Otmar Issing: Monetary policy in a new environment
Speech by Professor Otmar Issing, Member of the Executive Board of the European Central Bank, at
the Joint Bundesbank/BIS conference on "Recent developments in financial systems and the
challenges for economic policy", held in Frankfurt, 28-29 September 2000.
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1. The new monetary policy environment - challenges for the ECB
On 1 January 1999 the European Central Bank (ECB) assumed responsibility for monetary policy in
the euro area - the second largest economic area in the world after the United States. Overnight, the
euro became the currency of almost 300 million people. The transfer of responsibility for monetary
policy from eleven national central banks - many of them characterised by long histories and
impressive track records - to a new supranational institution was met with a great deal of scepticism.
Sceptics noted the historically unique situation created by the asymmetry between, on the one hand, a
single central bank and, on the other, eleven - and, with the participation of Greece from January 2001,
soon to be twelve - national governments.
The adoption of the single currency marked a watershed in the history of European integration. It
constituted a fitting climax to what was overall a period of impressive, if at times hesitant, progress in
this direction through the second half of the 20th century. In the 21st century too, European integration
will no doubt enjoy periods of progress punctuated by occasional setbacks. For example, while the
enlargement of the European Union (EU) is an important goal, it will call into question the EU's entire
institutional structure. The single monetary policy will also be affected by the accession of new
members.
This is simply one example of what will be the main theme of my remarks. Both the European Central
Bank and the single monetary policy are - and will continue to be - faced with great challenges.
Among these challenges numbers the continuing problem of high unemployment. Unemployment in
the euro area remains intolerably high and constitutes the main economic and social problem facing
policy makers. The euro area economy cannot exploit its potential for employment and real economic
growth unless the implementation of appropriate structural reforms results in more flexible labour
markets, less regulation in product markets and lower taxation. The best contribution monetary policy
can make in this regard is to maintain price stability and low inflation expectations, thereby providing
an environment in which structural reforms will work most effectively.
This having been said, an assessment made today of the first 21 months of European monetary policy
confirms that the single monetary policy has been introduced with resounding success. During its short
period of existence, the ECB can claim to have gained the confidence of investors in the sustained
maintenance of price stability in the euro area. The financial markets act as objective and pitiless
judges in this respect. The development of the long-term interest rate and other financial indicators
confirm the credibility of the monetary policy of the ECB.
What makes these successes even more satisfying is that they have been achieved in what has often
been a difficult and uncertain environment. The introduction of the euro took place in the aftermath of
the Asian and Russian financial crises of 1997-98, which served to weaken external demand and
increased uncertainty. Furthermore, the past years have seen a period of exceptional volatility in
international oil prices, which has had implications for price developments.
The uncertainties related to these economic shocks are compounded by the significant regime shift
associated with the transition to Stage Three of Monetary Union. The introduction of the euro has no
doubt changed - and continues to change - the way expectations are formed in the euro area, thereby
altering forward-looking economic behaviour. The effects of monetary policy on financial market,
consumption, investment, and wage bargaining - and therefore the whole transmission mechanism of
monetary policy to developments in the price level - have been among the important economic
relationships more or less affected by this regime shift.
Of course, in itself this may be no bad thing. Indeed, the contribution of the regime shift implied by
the transition to Stage Three to changing both public and private sector behaviour in favourable
directions may be one of the largest gains that the euro area can extract from Monetary Union.
Nevertheless, these changes have complicated the implementation of monetary policy, at least in the
short term, as past relationships between macroeconomic variables may no longer be sufficiently
reliable to constitute a basis for policy decisions.
The transmission mechanism of monetary policy to the price level in the euro area is therefore not
known with certainty. This is hardly unique in itself - after all, no central bank operates in an
environment of complete certainty. However, uncertainty about the transmission mechanism is
exacerbated not only by the regime shift associated with the introduction of the euro, but also by the
fact that, until quite recently, harmonised and comprehensive data have simply not been collected or
constructed for the new monetary and economic area EMU created. Although a growing number of
area-wide statistics are now available, they are based on new concepts, and the properties of the series
are sometimes not yet well known. In some cases, the long runs of high quality back-data required for
empirical economic analysis are unavailable.
