, from a medium to long-term
perspective, the short to medium-term indications from the economic analysis.
• Communication, transparency and accountability
The move towards central bank independence has been accompanied by great progress in
the areas of accountability and independence.
The concept of accountability refers to the legal and political obligation of an independent
central bank to justify and explain its decisions to its constituents, finance Ministers, analysts
and academics as well as to the citizens and their elected representatives.
is more of an economic concept and can be defined as an environment in
Transparency
which the central bank provides in an open, clear and timely manner all relevant information
on its mandate, strategy, assessments and policy decisions as well as its procedures both to
the general public and to markets.
We have seen earlier that the Treaty gave a clear mandate to the ECB: to ensure price
stability. Moreover, the Governing Council of the ECB quantified this primary objective and
stated that it will aim to maintain inflation rates below but close to 2% over the medium term
and explained in great detail its two-pillar strategy. Overall the ECB uses a combination of
rules and judgment and its approach is one of constrained discretion.
2. Imperfect knowledge and the conduct of monetary policy
Since the introduction of the euro, inflation rates averaged slightly more than 2% in the euro area and
this in a complex environment, characterised by a series of external and temporary shocks such as the
bursting of the dotcom bubble, terrorist attacks, geopolitical tensions and a continuous increase in the
prices of commodities, notably oil. However, since the introduction of the euro, inflation expectations -
notably average long term expectations as measured for example by Consensus Economic Forecast
or the Survey of Professional Forecasters- are firmly anchored at a level consistent with the
Eurosystem's quantified inflation objective of below but close to 2%. Break-even inflation rates,
defined as the yield differential between conventional nominal bonds and inflation-linked bonds, are
slightly above 2% but this may reflect risk premia for the latter type of bonds due to liquidity constraints
or technical factors. This anchoring of expectations at these levels is of vital importance, as it confirms
the credibility of the Eurosystem and its forward-looking, medium term orientation and as expectations
play an important role in shaping economic dynamics.
Taking decisions based under conditions of uncertainty is an unavoidable element, and perhaps even
a characteristic ingredient, of central banking. This uncertainty stems from two elements.
- First, economic knowledge is imperfect. There is no model, however sophisticated, which
can faithfully replicate the exact functioning of the economy. More particularly, uncertainty
clouds our knowledge of the transmission mechanism from interest rates to prices. This
transmission is characterised by long, variable and uncertain lags. Our imperfect knowledge
of the economy and the monetary transmission mechanism is further compounded by the
delays with which economic and financial data become available, and sometimes also by the
quality of these data, and this despite all efforts and progress made in the area of statistics.
- Second, the future is uncertain. Economic developments are continuously influenced by a
large variety of demand and supply shocks. Fiscal policies may turn out different than
expected. Exchange rates may move by more than warranted by underlying fundamentals.
Commodity prices not only depend on supply and demand but also on geopolitical tensions.
It is therefore a permanent challenge for the central bank to extract relevant information from
diffuse data and events and to determine the appropriate path of monetary policy.
Since the introduction of the euro, the Eurosystem systematically analysed and cross-checked
economic and monetary information under its two-pillar strategy, in the context of its forward-looking,
medium-term framework.
•
In 2001 the economic outlook deteriorated rapidly and medium-term inflation expectations
were in line with the Eurosystem's objective. The rapid expansion of M3 during the 2001-03
period was not considered a threat to price stability, as it reflected a portfolio shift to less
risky assets during a period of uncertainty. Consequently, it was possible to lower interest
rates during this period.
• By contrast, in December 2005, after a lengthy period of unchanged interest rates, the
Governing Council of the ECB decided to raise the rate on the main refinancing operation.
The re-acceleration of real GDP growth in the first months of 2006 materialised, confirming
the Eurosystem's views that economic growth is broadening and becoming more sustained.
The June 2006 Eurosystem staff projections foresee growth in the 1.8-2.4% range in 2006
and between 1.3 and 2.3% in 2007. Risks to price stability are signalled by the 2 pillars of the
monetary policy strategy. The first pillar, which indicates short-term to medium-term risks to
price stability, shows inflation above 2% for that period. The monetary pillar, which signals
medium-term to long-term risks to price stability, also indicates heightened risks to price
stability as reported in the latest Monthly Bulletin. This is the case even if one would filter out
a certain amount of noise in the statistics such as e.g. portfolio shifts. In this vein one could
also discuss whether there is a structural break in trend velocity developments in the euro
zone or whether the statistics are influenced by institutional product or regulatory
developments. However, even if these elements are discarded, we would still find a large
monetary overhang in the euro zone with heightened risks for unloading into transactions
balances and therefore into inflationary pressures.
