Jean-Claude Trichet: Issues in monetary policy - views from the ECB
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the luncheon
organised by the Economic Club of New York, New York, 26 April 2004.
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Mrs President, Ladies and Gentlemen, dear Friends,
It is a great honour and a pleasure to be invited to speak to the Economic Club of New York on the
eve of a defining moment in Europe's history.
Only five years ago we engaged in a grand enterprise of institutional design that irreversibly tied
together the economic and monetary destiny of eleven, then twelve, nations. In five days from now,
the European Union will complete its largest ever expansion. What was originally a Community of six
countries in Western Europe will become a Union of 25, spanning a geographic area that used to be
divided by an iron curtain. Today we can watch some 450 million Europeans dismantling the barbed
wire of political hatred and economic seclusion that had split the continent for more than half a century.
We can watch Europe, once again, engaging in a concerted effort to overcome differences and
manage diversity.
Taking issue with this historical transition, I intend to focus my remarks on the challenges of executing
monetary policy in such a rapidly changing world. A world in which high-speed structural change
- whether spurred by spontaneous economic forces or institutional evolution - may put time-tested
economic models at risk, and defy policy-makers' search for easy policy recipes.
I will describe the mechanisms that the ECB has set in place to protect itself against the risk of serious
misperceptions and policy mistakes. My conjecture is that these mechanisms can explain a great deal
of the reasons why the institutional transition in Europe has so far been accomplished in the smooth
manner in which it proceeded. And I will argue that the same mechanisms are also appropriate to
prepare Europe for the new challenges that lie ahead.
Central banks and uncertainty
The ECB, like all central banks, is faced with several dimensions of acute uncertainty. The economy is
continuously hit by disturbances that are often difficult to identify in real time. Even when
policy-makers are able to correctly assess the source and the nature of a disturbance affecting the
economy, tracking its propagation profile and assessing its final impact on the key variables of interest
to policymakers is a daunting task.
Econometric theory has spent decades devising sophisticated tools to isolate different types of shocks
from the tangle that appears in the data. But inference is often non-robust across various identification
schemes. And real-time identification remains central banks' Holy Grail. As a consequence, central
bankers are given little guidance by theory in their daily endeavour to filter out noisy data.
The task of policy-makers is further complicated if they suspect that customary cyclical movements are
compounded by an ongoing change in the deep structure of the economy. For one thing, structural
change amplifies the identification problem. It is difficult to ascertain whether the dynamic force that we
see appearing on the screen is going to be reversed and eventually vanish, or will become ingrained
in the underlying economic mechanism for many years to come. But more importantly, in case a
structural change is truly under way, macroeconomic relationships derived from empirical regularities
and historical averages are bound to lose significance. A new set of relationships would need to be
estimated and tested. But serious diagnostics for structural stability rarely give definitive answers. And
re-estimation requires sufficiently extended spans of data that simply do not yet exist.
Structural change on a global scale
The past decade, on both sides of the Atlantic, has not been kind to policymakers' aspiration to a
comfortably stable set of structural relations usable for policy analysis. At a minimum, the second half
of the 1990s and the early years of this century have sent us stark reminders that the economic
structure does not hold still for long. Our recent experience in coping with economic change has
provided more than one stress test of the macroeconomic models that are in use in our institutions. I
shall mention three examples.
On this side of the Atlantic, the policy debate has primarily focused on technological innovation, the
spread of information technology, and globalisation. Many distinguished analysts have identified in the
combination of these three dynamic factors the main structural force behind the reduction in economic
frictions and the narrowing of the ability of any single market player to influence prices and dictate
market conditions domestically. This course of events has increased competition. Through a better
allocation of resources, heightened competition has advanced the standards of living in more than one
country, notably the US. However, the same phenomenon has also reduced policymakers' confidence
in what seemed to be well-tested economic relations. For example, it has loosened the association
between output growth and inflation, and between these two variables and employment. And many US
observers were left wondering whether the intense capital deepening of the last few years - and the
associated measured growth in productivity - may have shifted substantially the relationship between
output and inflation. Of course, lasting shifts in productivity trends and their economic consequences, if
real, will be clearly visible only in retrospect.
