Jean-Claude Trichet: Monetary policy and private expectations
Text of the Zolotas Lecture given by Mr Jean-Claude Trichet, President of the European Central Bank,
at the Bank of Greece, Athens, 25 February 2005.
* * *
Ladies and Gentlemen,
Xenophon Zolotas, long-serving Governor of the Bank of Greece and Prime Minister of his country,
once said, with supreme synthesis, that "Political magic has always been anti-economic." In history,
monetary policy has sometimes reverted to magic in an attempt to eschew economic reality. The
outcomes of such attempts are well-known and their magic has proven short-lived.
A decisive change in direction started, in a large part of the industrial world, 30 years ago as a result of
a deeper understanding of the role of expectations in shaping economic behaviour. Today, solid and
credible institutions have been put in place in many countries and have earned a respectable
reputation of good policy management. Decades of experience accumulated from institutional
evolution and advances in economic thinking have provided us with guidelines for designing credible
institutions that are based on sound economic principles.
Clearly, the open-ended nature of economic progress confronts central banks with new and
unprecedented challenges and will no doubt keep central banks occupied in the years to come with
the issue of how to maintain expectations of low inflation and preserve credibility. The creation of the
Euro is an example of such a challenge.
These will be my themes today. Governor and Prime Minister Zolotas was an early advocate of a
monetary regime in which the formation of prices is fully protected from the influence of short-term
considerations. So, some thoughts on expectations and their subtle interactions with institutions and
policies might be an appropriate tribute to his memory.
Central banks' long quest for macroeconomic stability
30 years ago the formation of expectations moved from a peripheral area of theoretical enquiry into
the very core of macroeconomic thinking. Today, the economics of expectations and macroeconomics
itself are largely coextensive. The trigger of this transformation was, as is well known, the rational
expectations revolution, which started with the pioneering work by Robert Lucas (1972, 1973) and
Thomas Sargent and Neil Wallace (1975).1
The upshot of the Rational Expectations hypothesis is that - at least in a world in which information is
largely publicly available and speedily disseminated - individuals should not make predictable errors
when formulating conjectures about their future. This does not imply that individuals will invariably
forecast accurately if random movements are inevitable. But guesses about the future must be correct
on average if individuals are to remain satisfied with the mechanism by which their anticipations are
formulated. When agents diagnose systematic errors, they have an incentive to amend the basis of
their forecasts. Expectations are thus the outcome of a decision process and this process responds
and adapts to changing circumstances, in particular to possible changes in the behaviour of monetary
authorities.
Understanding expectations formation as a process underscores the strategic interdependence that
exists between expectations formation and economic institutions. Recognition of this interdependence
by central bankers and legislators profoundly changed the way in which macroeconomic authorities
view the nature of policymaking. Central bankers came to hold the view that monetary policy is not a
sequence of isolated policy actions. If agents, when forming their expectations, seek to capture the
general pattern of monetary policy, then the relevant problem to solve for central banks centres not
only on the size and the timing of a given interest rate move in response to a particular state of the
economy, but also and overall it relates to the strategy for repeatedly adjusting the policy instrument in
response to the state of the economy, whatever this might be.
So, monetary policymakers and, gradually, legislators came to recognise that the meaningful set of
choices that societies face relates to alternative monetary policy regimes, that is a clear specification
of the central bank objective and of its strategy in managing economic events. The notion that
monetary regimes are very powerful in shaping public expectations had received dramatic evidence
when the old monetary policy order, the Bretton Woods arrangements, foundered. In those
circumstances, private sectors in a large portion of the industrial world were left for years in the dark
about the "true" objectives of monetary policy, and about the determination with which central banks
were prepared to pursue it.
A new monetary order could not be established unless it tackled the problem of the mandate and of
the strategy squarely. Building on a time-tested tradition of prudent central banking - which after all
had survived in Germany, in Switzerland and in a number of other economies - a number of authors
laid out the essence of the mandate problem.2 It appeared that the anchoring of inflation and inflation
expectations is primarily a matter of delegating monetary policy to an independent central bank with
one overriding long-term objective: the maintenance of price stability.
