Jean-Claude Trichet: Activism and alertness in monetary policy
Lecture by Mr Jean-Claude Trichet, President of the European Central Bank, on "Activism and
alertness in monetary policy," at the conference on "Central Banks in the 21st Century" organised by
the Bank of Spain, Madrid, 8 June 2006.
* * *
Ladies and gentlemen,
Since 1 January 1999, the day on which it officially became the monetary authority of the euro area,
the ECB has changed its policy rate, the rate on its main refinancing operations, 18 times. Over the
same period, the Federal Reserve System has made 35 changes. The easing cycle that started on
both sides of the Atlantic - and of the Channel - in 2001 saw a cumulative reduction in the policy rate
of 275 basis points in the euro area, accomplished in a sequence of seven moves. The ECB started to
reverse that cycle in December last year and has since changed its policy in a sequence of three
steps. In the United States, the same easing phase saw 13 reductions, with a total loosening of 550
basis points, and was first reversed in June 2004. Since then, the Federal Reserve has hiked its target
rate 16 times in continuous steps.
I thought I would take advantage of the opportunity afforded by this impressive programme to revisit a
theme on which I have reflected in the past: "activism" in monetary policy. Is there a univocal definition
of this notion? Can "activism" be quantified by simple statistics such as the frequency and size of
policy moves? Can a central bank be "active" while moving its policy rate in a measured and
observationally cautious way? Was the ECB active enough in responding to the evolving state of the
euro area economy? The few facts that I have recounted seem to suggest otherwise. I will try to
convince you that the contrary is true.
I will offer some provisional answers on the basis of what I believe I have learned thus far. I suspect,
though, that the passing of time and further analysis of the euro area economy will be needed to
deepen our understanding of this issue.
My definition of activism in monetary policy is, I believe, conventional: activism is the strategic attitude
of a central bank that is constantly endeavouring to be faithful to its objective. In the case of the ECB,
it is the constant striving to keep inflation close to its arithmetic objective, and to take all the steps
needed to check nascent inflationary pressures while at the same time trying to minimise unnecessary
macroeconomic disruptions in the process. "Activist" is an attribute that applies to a strategy, not to a
policy path.
My answer to the question of whether or not activism can be measured by simple statistics is negative.
Strategic activism in monetary policy cannot be quantified in simple terms, not in abstraction from
knowledge of the key structural forces and economic relationships that govern the functioning of our
systems at any point in time. When evaluating the appropriateness of their action, central banks do not
have the luxury of linking policy to a handful of summary statistics. They engage in a complicated
process of signal extraction from a wealth of diffuse data and events. They calibrate decisions to the
key structural parameters of the economy in which monetary policy has to function, to the nature of the
shocks to which the economy is typically prone. The path of policy is adjusted accordingly.
The ECB's strategy is as active as it needs to be to fulfil our mandate. I would claim that clarity about
the objective of our policy afforded considerable latitude for action in the early years of the decade,
and a remarkable leverage over market conditions more recently. This has happened despite repeated
unfavourable shocks in the former period and apparent policy inaction in the latter. Always, our
strategy and the information coming from the real economy, as well as from the sphere of monetary
aggregates, much more than our words, have shaped market expectations beyond the very near term,
a sign that the complex analysis required to predict our judgement has not materially impeded market
participants in responding meaningfully to incoming data.
Policy activism and economic dynamism
To frame the issue, let us consider a stereotypical monetary policy reaction function that has a
shortterm interest rate on the left and a number of observable reaction variables on the right. Think, for
example, of any kind of reaction functions that econometricians and expert observers often use - and
sometimes abuse - to compare monetary policy strategies. In essence, they all encapsulate a simple
rule of thumb: raise the policy rate if anticipated inflation is higher than the objective and there are
signs that the economy is operating above capacity. An additional condition for ensuring
macroeconomic stability that applies to these rules is that the reaction in the nominal rate must be
strong enough for the real rate to be varied pro-cyclically: when inflation expectations rise, and the
economy expands above potential, real monetary conditions have to be tightened.