Financial markets have also been a very important source of structural discontinuity with the past, in
Europe and the US alike. We all have witnessed the frantic rise and the subsequent shake-up of
equity valuations. In addition, we have seen an unprecedented wave of mergers and acquisitions,
facilitated by deeper and more liquid financial markets. This wave not only has affected domestic
markets, but also very much has brought about tighter global linkages in the corporate sector. These
tighter linkages, in turn, may have affected the extent and pace of the transmission of economic
developments across the globe.
Structural change in Europe
Thirdly, let me mention some sources of structural change that are specific to Europe. I would like to
emphasise three dimensions. One is related to the institutional switch that the creation of the
single currency has represented for the nations that have adopted the Euro. It was not clear at the
outset to what extent the introduction of the single currency would affect financial markets and price
and wage-setting behaviour. Indeed, times of institutional change are arguably times in which private
expectations may fail to co-ordinate on a focal point. The widely-held presumption then was that the
statistical patterns emerging from past data might not be informative of the structure of the new
economic entity, and inference drawn on its basis might even be misleading. Those were times in
which the measure of uncertainty was closer to a 'Knightian concept' wherein probability distributions
for model coefficients could not even be known or existant.
The money market, for one, underwent a historical transformation on the eve of the launch of the Euro
in January 1999. Eleven national markets, so diverse in terms of participants, operating conventions,
settlement structures, credit facilities, had to merge into a unified trading area almost overnight. New
payments systems for large-value transactions were implemented. Capital markets traditionally
protected by currency fragmentation and national regulations were opened up to arbitrage and straight
competition. It could not be taken for granted that private agents could immediately form expectations
consistent with the new regime, and thus instability in behaviour could not be ruled out.
Let me also mention, en passant, that, although the process of preparing for the adoption of the single
currency had been carefully crafted, much remained to be accomplished on the side of constructing
homogenous statistics across the countries participating to the Euro area and the elaboration of tools
and models for the analysis of economic data.
The second dimension relates to ongoing efforts of the Euro area to implement structural
reforms in the labour and good markets. These reforms aim to make these markets more flexible,
strengthening the Euro area's competitiveness and its resilience to shocks. Several such reforms have
been already implemented and many more are to come. This is a factor that adds uncertainty to the
stability of economic relationships in the Euro area, a factor that the central bank has to take into
account when taking policy decisions.
The third dimension of structural change in Europe is that associated with enlargement. The
integration of these new countries will affect the European economy through a change in trade
patterns, capital and labour flows and a higher level of competition.
The enlargement will no doubt provide new opportunities for trade and investment flows. Some effects
are already visible in a high degree of economic integration between the current Member States and
the acceding countries. Lower trade costs and an increase in competition associated with the
enlargement of the Single Market can have a significantly positive impact on growth in the European
economy as a whole. But the side effect might be, again, a somewhat diminished ability to extrapolate
statistical patterns seen in the past to forecast the future, at least for some time.
One notable source of dynamics in structural relationships, looking forward, will be the convergence
across income and productivity levels. For acceding countries as a whole, per capita income today is
less than half of the average of the Euro area, so the potential for trade creation and redirection of
existing trade and production specialisation patterns is enormous. In the end, increasing prosperity
and living standards will be forthcoming for the whole Union. And along the way the drive towards
reallocation of production and re-specialisation will call for changes.
The ECB's monetary policy concept
Europe's transition to the single currency, no doubt, marked a time in which the signal extraction
problem in understanding economic developments was most acute. Yet, the transition was smooth
and the abrupt switch in the process by which agents form their expectations, that many observers
had predicted, did not materialise after all. So, amidst the challenges that loom in our future, we are
reassured that we did make it and that it bears testimony to our capacity to weather difficulty.