These uncertainties - arising directly from the transition to Stage Three itself - are both compounded
by, and inter-related with, the broader economic context in which Monetary Union was established.
The increasing internationalisation of the global economy, and the current rapid pace of technological
change, have affected all sectors of the economy, and the banking and financial systems in particular.
One manifestation of these changes is the current intensive debate about the possible emergence of a
so-called "New Economy" in the euro area. This debate is watched closely at the ECB and possible
indications of a New Economy are carefully monitored. As yet, there appears to be relatively little
evidence of a New Economy. Further structural reforms in the euro area may be required if the
introduction of new information and communication technologies are to yield faster productivity
growth.
All the factors I have just described will alter the relationships between economic variables that
monetary policy makers have used as a guide to their decisions in the past. Nevertheless, I believe the
ECB is well placed to meet the considerable challenges posed, inter alia, by these changes. It operates
within a well-designed institutional framework that clearly delineates its responsibilities and
objectives. It has articulated how these objectives will be achieved by announcing its monetary policy
strategy. And it has at its disposal a modern and efficient set of monetary policy instruments.
Against this background, today I should like to focus in particular on two important and topical issues
which are of direct relevance for monetary policy decisions: first, the role of the definition of price
stability in the institutional framework of the ECB; and second, the role of forecasts in the ECB's
monetary policy strategy.
2. The institutional framework
Monetary policy is not omnipotent. Unfortunately, this was not always recognised in the design of
institutional frameworks for monetary policy. In the past, central banks have often been charged with
meeting several, potentially conflicting, objectives. Because the central bank mandates underlying the
definition of these objectives failed to respect the neutrality of monetary policy with respect to real
variables over the medium term, many of these objectives were simply not realistic or achievable goals
for monetary policy. Unsurprisingly, the resulting inadequately designed institutional frameworks led
to poor overall economic outcomes.
Today, with the regrettable experience of high and rising inflation in the 1970s in mind, the
capabilities and limitations of monetary policy are better - although still not universally - understood.
A broad consensus now exists that the maintenance of price stability is the appropriate objective of
monetary policy. This consensus is rooted in the belief that monetary policy makes its best
contribution to overall economic welfare by maintaining price stability - and thereby allowing the
relative price mechanism to work more efficiently. This proposition is strongly supported by a very
broad economic literature investigating the medium-term relationship between real economic growth
and price developments, both across countries and across time.
The institutional framework for the single monetary policy described in the Treaty establishing the
European Community reflects this economic consensus. Of course, the Treaty was written with the
experience of the 1970s - and the results of the academic literature that emerged in the aftermath of
that unfortunate episode - in mind. First and foremost, the Treaty clarifies the objective of the ECB.
The primary objective of the ECB is to maintain price stability. The Treaty therefore establishes a
clear hierarchy of objectives for the single monetary policy, with price stability unambiguously
assigned overriding importance.
The experience of the 1970s and 1980s not only demonstrated the importance of assigning central
banks the clear objective of price stability. It also illustrated the advantages of central bank
independence in the pursuit of this goal. A monetary policy subject to short-term political concerns
and influences could not adopt the medium-term orientation required to maintain stable prices
credibly. Academic studies of the time consistency problem in monetary policy, such as the seminal
work of Barro and Gordon, offered an insight into this issue, while empirical evaluations showing a
correlation between central bank independence and greater price stability provided compelling
supporting evidence. By the early 1990s, the benefits of central bank independence had become
conventional wisdom. An increasing number of central banks achieved greater institutional
independence. This world-wide trend was reflected in the Maastricht Treaty, which made the ECB one
of the most independent central banks in the world.