As the collective reflections progressed, this notion was sharpened to a considerable extent.
Throughout the 1990s many central bank charters were stipulated with institutional independence and
the primary mandate of monetary stability. The 1998 decision of the ECB Governing Council to
characterise its understanding of price stability in quantitative terms can be traced to a shared
perception that such stipulations could help focus inflation expectations more tightly. Recent empirical
work indeed offers support to that perception. Monetary institutions that have been more explicit in
delineating what they mean - in numerical terms - by "price stability" have been more successful in
promoting lower inflation and lower output variability.3
However, an appropriate mandate is a necessary but not a sufficient condition for lasting
macroeconomic stability. Important sources of instability in inflation expectations could still arise if the
central bank - even one endowed with a clear mandate to preserve price stability - is not sufficiently
clear as regards its own monetary policy concept and strategy. The decision taken by the Governing
Council of the ECB in October 1998 to spell out the contours of its monetary policy strategy attests to
the extent to which the notion of a monetary policy strategy has become operationally meaningful.
To secure stability, a central bank has to act forcefully and pre-emptively to nascent signs of inflation
or deflation.4
* * *
To be sure, a world in which central banks' intended policy measures and market views are perfectly
aligned is likely to appear only in textbook analysis. However, central banks' preoccupation with
private expectations has established a new climate of mutual understanding with economic agents
and the public at large. Central banks have stepped up the number of institutional fora and occasional
gatherings at which they document their strategies and carefully explain their actions to broad
audiences. In 1998, when designing its mode of communication on monetary policy, the ECB chose to
be in the vanguard of this new practice.
As a consequence, the leverage of central bank pronouncements and actions over private economic
behaviour has considerably strengthened. One of the central banks' key tasks has become today
guiding the markets and stabilising sentiment.
These reflections might inspire two questions. The first is: how did the new European monetary regime
successfully impose itself in the broad perceptions of the public? And the second is: to which kind of
new challenges and new battles should we be prepared? Let me try to respond to these two
questions.
The transition to Economic and Monetary Union
How expectations react to a major change in policy regime is still an issue of contention. 20 years ago,
the fathers of the rational expectations revolution espoused an optimistic position: if an institutional
change - even an abrupt one - is sufficiently credible, expectations will focus instantly on the new
equilibrium. Other scholars are more inclined to think that instant refocusing is unlikely. Agents should
be expected to learn gradually about the new regime, and probe and test it with the benefit of time.
The extraordinary episode of the convergence towards Economic and Monetary Union in Europe in
the second half of the 1990s offers a laboratory case for discriminating between these two
hypotheses.
The Maastricht Treaty came into force in November 1993. Its fundamental inspiration was the need to
ensure that participants in EMU are like-minded in their pursuit of stability in economic and monetary
affairs. It vested the European System of Central Banks with a very high degree of independence and
safeguarded it against external interference. The new single monetary authority was to be indisputably
devoted to one overriding objective, the maintenance of price stability in the euro area. In that respect,
the Treaty embodied both the best monetary tradition available in Europe and the essence of the
principles that had been distilled through years of academic reflection.
In addition, convergence criteria were designed to provide countries with yardsticks against which to
measure their progress toward a true culture of stability in the run-up to Monetary Union. But the
interpretation of the entry criteria remained a matter of debate for most of the years that followed the
promulgation of the Treaty. Observers were divided. Some took the position that the Treaty's criteria
were too strict and ambitious, given the initial conditions from which a number of member countries
had to start convergence. Others, from the perspective of the most stable economies in the EU, were
convinced that they granted considerable, in fact excessive, latitude.
This debate between strictness and latitude left a margin of ambiguity, which largely affected the
evolution of expectations prior to 1998. The perception that the criteria might be impossible to meet for
countries too far off the benchmarks produced uncertainty over the number of countries able to
participate in Monetary Union from the outset. On the other hand, the suspicion that the Maastricht
criteria would tolerate a large dispersion of economic performances across countries produced anxiety
that Monetary Union - if it were ever to materialise - could mean convergence to the average, rather
than the best, standards of macroeconomic discipline.