I choose this way of framing the issue primarily because it is widely used by our observers, and
because it is sufficiently concise to be easily understood. But, before launching into the analysis, I
should add that, precisely because it is simple and pedagogical, this framework is also a very
incomplete description of our policy behaviour. Overall, because it does not capture the very essence
of the two-pillar strategy, based on an economic assessment of medium-term risks to price stability, on
the one hand, and a cross-checking based on medium to longer-term risks assessed though our
monetary analysis, on the other. Also, because such representations of our policy are not sufficiently
state-contingent, whereas my colleagues and I are far from being exclusively guided by mechanical
configurations of indicators, but are very interested in the contingencies, and finally take our decisions
on the basis of synthetic judgement enlightened by multiple experiences. As I often say, collegial
wisdom is of the essence in central banking. This underscores the tension between describing policy
simply and implementing policy simply: simple descriptions of policy need not - and indeed never do -
mean simple policy behaviour.
Assuming that the parameters attached to the various indicator variables in the reaction function
indeed capture the deep strategic preferences of the central bank, empirical estimates of these
coefficients are often used to quantify the strength with which the central bank intends to respond to
the state of the economy. In other words, these estimated parameters are sometimes viewed as
objective measures of strategic "activism" in monetary policy.
A central bank would qualify as strategically more passive - or less active - than another central bank
if the estimated coefficient attached to inflation expectations in deviation from the central bank's
objective, and the estimated coefficient penalising the indicator of macroeconomic slack, turned out to
be smaller. Why would this central bank qualify as more "passive"? Because, for given variances of
inflation and real activity, this central bank would indeed be inclined to take more moderate action in
response to changes in the outlook. It would move its policy rate by narrower margins - and perhaps
more infrequently - than its more "activist" counterpart. Moreover, as analysts typically append a
partial adjustment mechanism to the representation of how the central bank interest rate responds to
the economic state, there is an additional source of "activism" - or "passivity" - that would emerge
from these simple empirics. This is the inertia coefficient attached to the lagged interest rate
dependent variable, which in these rules moderates the pace of reaction of the policy rate to its
fundamental determinants.
In any case, in the naive theory of this world, plain comparison of the frequencies of policy moves and
the size of interest rate adjustments would suffice to tell the strategies of these two central banks
apart. A smoother policy path would signal a "more passive" strategy.
But of course the world is not that simple, and in fact there are serious pitfalls lurking behind strategic
inferences drawn on the basis of comparisons of variances in policy rates. It is not too difficult to
portray situations in which such inferences could be highly misleading. I will give three examples, all
relaxing one important qualification upon which my earlier example was predicated: the assumption
that our two central banks are confronted with the same economic environment.
First, imagine two central banks which are equally responsive to economic conditions: in the
reactionrule jargon that I am using here, these are two central banks that share exactly the same reaction
parameters. But one central bank now faces a less dynamic economy than its counterpart. By "less
dynamic" I mean an economy that - as a matter of regularity - is hit by shocks of smaller magnitude
which tend to fade away more gradually. Here, reaction parameters are the same - by hypothesis -
but the reaction variables fluctuate at different speeds. All other things being equal, the patterns of
adjustment of the policy rate that the same rule would induce in the two economies would be likely to
look very different. The central bank operating in the less dynamic economy would in all likelihood be
observed to adjust interest rates along a more moderate path. The other central bank would appear
more reactive. But any strategic implications drawn from the variance in the two policy paths would be
purely illusionary. The smoother course of policy would not reveal any deep-seated strategic inertia: it
would only reflect the same response to shocks with quite different dynamic properties. Monetary
policy would appear "passive" because the economy itself was evolving slowly.1
A second example again considers two identical central banks, now facing shocks of a different
nature. One central bank predominantly faces demand shocks, which result in persistent departures
from trend growth. This statistical pattern has symmetric and durable effects on output and inflation
and thus presents a relatively straightforward monetary policy problem under the rule that I am
postulating here for simplicity. As both reaction variables - forecasted inflation and output - would
frequently move in tandem, the policy rate of this central bank would have to be changed frequently
and forcefully in the same direction to offset the shock. But what would happen in the other economy,
if it - unlike the first - were more prone to supply shocks? Experience suggests that supply shocks
yield sharp transitory increases in inflation, possibly followed by smaller, more permanent
"secondround" effects, though the longer-run impact on inflation is obviously significantly determined by the
response of monetary policy. Given the transitory nature of the initial inflation bursts, the simple
hypothetical rule - which incorporates the reaction to expected inflation - would advise the central
bank to "look through" the immediate disturbance and change policy only to the extent needed to
offset the anticipated more permanent effects of the shock on inflation in subsequent quarters. Its
policy rate, again, would be observed to be less variable. What is important to note is that the same
rule - equally active strategies - would support two different patterns of observed policy behaviour in
different economic environments.