On the eve of the Euro changeover, markets immediately recognised the new rules of the game. They
adjusted swiftly to the new monetary policy environment. Money market developments indicated that
monetary policy was reasonably predictable from the start. Euro area medium and long-term inflation
expectations, as measured by survey data, have remained around 1.8%-1.9%, consistently pointing to
a high degree of credibility of the ECB's official announcement that it would aim to maintain inflation
below 2% over the medium term. In this respect, long-term inflation expectations aligned themselves
with the low levels of the best performing economies that were merged into the Euro. This is all the
more remarkable given that the ECB started without a track record of its own and was faced with a
number of sizeable, mainly upward, price shocks hitting the Euro area economy.
Faced by an environment characterized by an exceptional measure of uncertainty, the ECB identified
three principles for an efficient monetary governance. These three principles, stability,
comprehensiveness, and transparency have been incorporated in the monetary policy concept that
has guided our course since 1999.
Stability
There is, today, a general recognition that price stability is highly desirable from an economic
standpoint. It preserves an environment conducive to the optimization of resource allocation and
therefore permits to foster sustainable growth and job creation. There are several other reasons why
price stability is a public good of great value: In particular, preserving the purchasing power of the
citizens, including the most vulnerable, and preserving the correct functioning of the democratic
institutions.
In a world of accelerated changes, the concept of stability is even more of the essence. The central
bank has responsibility to be an anchor of stability, price stability being the ultimate goal and one of
the preconditions for financial stability.
This stability principle has two major corollaries: First, being as clear as possible as regards not only
the goal, but also the arithmetic definition of price stability. The Treaty establishing the Economic and
Monetary Union wrote in stone that the objective assigned to the European Central Bank was price
stability. In 1998, upon taking up its monetary policy tasks, the Governing Council of the ECB
sharpened the focus by defining price stability in quantitative terms as the year-on-year increase in the
Harmonised Index of Consumer Prices of below 2%. We further facilitated the coordination of private
expectations by clarifying that in the pursuit of price stability the ECB aims at inflation rates below but
close to 2%, thereby preserving a sufficient safety margin against the risk of deflation. This precise
definition had not only the advantage of permitting to anchor inflation expectations and to enhance
transparency and accountability of the European Central Bank. It was also absolutely instrumental in
preserving continuity in the moment of transition from the previous national currencies to the Euro: the
Euro was given the very same definition of price stability as the one attributed to the most credible
national currencies benefiting from the lowest market interest rates. That has contributed to one of the
most remarkable - and unduly discrete - process of the setting up of the Euro: From day one the Euro
was given the best yield curve available in the economies of the Euro area.
Second, immunizing monetary policy against short-termism by solidly anchoring it on a medium-term
perspective. Constantly bombarded by economic news, a central bank risks being swamped by the
latest indicator and by its conjectures concerning markets' likely reaction to the latest indicator. This
mechanism can lead monetary policy gradually astray from its foremost role of providing a firm
medium-term anchor for the economy. The ECB has built into its strategy a mechanism against
short-termism by adopting a "keeping its composure" approach to countering shocks.
Instrumental in this steady-hand framework is our notion that the appropriate horizon for monetary
policy is the "medium term". In this respect, the time horizon over which price stability has to be
re-established needs to be tailored to the circumstances prevailing in the economy. Sometimes,
notably if there is suspicion that asset prices are moving substantially up or down, it pays to look even
very far ahead, beyond the average lag of monetary transmission. In other cases, the economy can be
expected to return to price stability within a shorter horizon. Such horizon would depend on whether
the shocks are temporary or permanent, whether they emerged on the supply or the demand side, on
their domestic or external origin, their potential for becoming entrenched in pricing decisions and on
their implications for the fragility of the financial system. In all events, the central bank has to preserve
its credibility, ensuring that expectations remain consistent with its declared policy objective.
Comprehensiveness of the analytical framework
A central bank, in its daily operations, has to filter an enormous amount of information. It routinely
seeks to define the state of the economy as new circumstances arise and evaluate their implications
for the risks to price stability. As I tried to argue above, this is a highly demanding exercise, because
shocks do not come about with labels and the economy is potentially always subjected to structural
changes. As a consequence, it is clear for all central banks that no simple rules linking policy to one or
two privileged indicators can substitute for an accurate examination of economic developments in all
their decisions and forecasts.