Assigning responsibility for an important public policy to an independent institution needs to be
accompanied by a transparent and accountable policy framework. In a democratic society, a high
degree of transparency and accountability in monetary policy making should bolster both the
legitimacy of the central bank and public support for its price stability mandate. At the same time,
transparency and accountability impose an external discipline on policy makers which can add to the
credibility, and thereby the effectiveness, of monetary policy. The ECB has set high standards in both
regards by establishing channels for communication and accountability suited to the specific, and
distinctive, institutional and cultural setting in Europe.
I will return to the important issue of communication later in my remarks. With regard to
accountability, let me simply highlight one crucial point. The institutional framework for monetary
policy in the euro area assigns the clear objective of price stability to an independent European Central
Bank.
Using a terminology developed in the academic literature, it is clear that the ECB enjoys "instrument
independence" - that is to say, the Governing Council of the ECB is fully responsible for monetary
policy decisions and the setting of monetary policy instruments. Yet the ECB is not "goal
independent". The primary objective of the ECB is mandated by the Treaty - it is not chosen by the
Governing Council. The governments and parliaments of the Member States of the EU - representing
the people who elected them - have chosen to enshrine the primary objective of price stability in the
Treaty. On the basis of sound economic argumentation, this gives the primary objective a
constitutional status. Acting as sovereign bodies, the legislatures - but, of course, not the central
bank - took a conscious decision to protect the mandate for monetary policy, namely price stability,
from the influence of short-term political considerations, such as changes in government or upcoming
elections.
Of course, in principle nothing is set in stone for eternity. The objective for monetary policy could also
be changed. A democratic procedure for such a change exists, namely an amendment of the Treaty.
This is a constitutional process similar to that which originally set the mandate which requires
approval by the legislatures of all Member States.
The status of the primary objective of price stability is therefore fundamentally different from that of
an inflation target in a direct inflation targeting regime. Inflation targets are typically set by the
government of the day for a fixed and relatively short horizon. In contrast, in the euro area the primary
objective of price stability has a special constitutional - and thus lasting - status, placing it above
shorter-term political influences.
Having been assigned the mandate to maintain price stability, the ECB - in view of its desire to be
both transparent and accountable - could not simply have remained silent on how it interprets this
concept. Consequently, drawing on the successful experience of those central banks which later
formed the Eurosystem, in October 1998 the Governing Council of the ECB decided to publish a
quantitative definition of price stability, both as a focus for inflation expectations and to provide a
clear yardstick against which the public, its elected representatives and agents in the media, can hold
the ECB accountable. The Governing Council therefore defined price stability as an annual increase of
the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.
Many considerations went into the formulation of this definition. In theory and prima vista, it would
have been simpler to define price stability as a zero change in a specific price index. However, such an
approach would have ignored important statistical issues, such as the potential existence and
magnitude of so-called measurement bias in consumer price indices.
Nonetheless, one issue was clear. The ECB had no option other than to define its primary objective in
a way that deemed inflation rates above 2% in the medium term inconsistent with price stability. This
largely reflects the legacy of the definitions of price stability used by the national central banks
(NCBs) prior to the irrevocable fixing of intra-euro area exchange rates at the start of January 1999. At
the outset of Monetary Union with the introduction of a wholly new currency, it was extremely
important that the public was reassured that the environment of price stability, which had been
successfully achieved through the convergence process in the 1990s, was here to stay. Price stability
should not be viewed as a temporary phase, but rather as a lasting - indeed, permanent - feature of the
euro area economy.
Announcing a quantified definition of price stability and credibly committing to the maintenance of
price stability on this definition helps to stabilise medium-term inflation expectations, thereby
improving the effectiveness of a monetary policy aimed at price stability. The 1980s and 1990s
provide ample evidence of the costs of inflation. These are often most visible during the process of
disinflation, which is just the other unavoidable flip side of the preceding inflation. With price stability
achieved in the euro area at the start of Monetary Union, it was vital that the associated benefits were
"locked in" by the ECB.
It is especially important that those responsible for wage developments base their decisions on the
clear commitment of the Governing Council of the ECB to maintaining price stability over the
medium term. Short-run deviations from the primary objective which we observed in past months
should clearly not be taken as a reason to end the process of wage moderation which has been so
effective in contributing to the reduction of unemployment which we observed over the last years. It is
crucial that medium- and long-term inflation expectations remain safely below 2%.