The third case is perhaps the most interesting of all. Here exogenous shocks are identical, but
economic structures differ. Different transmission mechanisms therefore propagate the same shocks
with lags that vary between the two economies. The first economy has more rigid adjustment
mechanisms: price-setters and wage-negotiators are more sluggish than those in the other economy
in processing economic news - including changes in the stance of monetary policy - and bringing
them to bear on their decisions. What is the source of those rigidities in the first economy? There can
be many reasons for rigidity. Perhaps labour practices and contractual institutions - dating from the
early post-war decades when the economy was heavily regulated - induce distortions in large
segments of the labour market. This stands in the way of an efficient matching of skills and productive
capabilities. Perhaps tight regulatory restraint on business and statutory inhibitions discourage
innovation and impede a faster response to new shocks and new opportunities. Whatever the source
of rigidity, the observational result is that prices and wages in the first economy reflect changes in
fundamentals with considerable lags.
How should monetary policy respond to shocks in these conditions? Note that I am moving away from
the naive world of simple policy rules and am taking a step further into the - admittedly no less
conjectural - realm of optimal policy design. The answer to my question depends critically on the
inflation process that we postulate. We know that when inflation expectations are well-anchored
around the inflation objective of the central bank, the evolution of inflation over time is influenced by
the numerical objective of policy more than by the history of inflation itself. We can state this
differently, saying that when the economy internalises the central bank's objective firmly, the inflation
process becomes less persistent and more forward-looking. If inflation expectations are well-anchored,
a shock to inflation in the recent past is likely to have a lesser impact on inflation in the future. One
reason for this is that the shock will not encourage workers to bargain for commensurate rises in
nominal wages to protect the real value of earnings. Equally, firms would certainly resist such potential
bargaining. All such parties and other price-setters will anticipate that the central bank will ultimately
drive inflation back to its pre-shock level. Hence, they will tend to treat past inflationary shocks as
transitory and inconsequential for the future outlook.
In the first economy in this example, where prices are sticky and inflation expectations are
wellanchored, monetary policy can be more patient and focused on the medium term when confronting a
cost-push shock. Again, as in the other two examples, it is likely to be observed to change policy less
aggressively in the face of an unexpected shock to headline inflation. But this seeming "patience",
once again, does not signal inertia, "passivity" or neglect for macroeconomic conditions. It reflects a
careful calibration of the policy course to the structural peculiarities of the underlying economy. First
and foremost, the policy response to the inflationary shock will be less persistent because the
inflationary consequences of the shock will be more promptly reabsorbed in the first place. Second,
with stickier prices, a change in the nominal policy rate of a given size will have a stronger impact on
the real rate, which is all that matters when it comes to measuring the stance of policy. In these
conditions, a more moderate policy path is not a cause of instability. In fact, it is the very precondition
for avoiding the dangers of over-steering, of accidentally destabilising the economy.
Of course, the thought experiments that I have been sharing with you so far are only as useful as the
rules or the optimality benchmarks with which real-world behaviour has been compared. And I am
certainly not the only one here who believes that simple reaction rules - or monetary policy optimality
exercises, for that matter - cannot serve as the ultimate test for actual policy behaviour. But I hope I
have conveyed one notion. Even in the over-simplified world of my canonical examples, where the
macroeconomic state can be adequately described by a handful of facts, where these facts are reliably
condensed in summary indicators - which, too, are immune from sampling errors and statistical
revisions2 - and where policy algorithms are an acceptable description of policy choices, even in that
conjectural world the variability of the policy instrument would not be a sufficient statistic with which to
judge monetary policy strategies. In particular, even in that world, a slower-moving, structurally more
rigid economy would support an observationally more moderate policy course.
In the real world, as I will try to explain next, that observationally moderate path for policy receives an
even stronger justification.