From the beginning, the ECB felt the need to endow itself with a conceptual framework that could help
it sort through a wealth of conflicting statistics, and organize the various pieces into a reliable road
map for internal analysis and communication with the public. This called for the adoption of a
framework that concentrated more on picturing the economy as a large, complex and permanently
evolving system, rather than trying to condense this complexity into too simple summary statistics and
models.
In the event, we opted for a 'binocular' perspective over the economy, organised in an "economic
analysis" and a "monetary analysis". This policy framework, which came to be known as the 'two pillar
approach', permits to convey the notion of a diversified analysis and, in our view, ensures that no
information is lost in the assessment of risks to price stability.
An important rationale for the two-pillar approach relates to the difference in the time perspectives
relevant for analysis of price developments and for the formation of private inflation expectations.
Empirical analysis has shown that the inflation process can be broadly decomposed into two
components. One is associated with the interplay between demand and cost factors at a high
frequency. The other is connected to more drawn-out and persistent trends. The latter component
demonstrates an empirical association with the trend growth of money on a long-term basis.
The short to medium-term "economic analysis" - with its focus on real activity and financial conditions -
is well equipped to study shorter-run deviations of inflation from its long-term trend. However, it often
fails to track the mechanisms by which monetary factors act over extended horizons to nail down such
trends. As a consequence, a monetary policy framework exclusively centred on such analysis would
leave a 'loose end' in the expectations formation process, to the extent that it would offer no anchor to
anticipations of price developments as the horizon - over which these are formed - lengthens.
There are, therefore, merits in cross-checking the indications for the monetary stance that emanate
from the shorter-term "economic analysis" with those stemming from the monetary analysis. Monetary
analysis constantly reminds the central bank of the fundamental principle that, while responding to
economic developments as they unfold, it must never lose sight of the fact that, over sufficiently
extended horizons, the rate of money growth must be consistent with its price stability objective. This
cross-check ensures that monetary policy has a nominal anchor beyond - and even well beyond - the
conventional projection horizon. It also induces and reinforces a firm sense of direction, discouraging
policy agitation.
Let me also observe that the success of the transition to the Euro was also very much depending on
the lasting anchoring of long-term and even very long-term inflation expectations. As a matter of fact,
to benefit at the very start of the Euro from the best yield curve available in the Euro area, to be able to
extend immediately the very low market interest rates that existed only in a small number of
economies to the full body of the Euro area, one needed to be very credible. And this credibility in the
delivery of price stability had to be intact not only in a two-year or five-year perspective, but also on a
ten-year and thirty-year basis.
Despite the fact that the ECB had a precise definition of price stability which the Federal Reserve
System had not, like the Fed the ECB deliberately chose not to mould its own monetary policy strategy
as one of "inflation targeting." To be sure, the concept of "inflation targeting" is not always a clearly
defined concept. However, if it is understood as a framework that makes macroeconomic forecasts the
principal, if not the sole, statistical input feeding the policy-making process, then we would consider it
too narrow a description of what monetary policy should look at.
Indeed, attempts to characterise the state of an economy in terms only of inflation forecasts would
neither do justice to the intrinsic complexity of the decision-making process, nor would it provide a
robust and safe approach to policy. This is particularly true in a world of accelerated structural change
in which central banks face a high degree of uncertainty about the future.
A central bank needs to maintain appropriate flexibility in the way it responds to shocks, taking
decisions which are robust across a set of different plausible scenarios for the future. In this respect, it
has been increasingly recognised that a central bank that focuses on inflation forecasts at one or
two-year horizon would not be able to appropriately take into account the formation of financial
imbalances, as they generally exert effects on price developments at longer horizons. Especially in the
face of substantial uncertainty about the sustainability of asset-price developments, it may instead be
advisable to set interest rates with a view to a time frame extending well beyond conventional forecast
horizons.
More generally, the existence of uncertainty requires central banks to put strong emphasis on the
robustness of their decisions, which implies that a good monetary policy strategy needs to perform as
well as possible across a variety of empirically plausible models and scenarios. And it is in particular
our view that the complexity with which monetary policy-makers are faced with should be presented to
the public in a transparent manner.