The power of a credible institutional change to bend expectations became evident in late 1996 and
1997. The latter part of 1996 saw a determined drive toward fiscal consolidation in Italy and Spain.
This facilitated in those countries a sharp fall in interest rate premia at long maturities and an easing in
monetary conditions more generally [see Charts 1d and 1a]. In June 1997, the Stability and Growth
Pact was sealed in Amsterdam. It reassured the markets that the adjustment made in public finances
in a large portion of the European Union would be lasting and would survive a country's adoption of
the euro. By the first half of 1997 interest rate differentials had been compressed to levels not seen in
decades. Uncertainty surrounding the breadth of Monetary Union at its starting date thus quickly
disappeared.
But a measure of anxiety remained about the standards that would apply in the new economic and
monetary entity. This source of anxiety came to the surface in summer 1997, when the
intermediate-maturity yields paid by those core countries which had reached complete alignment
started to rise in sync [see Chart 1b and 1c]. The balance of market expectations seemed to be
shifting toward a loose interpretation of the new regime. A conviction that was gaining ground was that
the rapid descent of short-term rates in the converging economies of Italy, Spain and Portugal would
be matched by a gradual increase in the short-term rates of the low-yield economies. The two paths
would meet somewhere half-way.
This instability of market expectations did not go unnoticed in particular in the Central Banks issuing
the currencies that had already converged. Signs of an upswing were still tentative and price strains
were not yet fully in sight in this core currency area. Nevertheless, in October, pre-emptive action took
place to forestall the build-up of an inflationary potential in the delicate phase of transition to monetary
union. This interest rate move was a strong sign of determination. The policy message was reinforced
through a consistent communication campaign which the Central Banks concerned, together with the
European Monetary Institute, launched in the last few months of the year to explain the meaning of
their action. The essence of the message was the following.
The assumption made by some observers and by part of the market literature, according to which the
entry interest rates in the Euro on 1 January 1999 would be some kind of average of the interest rates
of the composing currencies was totally wrong. On the contrary, the very construction of the Euro was
based on total continuity with the most credible national currencies. The concept of the transition was
based upon "benchmarking", namely convergence towards the best performers and not convergence
towards a mean. The modest interest rate increase that took place in a small number of economies
was designed exclusively to preserve monetary stability and inflationary expectations for the
corresponding currencies which were the benchmark for the Euro. The ECB itself, the soon to be born
monetary authority, would be uncompromising in its role as guardian of price stability, in close
continuity with its forebears. It was therefore fully justified that interest rate convergence inside the
future Euro area would take place progressively on the basis of a merge of the different yield curves of
the various currencies with the benchmark yield curve corresponding to the core currencies that had
already converged.
How did markets react to that action? In particular, what was the impact of the October 1997 interest
rate hike on long-term interest rates?
Before I answer that question, it could be instructive to reflect on the way markets typically react to an
interest rate hike. A shift to a tighter policy raises short-term interest rates. Since longer-term rates are
determined in good part as averages of expected future short-term rates, an initial tightening of policy
- not to be immediately reversed - should exercise an upward pull on the yields paid by instruments
with longer maturities. However, the factors determining long-term rates, notably those at the very long
end of the term structure, are mostly associated with the premium to compensate for expected inflation
and for the risk that inflation might vary widely over those horizons. Therefore, if the policy tightening is
perceived as an effective action to restore or preserve conditions of price stability, then a hike in
short-term rates does not necessarily suggest a rise in market rates on instruments with very long
maturities. In fact, by soothing concerns about inflation looking far into the future, a policy hike could
be reflected in a lower inflation premium and a decline in nominal long bond rates.
Indeed, empirical tests find that the sign of the overall response of long rates to a change in policy is
not independent of the credibility rating that markets assign to the monetary regime in which they
operate. With some simplification, two polar regimes have been identified. On the one side, a
full-credibility environment is one in which there is no dispute over the "true" objective of monetary
policy and about the central bank's determination to do all it takes to keep inflation low and steady
around that objective. Markets are not inclined to project an observed inflationary shock far into the
future, as expectations are well-anchored. So, long-term rates are minimally affected by any inflation
shock that might hit the economy in the current period, and by the monetary policy move that
authorities might execute in response to it. Presumably, this is a world in which nominal long-term
bond rates are most unresponsive to changes in policy. A world in which long bonds are regarded as a
conservative type of investment, with stable and dependable real returns.