Facts and policy in the euro area
My emphasis on a structurally more rigid and less dynamic economy periodically facing adverse
supply shocks is, of course, deliberate. That laboratory case resembles the euro area that I know. I will
organise my interpretation of stylised facts about the euro area in the recent past into three broad
categories: shocks, structures and monetary policy.
Shocks
One reason the euro area resembles my third example is that, compared with the United States, it
seems to be subject to demand shocks of smaller magnitude but to be more frequently hit by supply
shocks.3 In the last ten years this shock pattern seems to have grown even more pronounced, despite
globalisation and a generalised shift towards closer international economic integration.4 This is
nowhere more evident than in the anatomy of the boom-bust cycle that spanned the decade starting in
1995 in the two economies. In the United States, the run-up phase was significantly propelled - as we
know with hindsight - by overly optimistic views about long-run earnings growth and, notably,
exaggerated beliefs in the profitability of emerging technologies. But the strength in business
investment that the boom brought with it also had important implications for the supply side of the US
economy, through its influence on the rate of increase in labour productivity and thus the economy's
sustainable level of potential output. ECB staff calculations estimate that the contribution to the growth
of output per hour worked coming from capital deepening doubled in the United States in the course of
the 1990s. Subsequently - and despite the sharp reappraisal of those expectations and the
unprecedented drop in business investment that followed the market collapse in 2000 - it stabilised at
the elevated levels that it had reached at the turn of the millennium. Since then, remarkably, capital
deepening has been replaced, as the main engine of output per hour growth, by extraordinary
advancements in total factor productivity (TFP). Arguably, US firms have been able to meet expanding
demand with a more efficient organisation of the production processes.
The same ten-year episode had a distinctly different face in the euro area. The stock market
appreciation - comparable in size to that seen in the United States - went hand in hand with a decline,
not a rise, in the contribution of capital to measured productivity. And a contemporaneous steady
decline in TFP throughout the decade has reinforced, rather than offset, the diminishing contribution of
capital.5 The euro area seems to have had its fair share of stock market turbulence, without enjoying
the side benefit of improved supply conditions.
The slowdown in trend productivity has been a primary determinant of the weak economic
performance of the euro area. By depressing income growth prospects and by reducing the
prospective return on capital, it has held back consumption spending and business investment, which
has been further curtailed to some extent by the ongoing demographic shift towards a more elderly
population.6 Rapidly decelerating productivity was one force behind the counter-cyclical rebound in
unit labour costs that we observed during the early part of the new millennium. [See Figure 2].
This surge in unit labour costs was atypical, if contrasted with the way in which unit labour costs in the
United States elastically responded to the downturn with a sharp decline, and it represented an
ongoing source of inflationary pressures. Adverse underlying developments in productivity have made
it more difficult for our firms to smooth through the volatility of the many non-wage cost disturbances
that they have encountered since 1999. This lesser degree of resilience has kept the evolution of
inflation - and real activity as well - constantly vulnerable to unexpected shocks, such as the
increases in the prices of energy and beef - to name only two - which have been brought about by
3
See, for example, the structural comparative analysis in F. Smets and R. Wouters, "Comparing shocks and frictions in US
and euro area business cycles: a Bayesian DSGE approach", Journal of Applied Econometrics, 20(1), January 2005.
4
This is a well-known, if certainly surprising, fact. See, for example, J. Stock and M. Watson, "Has the business cycle
changed? Evidence and explanations", paper presented at the Federal Reserve Bank of Kansas City Symposium "Monetary
Policy and Uncertainty," Jackson Hole, Wyoming, August 28-30 2003.
5
See G. Gomez-Salvador, A. Musso, M. Stocker and J. Turunen, "Labour productivity developments in the euro area",
forthcoming as an ECB Occasional Paper. They report that the average contribution of capital to measured productivity
growth in the United States was 0.6 percentage point in the first half of the 1990s, increasing to 1.1 percentage points in the
second half of the decade and stabilising at 1.0 percentage point on average between 2000 and 2004. In the euro area, the
trend was reversed: a contribution of 1 percentage point in the first half of the 1990s became 0.4 percentage point and 0.6
percentage point, respectively, in the second half of the 1990s and in the first five years of this century. The TFP
contribution, calculated on the basis of the Solow residual, tripled in the United States from the early 1990s to 1.6 percent on
average in 2000-2004, but halved in the euro area from 1.3 to 0.6 percent in the same period. Correcting the euro area TFP
measures mentioned above for variable capital utilisation does not change the picture. In fact, such correction would shift
the start of the slowdown in productivity to the mid-1990s.