3. The monetary policy strategy of the ECB
The most difficult task for the European Central Bank was the development of a monetary policy
strategy suitable for the new environment of Monetary Union. The definition of price stability which I
just explained is one of the key elements of this strategy. Regarding the other elements, the Council
recognised that options that had been tried and tested in a completely different context were, for a
number of reasons, out of the question. While it was important to learn from the experiences and
successes of other central banks, it was also crucial to recognise the new environment for monetary
policy making in the euro area, and acknowledge the high level of uncertainty which was an inevitable
result of the introduction of the new currency and the creation of such a large and complex currency
area. A broad range of empirical and theoretical findings were taken into account in this unique
situation.
While no central bank can afford to neglect the fact that ultimately inflation is always a monetary
phenomenon, the conditions for a monetary target did not exist in the special circumstances prevailing
in the euro area at the outset of Monetary Union. Two important questions therefore arose: first, how
could the central bank specifically take into account the importance of money and, more generally,
liquidity, for monetary policy making? Second, how should the ECB - in an honest and transparent
way - account for the fact that, at least up to now, there is no agreement on the structure of the
economy in general, and the precise role of money in the transmission mechanism of monetary policy
in particular?
The Governing Council of the ECB has provided answers to both questions. As regards the first, the
Council decided to assign a prominent role to money. This prominent role was signalled to the public
by the announcement of a reference value for the growth of a broad monetary aggregate. The
prominent role assigned to money implies, in particular, that the ECB is obliged to analyse the
information content of monetary and credit aggregates with a view to identifying the nature of shocks
hitting the euro area economy and assessing the resulting risks to price stability.
The prominent role of money constitutes the "first pillar" of the ECB's monetary policy strategy. The
analyses underlying this pillar provide very valuable information which needs to be taken into account
in forward-looking monetary policy decisions aimed at the maintenance of price stability over the
medium term. Given the lags in monetary transmission, it is difficult at this still early stage of
Monetary Union to make a thorough assessment of the importance of the prominent role of money.
Nevertheless, with the benefit of hindsight, one can say that monetary analysis, and also the signals
given by "headline" growth rates of key monetary aggregates, have proved more reliable guides for
monetary policy decisions than many external observers anticipated when the strategy was announced
two years ago. Of course, one can never exclude that monetary aggregates may be significantly
distorted in the future. We may face shocks to money demand or special factors. Therefore, the
Governing Council has always made clear that it does not react in a mechanistic way to monetary
aggregates - rather a careful reading and thorough analysis of (headline) monetary developments will
always be needed.
As regards the second question, the Governing Council recognised that although the monetary data
contain information vital to informed monetary policy making, on their own they will not constitute a
complete summary of all the information about the economy required to set an appropriate monetary
policy which maintains price stability. Therefore, in parallel with the analysis of monetary growth in
relation to the reference value, a broadly based assessment of the risks to price stability in the euro
area - the so-called "second pillar" - plays a major role in the ECB's strategy. Analyses in which
monetary and credit aggregates do not play a major role are consolidated in the second pillar. These
analyses include the assessment of a wide range of non-monetary economic variables, such as labour
market indicators, including wages and unit labour costs; fiscal policy indicators; and, financial market
indicators, such as the yield curve and stock prices.
The two pillar structure of the ECB's strategy is often misunderstood by external observers as
implying multiple targets for monetary policy, such as, on the one hand, an intermediate monetary
target and, on the other hand, an inflation target. However, as I have already discussed, the
maintenance of price stability in the euro area over the medium term is the primary objective of the
strategy. Both pillars of the strategy should be understood as instruments which help us to achieve this
ultimate overriding objective. Taken together, the two pillars of the strategy form a framework which
organises the presentation and analysis of the "full information set" which is relevant for monetary
policy making in order to assess risks to price stability and allows for cross-checking of information
from different sources and approaches.