The opposite happens when inflation expectations are not firmly secured. In circumstances of
incomplete credibility, an inflationary shock is more likely to be extrapolated far into the future,
because inflation itself is more persistent, and because changes in the short-term rate are viewed as
less effective in restraining inflationary pressures. In this regime, a policy tightening comes together
with expectations of higher and more obstinate inflation in the future. So, long-term nominal yields will
tend to move up in the aftermath of an interest rate hike.
A third typology is also conceivable: a situation in which markets perceive a shift from one regime to
the other. Imagine that market participants were to regard a policy move as a signal dissipating all the
ambiguity that might have existed before about the true objectives of monetary policy. Imagine that a
single move in a particular situation were to show the foundations of a new regime, and show it to be
more likely than the past regime to operate according to the rules of a full-credibility monetary
standard. In this situation, one would expect to see an interest rate hike being accompanied by a
decline in long-term rates.5
This brings me back to 1997. The evidence that we gather from that episode is very difficult to
rationalise and highly controvertible, especially because the financial crises in Asia and Russia -
which took place around the same time - might blur the picture as we look back to those times.
Overall, the evidence certainly warrants closer and better scrutiny. But my reading of the episode is
that it is consistent with a shift to a more credible policy regime.
After the announcement of October 1997 and the communication thereafter market rates reacted in a
direction that few could have anticipated. Not only did the remaining spread between the converging
economies and the core countries progressively disappear. Thus, the remaining ambiguity about the
very nature of the convergence process finally dissipated. But many commentators and market
participants - not to mention policymakers - noted that the benchmark yield curve itself was changing
shape in a direction that demonstrated an additional clear break in expectations.6
This is without doubt a remarkable success. Yet, it is not one grounded in magic but based on a
sequence of sound institutional, economic and monetary decisions.
Securing and reinforcing credibility
To sum up my understanding of why we have so impressively succeeded in mastering a smooth
transition to the euro, I will mention six necessary conditions that had to be met and were met. Had
only one of these conditions not been met, the transition would not have been a success. These
conditions are the following:
1. Independence: full guarantee for the independence of the ECB was given by the Treaty and
guaranteed by it;
2. Clarity: clear primary objective of price stability given by the Treaty to the new independent
institution, the ECB;
3. Continuity: choice by the new institution of an arithmetic definition of price stability in the
medium run for the euro area identical to the previous core definition of price stability;
4. Conceptual anchoring: choice by the new institution of the monetary policy concept based on
a two pillar approach, with not only an economic pillar, but also a monetary pillar - helping, in
particular, to anchor the long term side of the inflation expectations.
5. Transparency: decision to make public, from the very beginning, the arithmetic definition of
price stability, the monetary policy strategy that would be applied by the ECB, as well as
giving in real time the monthly diagnosis of the Governing Council and the reasons of the
decisions taken on interest rates on the occasion of the press conferences following the
meeting of the Governing Council;
5 That the response of long-term rates to a change in policy depends on the credibility of the monetary policy regime is
conjectured in Marvin Goodfriend (1998), "Using the term structure of interest rates for monetary policy", Federal Reserve
Bank of Richmond Economic Quarterly, Vol. 84/3. Empirical confirmation of that conjecture is provided in Jagjit Chadha and
Joe Ganley (1998), "Monetary policy, inflation persistence and the term structure of interest rates: Estimates for the United
Kingdom, Germany and the United States" in Ignazio Angeloni and Riccardo Rovelli (eds.), "Monetary policy and the term
structure of interest rates", London: McMillan. Further support is found in Tore Ellingsen and Ulf Söderström (2001),
"Monetary policy and market interest rates", American Economic Review, Vol. 91(5), pp. 1594-1607.