Transparency
Indeed, the third principle that we have adhered to since the inception the ECB is the importance of
open and transparent communication with investors, savers, market participants and the public at
large. This is a prerequisite for appropriate accountability and enhances the understanding among the
markets of how the central bank conducts its monetary policy, thereby enhancing substantially policy
effectiveness.
This was especially important for a new institution such as the ECB which was lacking a track record.
The announcement of our monetary policy strategy in October 1998, before the ECB actually started
to be in charge of conducting the single monetary policy in the Euro area, was a key element in our
striving for transparency. It clearly stated the rules of the game and helped to reduce the uncertainty
faced by market participants.
Communication with the public and the markets has also being facilitated by the fact that our
assessment of the economic situation and the risks to price stability is regularly published and that
monetary policy decisions are explained in the press conference that we give after each monthly
meeting in which monetary policy is discussed. The ECB produces on a monthly basis a bulletin that
provides a detailed economic assessment to the public.
We have been told from time to time that we were not sufficiently transparent. I think this is not
justified. As a matter of fact, we have been very imaginative and creative in this respect at the very
beginning of the Euro. In 1999 the state of the art of central banking was to display the diagnosis of
the Central Bank 5 or 6 weeks after the decision was taken in publishing the minutes. No explanation
at all was given in real time. We have been the first Central Bank to publish a full, detailed, real time
public display of our analysis and of the reasons why we had taken our decision. And we have also
been the first to embark on a press conference organised by the President and the Vice President to
explain the decision of the Governing Council.
In that sense, we are one of the most transparent Central Banks in the world. And we have contributed
substantially to modify the state of the art of Central Banking: Today it would not be possible for a
Central Bank to take a decision without displaying a real time explanation of the decision.
Monetary policy and asset prices
I have already alluded to some of the challenges that monetary policy must face in relation to
asset-price movements. Let me, therefore, at this stage pose on this issue that has recently attracted a
great deal of attention in the debate among policy-makers, academics and the public at large.
There are many challenges that central bankers face in relation to the links between monetary policy
and asset prices. To name a few: Should central banks react to asset-price movements? How to
identify the insurgence of dis-equilibrium in asset prices when the equilibrium level is unknown? How
to avoid a moral hazard problem? How to communicate with the public in case of asset-price bubbles?
Unfortunately, there is no clear-cut answer to any of these questions. Instead, faced by starkly
competing models and conflicting explanations of virtually all financial phenomena, central banks are
constantly reminded of the great value of robustness and pragmatism in monetary policy. In this
respect, I shall contend that the strategy adopted by the ECB involves some features which help to
see through and tackle these challenges.
First of all, the overriding objective of price stability, which monetary policy should be geared to, makes
clear that asset prices cannot be a target for a central bank. This follows from the notion that in the
long run, asset prices - such as stock or real estate prices - are fundamentally determined by real
factors such as productivity, the inter-temporal preferences of society, and demographic
developments. A central bank cannot control these factors and therefore it cannot aim at bringing
about any asset price configuration that is not rooted in such fundamental forces.
In addition, it is widely recognised that the central bank's focus on the overriding objective of price
stability helps to reduce investors' misperceptions about future return possibilities and alleviates the
problem of asymmetric information between borrowers and lenders. At the very least, even though
price stability cannot guarantee financial stability in all circumstances, it is clear that the absence of
price stability would only exacerbate the problems associated with asset-price misalignments.
Incidentally, as I have already mentioned, adopting a flexible medium-term orientation in the pursuit of
price stability has the effect of lengthening the monetary policy horizon beyond the two years within
which meaningful inflation forecasts are usually constructed, depending on the prevailing economic
circumstances. This lengthening of the policy horizon helps to trace out the likely macroeconomic
impact of a putative financial misalignment.