Precisely because of the lack of consensus about the structure of the economy and in particular the role
of money in the transmission mechanism, economists are currently forced to work with a number of
approximating models and frameworks, which each capture some important aspects of reality, but
each of which is - when viewed on its own - inherently incomplete or mis-specified.
In this situation, a strict adherence to a single framework or model to the exclusion of alternatives
would be unwise. It would carry the risk of making substantial policy mistakes if the framework used
for policy turned out to neglect those aspects of economic behaviour which ultimately came to play an
important role. In this context, a well-designed monetary policy will be "robust". It should ensure that
price stability over the medium term is maintained in a variety of relevant possible settings or models
of the economy, rather than narrowly focus on trying to pursue some narrow notion of optimality
within one specific framework.
One implication of the need to make robust policy decisions is that there is a need to take an eclectic
and diversified approach to guide policy judgements, incorporating as broad a range of data and
analyses as is feasible. This approach will reduce the risks of making large policy errors. The two
pillar structure of the strategy adopted by the ECB provides precisely this diversified approach and
thus far has avoided making mistakes. This marks a not insignificant achievement in the environment
of pervasive uncertainty which we face at the beginning of Monetary Union.
4. The role of macroeconomic forecasts within the strategy
The ECB is expected to publish macroeconomic forecasts for the first time at the end of the year.
Against this background let me clarify some important issues regarding the role of forecasts in
monetary policy and in particular in the ECB's strategy. Many misunderstandings exist regarding this
issue - not least on the part of some prominent observers and critics of the ECB.
There can be no doubt that forecasts play an important role in the monetary policy process. This is
necessary given the forward-looking orientation of the ECB's strategy. Forecasts help to summarise
and synthesise a large quantity of information that may otherwise become too unwieldy to form a
sensible basis for policy discussions. Forecasts provide a platform for the integration of analysis in a
coherent and internally consistent way, which respects accounting identities and basic economic
relationships.
There are many organisations and public companies which regularly produce forecasts. The staff of
the Eurosystem also does so. The Monetary Policy Committee (MPC) of the ECB, which brings
together experts from both the ECB and the NCBs, is in charge of producing two forecasts per year.
These are not the only forecasts which are produced within the Eurosystem, but they are certainly the
forecasts which involve the greatest interaction between ECB and NCB staff experts.
The Eurosystem's macroeconomic forecasts are produced using a number of inputs. First, a variety of
macroeconometric models of the euro area are used. Employing a suite of models, each embodying a
different view of the world or estimated using a different methodology, is preferable to relying solely
on a single - and inevitably imperfect - framework. Second, the projections produced by these models
are influenced and adjusted using the technical judgement 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 forecasting procedure. Given this description of the Eurosystem's forecast process, it should
be clear that forecasting is not treated as a mechanical exercise. Realistic forecasts cannot be produced
by the mechanical application of a single model. Nor should they be.
The ECB forecast is thus produced twice per year by the staff of the Eurosystem and is based on the
staff's technical expertise. The forecast is therefore an into the policy making process. The
input
forecast does not embody the policy judgement of members of the Governing Council.
When the public evaluates forecasts published by the ECB, the fact that forecasts are an input to policy
making will be extremely important to keep in mind. The published forecast does not necessarily
represent the opinion of members of the Governing Council. Policy makers will always need to
exercise a policy judgement in deciding how to interpret the staff forecast and the uncertainties
around it. This exercise of judgement is part of what has been called the "art of central banking" - it
is what distinguishes policy making from a purely mechanical or technical exercise. Any blurring of
the distinction between policy making - which is the preserve of the Governing Council and is
ultimately captured in the final monetary policy decisions - and preparing technical analysis as input to
the decision making process - which is the responsibility of central bank staff - will only serve to cause
confusion.
Precisely because the exercise of policy judgement remains the preserve of the Governing Council,
one should not expect policy decisions to feedback mechanically from developments in the published
macroeconomic forecast. Forecasts are only one - albeit important - input into the policy process.
They are always evaluated in the context of other analyses and indicators.