6
As the share of the population that is of working age declines, the rise in the capital stock needed to equip the labour force
decreases. Lower rates of investment in some member countries may also reflect some relocation of production to China
and other newly industrialised countries (where investment rates have been quite high in recent years).
BIS Review 53/2006
adverse changes in supply conditions.7 Note that inflation [Figure 3] edged higher in the downturn
phase and remained at elevated levels thereafter, at a time when the accumulating margin of slack in
labour and product markets could in fact have been expected to reduce price pressures. Again,
compare these developments with the sharp disinflation which occurred, during the same period, in
the United States.
Of course, we cannot directly observe full capacity of either labour or other production factors.
Consequently, we can never be certain about the level of activity that would represent the full
utilisation of available resources, and even less so about the strength of the relationship that links
utilisation and inflation. However, I hope that I have demonstrated that this connection is seemingly
weak in the euro area, probably weaker than across the Atlantic.
Structures
This structural feature brings me to the second category of my remarks: the structure of the economy
on this side of the Atlantic. I will concentrate on two factors that critically affect the relationship
between inflation and the fundamental shocks that drive the economy and determine its state: price
flexibility and the anchoring of price-setting.
Extensive empirical research on price flexibility and inflation persistence in the euro area has recently
been produced in a concerted effort that has occupied staff of the ECB and of the entire European
System of Central Banks.8 It comes to two main conclusions. First, in the euro area, prices are
distinctly less flexible than, say, in the United States. Prices change infrequently: the average duration
of a consumer price spell - a measure of the time that it takes for retailers to reprice their products - is
13 months [Table 1]. According to surveys, it is 11 months for producers. In the United States,
comparable figures indicate durations of less than 7 months and slightly more than 8 months
respectively.9
8
See E. Dhyne, L. Alvarez, H. Le Bihan, G. Veronese, D. Dias, J. Hoffmann, N. Jonker, P. Lünnemann, F. Rumler and J.
Vilmunen, "Price-setting in the euro area: some stylised facts from individual consumer price data", ECB Working Paper No
524, 2005. The paper reports that the average duration of CPI price spells in the euro area is 4.3 quarters. By comparison,
M. Bils and P. Klenow, in "Some evidence on the importance of sticky prices", Journal of Political Economy 112, 2005,
calculate that the average duration of CPI prices in the United States is 2.2 quarters. Other Phillips curve-based analyses
broadly confirm these results. For the euro area, see J. Gali, M. Gertler and D. Lopez-Salido, "European inflation dynamics",
European Economic Review 45(7), 2001, and J. Gali, M. Gertler and D. Lopez-Salido, "Erratum", European Economic
Review 47(4), 2003.
9
Abstracting from methodological differences in price-collecting procedures across statistical institutes, differences in the
frequency of price adjustments can be due to various causes. Differences in the degree of competition, especially in the
services sector, may be a factor, particularly given evidence that the divergence of such frequencies is most pronounced in
that sector. Another factor that is often cited is the fact that small corner shops, which change their prices less frequently
than supermarkets, have a higher market share in euro area countries than in the United States.
Table 1: Measures of price stickiness for the euro area and the United States
Sources: For the CPI in the euro area, Dhyne et al. (2005), Bils and Klenow (2004) in the US. For the PPI, Vermeulen et al.
(2005). Surveys: Fabiani et al. (2005) for the euro area, Blinder et al. (1998) for the US. New Keynesian Phillips Curve:
Estimates in Galí et al. (2001, 2003) refer to the GDP deflator and are converted from original quarterly figures.
More infrequent price revisions make the setting of prices less responsive to economic news,
including, as I already pointed out, changes in monetary conditions. In general, sticky price revision
processes reduce the odds that the imbalances created by economic shocks can be rectified by
adjustments in prices. Conversely, they make the burden of adjustment to a shock fall
disproportionately on changes in output, incomes and employment. Also, stickier prices tend - all
other things being equal - to increase the persistence of inflation. This is because the impact of a
shock that today modifies firms' real cost conditions tends to be spread out over an extended future,
as staggered price adjustments catch up only slowly with the changed underlying circumstances.