As President Trichet1 remarked during a lecture at the Banco de España in early June, other central
banks, such as the US Federal Reserve system, changed interest rates more frequently and by larger
amounts during the 1999-2006 period than the ECB. This is very clear on this slide, which shows the
MRO rates in blue and the target Federal funds rate in red. While phases of interest rate hikes and
decreases broadly coincide on both sides of the Atlantic, the Eurosystem modified interest rates 18
times from 1999 until today, while Federal Reserve changes were about twice as frequent (35).
MRO and Federal Funds Target- January 1999 - June 2006
7,00%
6,00%
5,00%
4,00%
3,00%
2,00%
1,00%
0,00%
05/01/1999 05/04/1999 05/07/1999 05/10/1999 05/01/2000 05/04/2000 05/07/2000 05/10/2000 05/01/2001 05/04/2001 05/07/2001 05/10/2001 05/01/2002 05/04/2002 05/07/2002 05/10/2002 05/01/2003 05/04/2003 05/07/2003 05/10/2003 05/01/2004 05/04/2004 05/07/2004 05/10/2004 05/01/2005 05/04/2005 05/07/2005 05/10/2005 05/01/2006 05/04/2006
Does this mean that the Eurosystem is passive, or at least relatively more passive than other central
banks?
In the opinion of the Eurosystem, activism cannot be quantified by the frequency or size of changes in
interest rates. Activism refers to a strategy, not to policy implementation or changes in a policy
instrument. A central bank should be as active as it needs to be in order to fulfil its mandate. What
matters, is that the Eurosystem is permanently pursuing its primary objective and that it is constantly
on alert to risks to price stability.
Moreover, how often and by how much a central bank should adjust interest rates in order to maintain
price stability depends also on the structure of an economy and the type and frequency of shocks it is
subject to. Several remarks can be made here.
- The euro area, compared with the USA, is more rigid and a central bank operating in a
relatively rigid economy is able to deliver the same degree of monetary accommodation by
adjusting its interest rate in more moderate steps than in a more flexible economy.
- The type of shocks affects the optimal reaction by the central bank. In case of a demand
shock, forecasted inflation and output move in the same direction, leading the central bank to
adjust rates more often and to a greater extent. By contrast, supply shocks cause more
substantial transitory increases in inflation, possibly followed by second round effects. It is
advisable for the central bank to adjust its policy instrument only to the extent needed to
neutralise the anticipated more permanent effects of the shock on inflation over the following
months or quarters. As, relative to the USA, the euro area seems to be exposed to demand
shocks of smaller magnitude but to be hit more frequently by supply shocks2, less frequent
and less forceful changes in the policy instrument seemed appropriate.
- In addition, important structural elements of an economy, that influence the relation between
inflation and the shocks to which an economy is subject are price flexibility and the anchoring
of price setting. In the euro area prices are less flexible than in the US3. Retailers reprice
their products every 13 months, compared to 6.7 months in the US. Stickier prices imply that
adjustments to external shocks operate more through changes in output, income and
employment than would be the case in a situation where prices are more flexible. They also
imply an increased persistence of inflation. Nevertheless, despite these rigidities, inflationary
shocks dissipate quickly in the euro area. An ECB study4 shows that this paradox is
explained by the fact that the impact of the ECB's inflation objective on the evolution of
inflation outweighs the influence of past shocks and thus at least partly compensates for the
added inertia resulting from a more rigid economic structure.
In other words, when the economy adopts the central bank's objective, the inflation process becomes
less persistent and more forward-looking. All economic agents anticipate that the central bank will
eventually bring inflation back to its pre-shock level and treat past inflationary shocks as transitory and
inconsequential for the future. In an economy like the one of the euro area, where expectations are
well-anchored, monetary policy can be more patient and focused on the medium-term when
confronting a cost-push shock. The reverse side of the coin is that deviations of expectations from the
inflation objective could prove more costly to correct at a later stage and therefore require a stronger
policy response in terms of timing and or size.
Expectations that inflation will not diverge from its anchor afford some short-term flexibility to respond
to economic disturbances. Establishing and maintaining its credibility is therefore of paramount
importance for the central bank and requires commitment to a systematic strategy. The fact that the
Eurosystem is particularly transparent by having a clearly defined primary objective, a quantified
inflation target, a well-documented two-pillar strategy and has implemented its monetary policy in a
consistent manner since 1999 explains this success in anchoring inflationary expectations, even in
turbulent times.
Success in anchoring inflation expectations and facilitating the task of the public and the financial
markets in predicting future monetary policy decisions is not, however, tantamount to pre-committing
the Eurosystem to a certain policy path. Vigilance for the Eurosystem requires keeping all options
open, including a quick change in policy if warranted by new information. There is no pattern of
historical monetary policy decisions that could simply be repeated or mechanically extrapolated into
the future.
The ECB will continue to check carefully all available information concerning risks to price stability
under both the economic and the monetary analysis of its two-pillar strategy in order to avoid acting
belatedly and to anchor inflation expectations.
Ladies and Gentlemen, I thank you for your attention and stand ready to reply to your questions.