6 One possible interpretation is that markets were growing more convinced that the new regime would embody an even larger
amount of credibility than they had attributed to the national central banks with the best monetary record in Europe. In this
respect, it should also be noted that in January 1997 the Deutsche Bundesbank had revised its "price norm," i.e. the
"unavoidable inflation rate" that was used for the calculation of the monetary target, from 2% to a range between 11⁄2 and
2%, whilst the Banque de France, for instance, was referring to less than 2 per cent as its definition of price stability. It is a
remarkable achievement that the definition of price stability as "less than 2 per cent" was shipped intact to the whole union.
This remarkable transition might have been helped by the fact that international financial markets were internalising the
dawn of a new era of low inflation and high credibility across a wide range of industrial countries in precisely that very same
period. This interpretation receives some support from the fact that US long-term bond rates and the implied forward
short-term rates were declining as well.
BIS Review 12/2005
6. Fiscal consistency: guarantees for sound fiscal policies enshrined in the Treaty in the form of
the Maastricht criteria and appropriate implementation of these principles by the Stability and
Growth Pact regulations.
It is my conviction that each and every of these six conditions were and are necessary. My personal
conjecture is that the 6 together have proved to be a sufficient set of conditions to permit the full
success of the transition. That being said, it remains absolutely remarkable that the real progress
made in reducing inflation expectations in the core currency area in the few months leading up to the
final decision over EMU participation in May 1998 was fully preserved at the moment of the transition
and afterwards. I would suggest that economic research continue to work actively on the question of
the optimality of the transition. After all, the setting up of the euro is historically the most important
monetary reform of all times and this transition contains a wealth of information and lessons that have
not yet been fully explored.
Anchoring solidly inflation expectations at a low level at the birth of the currency was a success. But
credibility is never gained once and for all. It has to be permanently preserved and enhanced. That is
the reason why for central bankers vigilance is always of the essence. To exert vigilance effectively
and efficiently the anchoring and monitoring of inflation expectations, particularly on the long end of
the time horizon, are both very important. Let me elaborate a little bit on that.
We know that excess volatility of expectations can be signalled by abnormal developments in
monetary and credit conditions. This is likely to be the case when unsustainable surges in asset prices
- propelled by flights of optimism, and sustained by unanchored expectations - are built on conditions
of excess liquidity. The drifting of expectations away from the central bank objective toward chronic
inflation or debilitating deflation has historically very often been associated with monetary imbalances
foreshadowing and facilitating the process. So, broadening the scope of macroeconomic analysis to
include a systematic monitoring of monetary and credit developments can offer a strong failsafe
mechanism against the risk that, with inflationary pressures apparently at bay, the central bank might
be encouraged to favour or tolerate boom-bust developments of credit and liquidity. The central bank
committing to monitoring monetary developments and referring to a given path of long-run monetary
growth - compatible with price stability and with steady-state growth for the real economy - has a
powerful tool for anchoring long-term inflation expectations. The possibility that these expectations
might not find a focal point, or might settle on a point inconsistent with the central-bank declared
objective will be minimised.7
Monitoring a wide range of expectation indicators
The ECB also monitors a range of indicators that provide more direct evidence on inflationary
expectations in the euro area.
It seems obvious that the way private agents form their anticipations will most likely differ in important
dimensions across different types of agents. A central bank should thus not rely on a single indicator
when monitoring these expectations but rather take a comprehensive and pragmatic approach that
balances the information provided by various sources.8 From this perspective, a single measure of
expected inflation - one constructed on the basis of the central bank's own internal analysis - might
be particularly misleading.
By their very nature, inflation expectations are not directly observable. However, there exist two main
ways to construct measures of inflation expectations. A direct way consists in asking people about
their expectations of future inflation. A more indirect way is to extract the information revealed by
observable financial data. The ECB makes constant use of both measures.
Direct measures of inflation expectations in the euro area are provided by a number of surveys. These
are regularly analysed in the ECB's Monthly Bulletin. One comes from the ECB Survey of Professional
Forecasters. This is a quarterly survey conducted by the ECB. It asks experts affiliated with financial or
non-financial institutions based within the European Union to forecast euro area inflation up to five
years ahead. Importantly, survey respondents also provide a quantitative assessment of the
uncertainty surrounding their forecasts in the form of ranges. The dispersion and asymmetry around
the mean provide useful information about shifts in inflation expectations that might be in the pipeline.