Although asset prices cannot be a target for monetary policy, they no doubt reveal very useful
information about future risks to price stability that a central bank should take in due consideration. It is
important to recognise, however, that a rise in asset prices does not always signal increased
inflationary pressure. Whether or not this is the case very much depends on the underlying shock to
the economy. There is thus no easy way to shortcut the signal extraction problem faced by a central
bank in the financial markets and the design of an appropriate monetary policy reaction to a given
movement in asset prices. Instead, a careful identification of the shocks driving the markets to best
evaluate their implications for the risks to future price stability is needed.
Movements in asset prices that astray from their fundamental value, so-called asset-price bubbles,
pose specific and additional challenges for monetary policy. The first - and already very big - challenge
is to detect in real time whether a bubble is developing. Asset prices are inherently forward looking
and it is very difficult to assess ex ante whether the expectations underlying an ascending or
descending trend are realistic or are just validating themselves. In this respect, the central bank
typically has no better knowledge about future fundamentals than the market itself.
This does not mean that a central bank is left all by itself in the face of major asset price movements.
For example, some simple measures for identifying overly optimistic expectations in the valuation of
stocks seem to have been reliable indicators on quite a few occasions in the past.
Moreover, apart from significant deviations of asset prices from past trends or from model-based
predictions, it appears that it is also useful to look at developments in credit and monetary variables in
order to identify bubble phenomena in real time. In this respect, we have gathered some evidence that
growth rates of money and credit which are persistently in excess of those needed to sustain
economic growth at non-inflationary levels may, under certain circumstances, provide early information
on emerging financial imbalances. Incidentally, this is another important argument for devoting
systematic attention in our analysis to the monitoring of money and credit developments in our
monetary policy strategy. Finally, careful analysis of the balance sheets of the different sectors of the
economy may also be able to provide early signals regarding the formation of bubble phenomena and
financial imbalances in real time.
But despite all this, it is clear that the difficulties involved in identifying asset-price misalignments in
real time are enormous. Central banks need to be very cautious in forming their assessments and
keep the caveats underlying their analyses always in mind.
And the challenges faced by central banks in the face of sustained market movements are not
exhausted by the identification problem that I just described. Even in the rare cases in which the
central bank can confidently claim to be facing an unusual and possibly destabilising asset price
movement, the design of its reaction is all but automatic.
It is often argued that a central bank in such circumstances should carefully tighten its monetary policy
at an early stage in order to suppress the bubble process before it escalates to disproportionate
dimensions. If a bubble exists, a somewhat tighter policy along the build-up phase - so the argument
goes - may help to avoid that even larger imbalances may develop down the road.
However, a bold opposite view has also found some supporters among economists. This alternative
policy option would tend to suggest that, due to the rather long lags in the operation of monetary policy
impulses, the central bank should consider loosening - rather than tightening - its policy in anticipation
of the bubble collapse. This would cushion the negative effects of the expected economic downturn in
a forward-looking manner. There is a very strong argument against this policy option because, when a
bubble process emerges, it is then almost impossible for the central bank to predict the timing of the
turnaround in asset prices. And if the central bank cannot be sure that the bubble will burst of its own
accord, a loosening of policy will further strengthen the bubble process.
But the dilemma - where not only the measure of misalignments, but also the sign of the monetary
policy response to it is somewhat controversial - exemplifies the amplitude of the policy dilemma.
If and when the bubble bursts, there is a dimension of strategic interaction that a prudent policymaker
cannot ignore. This offers a rather strong argument in favour of symmetry in the central bank's
behaviour in boom and bust periods. If a central bank were to react in an asymmetric manner, namely
only with looser policy at times of asset price busts but not with tighter policy when asset price bubbles
emerge, the central bank may create through its own behaviour a moral hazard problem among
market participants. It is crucial for a central bank to avoid this, since a perception that it insures
investors against the risk of large losses could easily contribute to the formation of new bubbles in the
future.
All these considerations underscore how delicate is the issue of how to best communicate with the
public during episodes of sustained asset-price movements. The principle of transparency in the
conduct of monetary policy would demand that if the central bank's view about the bubble enters into
its monetary policy considerations it should make its views known to the market.
Two central banks in comparison
In conclusio