Despite sluggish price-setting mechanisms, however, inflation persistence in the euro area is low by
international standards. This is the second important finding of the new body of evidence that I
mentioned: an inflationary shock dissipates quickly in the euro area despite rigidities, and inflation has
a tendency to return to its long-run norm reasonably quickly. The half-life of the effect of a shock to
inflation is considerably less than one year, which is close to the figure that one obtains, for example,
for the United States, again notwithstanding vastly different patterns of price-updating practices across
the two areas.
What explains this apparently inconsistent evidence? Another ECB study, estimating a structural
model on euro area and US data, goes some way towards reconciling empirical stickiness in prices
and low persistence in inflation on the basis of a model of inflation determination that features real
costs and expectations.10 As I said before, even if price sluggishness introduces persistence into the
inflation process - which in itself tends to perpetuate past inflation pressures into the future - some of
that persistence can be undone if the expectations of price and wage-setters are focused on the
objective of the central bank. Indeed, this study finds that the influence of the ECB's inflation objective
on the evolution over time 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. We are pleased to
observe that analysis of survey-based measures of inflation expectations suggests that central bank
leverage on expectations has become much stronger since the establishment of the euro.11
Monetary policy
Having reviewed structures and shocks, I now move on to the third aspect of my discussion of the
euro area: monetary policy. Did considerations pertaining to the nature of the shocks that occurred in
the recent past and to the structural peculiarities of the euro area play any role in positioning the
stance of monetary policy? Can they go some way towards explaining the observationally moderate
path that the policy rate has followed in the euro area? Did the smoother path of our policy rate
impede a smooth adjustment of the euro area to the shocks that have hit the global economy in the
recent past? Finally, does low inflation persistence provide reason for complacency?
When the ECB in early 2001 initiated the easing cycle that we started to reverse in December last
year, this was done on the heels of significant adverse supply shocks, relatively strong wage
dynamics, and headline inflation rates at levels unseen in Europe since the late phases of
convergence to the new currency. Yet the Governing Council judged that our commitment to attaining
price stability, in line with our official definition, through our monetary policy strategy was sufficiently
credible for us to take that easing decision without running the risk of destabilising inflation
expectations. That conviction was reinforced by a rapidly deteriorating outlook and by reassuring signs
that inflation expectations discounted a scenario in which inflation would settle in the zone of price
stability in the medium term. The rapid softening of activity that we saw coming and the increasing
odds that the recovery would not materialise soon - we believed - would validate ex post the inflation
expectations and make the threat of renewed inflation considerably weaker. Information extracted from
monetary trends supported our prediction of subdued inflation looking into the more distant future.
Monetary accommodation was quicker and, in retrospect, far more persistent than could have been
predicted on the basis of the policy regularities on record. In the end, monetary action amounted to an
interest rate reduction of 275 basis points, bringing the policy rate to a level which was below the
lowest intervention rate of the central banks of an overwhelming majority of member countries,
including Germany, during the last 50 years. It is all the more remarkable that we were able to follow
such a historically unseen trajectory for our vast continental economy, the euro area, given that the
individual countries had very diverse and mixed legacies as regards past monetary credibility.
It is difficult to work out a convincing counterfactual: what would have happened if the reaction of the
ECB had been more in line with the patterns of policy behaviour established in the past, rather than
the more forceful action we took. However, structural - if model-specific - analysis of the mix of the
macroeconomic shocks that have hit the euro area since 2001 reveals with hindsight that the extra
monetary policy stimulus that we introduced has been critical in avoiding a deeper and more enduring
recession here and on a global scale.
I judge that the policy course was carefully calibrated to the structural characteristics of the euro area
transmission mechanism, some features of which I tried to outline earlier. We were guided, in
particular, by the understanding that a central bank operating in a relatively rigid economy is able to
deliver the same quantum of monetary accommodation by adjusting its policy instrument in more
moderate steps than in a relatively more flexible economy. Under the structural conditions that prevail
in our economy, a more aggressive easing would have introduced unwelcome volatility in both inflation
and output that would ha