Another measure of inflation expectations is provided by the survey conducted by Consensus
Economics, a private firm. It asks private sector economists to give their short-term and long-term
inflation expectations. A further source of information is the European Commission's monthly Business
and Consumer Survey. It asks a large number of manufacturing firms about their selling price
expectations and consumers about their inflation expectations. This survey has some limitations
however. It provides qualitative information only.9 In addition, it is available only for a very short time
period ahead (12 months). Despite these limitations, detected changes in the direction towards which
firms' and consumers' expectations are heading may provide useful information.
The information that we gather from these diverse sources at present is consistent with a picture of
stability. The mean point estimate for HICP inflation indicated by the respondents to the ECB survey in
the 4th quarter of 2004 is close to and below 2%, in line with the ECB's quantitative definition of price
stability. This holds true for the expectations relating to the years 2005 and 2006, but also for the
five-year period up to 2009. The uncertainty surrounding these forecasts is fairly small, implying that
survey respondents assign only small probability to inflation outcomes outside the main scenario.
It has to be taken into account that a number of these measures - particularly those stemming from
the "break-even" inflation rates extracted from the indexed bonds - remain imperfect indicators of
inflation expectations, as several premia, most importantly an "inflation risk premium" but also a
"liquidity premium," are potentially embodied in their calculation. Changes in break-even inflation rates
over time could therefore reflect changes in the level of expected inflation, changes in perceived
uncertainty about future inflation, changes in the perception of the liquidity risk, or a combination of the
three. In addition, their information content could be temporarily distorted by technical market or
institutional factors and should therefore be interpreted with caution.
During the first half of 2004 break-even inflation rates for the euro area displayed a slight upward
movement, unlike the survey evidence reviewed before. In recent months this movement has been
partially reversed. While the different behaviour of break-even inflation rates and survey expectations
may reflect a time variation in the risk premium contained in nominal bond yields, due for instance to
uncertainties associated with the recent increases in energy price, these recent developments have
not gone unnoticed at the ECB.10 Whether the movements in the break-even inflation rates, which are
fairly small in absolute terms, reflect or not underlying changes of various risks premia is not yet clear.
We are looking at it very carefully.
Concluding remarks
A renewed fellowship between the academic community, the markets and central banks - so
uncharacteristic if viewed from the angle of the dissonances of the ancient past - has been beneficial
to the design of appropriate institutions and monetary strategies that allow central banks to effectively
deliver the results society ultimately needs: stability and predictability in monetary matters.
What matters most is that inflation, thanks to these conceptual advances, has become a
mean-reverting process, making occasional deviations from price stability a temporary event. We are
living in a world where the possibility of solidly anchoring long term inflation expectations and
eliminating the correlation between these long-term inflation expectations and actual inflation has
become reality.
The ECB and the Eurosystem are proud to have been at the forefront of these advances. Not only
have they fully preserved the solid anchoring of inflation expectations all along the past six years, but
they have proved that it was possible to ship to the new currency, from day one of its existence, the
best anchoring that was available in Europe, which was a major contribution for sustainable growth
and job creation. I am fully conscious of the exceptionally high level of confidence and trust the private
sector is bestowing on us. This trust is well placed. Economic agents, market participants and our
fellow citizens of Europe can be assured that we are determined to remain worth it in all the years to
come.
Charts
Chart 1. Interest rates in Germany, France, Spain, Italy and the Netherlands (1991-2005)
Annual percent
Chart 1a: 3-month interest rates Chart 1b: 2-year interest rates
Chart 1c: 5-year interest rates Chart 1d: 10-year interest rates
Chart 2. German implied forward overnight interest rates ten years ahead
Sources: Consensus Economics, Deutsche Bundesbank and ECB calculations. Last observation: January 2005.
Note: The implied forward overnight rate is the nominal rate expected to prevail in 10 years time. It is constructed on the
assumption that the terminal value of a portfolio invested in t-period bond is equal to that of the portfolio continually reinvested at
the overnight interest rate.