This is, by the way, true for all central banks. To my knowledge, there is no central bank in the world
which bases its monetary policy decisions solely on a mechanical reaction to an inflation forecast. One
reason for this is that macroeconomic forecasts suffer from a number of practical shortcomings which
mean that they cannot constitute the only input into policy decisions.
For example, in practice the information from monetary aggregates is not incorporated into
conventional macroeconometric forecasting models. However, monetary analysis is an important piece
of information for assessing risks to price stability from a different perspective. As the ECB's
macroeconomic forecasts rely on structural macroeconomic models, they should be seen as forming
part of the second pillar of the ECB's strategy. These forecasts have to be cross-checked against the
information from monetary aggregates for future price developments. This is the essence of the two
pillar strategy. Both pillars, from different perspectives, analyse economic developments in a way
which contributes to forming a judgement about risks to price stability and thus inform well-designed
forward-looking monetary policy decisions.
When looking at forecasts, other aspects also need to be kept in mind. For example, the latest
developments of key real economy variables cannot be fully integrated into macroeconomic forecasts
in a timely manner. Moreover, the assumptions on which the forecast is based - such as the assumed
paths of oil prices or external demand - can change rapidly, causing the forecast to become quickly
outdated.
Furthermore, it has to be kept in mind that the projections which could be published by the ECB are
the products of a technical exercise which are based on the assumption that policy interest rates will
not change over the forecast horizon. For this reason, they are not true forecasts about future
developments but merely an input into the decision making process which is designed to inform the
Governing Council about what to expect if interest rates are not changed for some time into the future.
Obviously, if the Governing Council identifies risks to price stability and acts on this basis by
changing interest rates, the projections made by the forecast will not materialise. This is crucial to
understand. The forecasts which will be published by the ECB are not predictors of the most likely
outcome under all circumstances. Rather they will be scenario exercises describing what would
happen if interest rates did not change. For this reason the Governing Council will make sure that,
when forecasts are published, inflation expectations should and will remain firmly focused on price
stability. The publication of conditional inflation projections should not in any way influence the
formation of inflation expectations.
Of course, the Governing Council will continue to look also at forecasts produced by other
organisations as well as financial market expectations, for example as embedded in bond yields. All
this information should form the basis for decisions by the Governing Council and allows for the best
possible insight into the situation.
All these remarks should make clear that the Eurosystem forecast does not constitute the sole or even
necessarily the main vehicle for policy decisions. On the contrary, a key feature of the Eurosystem's
strategy is that it permits a diversified approach to the assessment of economic developments and
encourages cross-checking between different forms of analysis. This robust approach is intended to
help avoid major policy errors.
My remarks should also have made clear that neither the Eurosystem's strategy as a whole, nor the
second pillar within it, should be characterised as inflation targeting. More specifically, it certainly
should be clear that monetary policy decisions do not feed back from deviations of the inflation
forecast (based on the assumption of unchanged policy interest rates) from an inflation target at a
specific time horizon.
Publication of macroeconomic forecasts would thus not change the ECB's monetary policy strategy.
In particular, the role of forecasts in decision making which I have described at some length will be
unaffected. The ECB has adopted a new and distinct strategy which reflects the complexity of
implementing monetary policy in a large and diverse single currency area consisting of soon to be
twelve different sovereign nations. This complexity is compounded by the challenges posed by the
novelty of the monetary policy regime, which implies that the tools and approaches used to identify
risks to price stability as well as the procedures used to produce macroeconomic forecasts for the euro
area need to be continuously re-evaluated and monitored closely. Even less than would be possible
under "normal" circumstances, in such an environment monetary policy cannot be reduced to reacting
in a quasi-mechanical manner to monetary developments or inflation forecasts. The complexity of the
environment requires a more sophisticated approach, embodied in the ECB's strategy.
Let me finally say that I am hopeful that the publication of macroeconomic forecasts will improve the
presentation and explanation of monetary policy decisions to the public. By publishing an important
input into the decision making process, the considerations facing the Governing Council when taking a
decision should become clearer to the public. However,