Christian Noyer: Monetary policy formulation in the euro area
Speech by Mr Christian Noyer, Vice-President of the European Central Bank, at the "Monetary Policy
and the Markets" conference of the National Association for Business Economics, Washington, DC, 21
May 2001.
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Introduction
Ladies and gentlemen,
It is a pleasure, and a very great honour, to have been invited to address this special meeting of the
National Association for Business Economics and to present the monetary policy of the ECB before
this distinguished audience of business economists and policy-makers. The theme of the conference,
"Monetary Policy and the Markets" is of the greatest interest - I believe - both to market participants
endeavouring to discern and assess central banks' policy directions, and to the ECB, which, since its
creation almost three years ago, has been assigning a prominent role to transparency and openness
in its policy-making.
In my brief remarks today, I will first elaborate on the institutional set-up of the ECB and its objectives.
Against this background, I will then attempt to explain the ECB's decision-making process as it is
structured by our monetary policy strategy.
The institutional set-up and the objective of the ECB
The body collectively responsible for monetary policy decisions in the euro area is the Governing
Council of the ECB, which consists of the ECB's President and Vice-President, the remaining four
members of the Executive Board of the ECB and the Governors of the national central banks of those
Member States that have adopted the euro as their currency.
The Executive Board is responsible for the preparation of the meetings of the Governing Council and
the implementation of the decisions the Governing Council takes. In particular, the Executive Board
instructs the national central banks on the operations to be completed in accordance with the
Governing Council's directions, making sure that the entire process develops in a consistent and fully
harmonised manner.
The Treaty establishing the European Community assigned to the ECB the maintenance of price
stability in the euro area as the primary objective and unambiguous mandate. Rooted in the
long-standing experience of the participating national central banks, there rests the conviction that it is
with the credible and lasting maintenance of price stability that the ECB could best enhance the
welfare of EU citizens. Given the uncertainties surrounding the monetary policy transmission
mechanism that arise from the complexity and the continuous evolution of economic behaviour and
institutional structures, the ECB is ill-suited to fine-tune economic developments. Attempts to support
growth and employment by deviating from a monetary policy needed to maintain price stability would
prove detrimental over longer horizons, thereby decreasing welfare and undermining the credibility of
the single monetary policy. On the contrary, by focusing on its mandate and therefore avoiding both
prolonged inflation or prolonged deflation, the ECB creates the stable environment in which
appropriate structural and fiscal polices may promote output potential effectively.
To support and safeguard the pursuit of price stability, the Treaty endowed the ECB with a high
degree of institutional independence, and in order to ensure transparency and accountability, it
imposed on the ECB extensive reporting requirements.
The definition of price stability and the two pillars of the ECB's strategy
The complexity of the monetary policy transmission mechanism requires that the preparation,
discussion and presentation of policy decisions be placed in a coherent clarifying framework. This is
the task of the monetary policy strategy that is designed both to grant the policy-making of the
Governing Council a clear and consistent structure, and to provide the most suitable vehicle for
communication with the public.
The monetary policy strategy chosen by the Governing Council ensures a comprehensive assessment
of the economic situation, of the size and nature of the shocks hitting the euro area and of the related
risks to price stability.
The quantitative definition of price stability constitutes the first feature of this strategy. The
announcement of a numerical definition has been devised to enhance clarity, anchor expectations and
offer a yardstick against which the ECB can be held accountable. The Governing Council defined price
stability as "a year-on-year increase in the Harmonised Index of Consumer Prices for the euro area of
below 2%". The upper bound of 2% is in line with the practice of participating national central banks
before the start of Stage Three of Economic and Monetary Union (EMU). It enables the existence of a
possible positive measurement bias in the HICP to be taken into account and creates a "safety
margin" which helps ensure that negative rates of "true" inflation are avoided. The headline HICP is
the indicator chosen as the preferred measure to quantify our primary objective because this is the
homogeneous statistic that most closely approximates the "true" basket of private households'
consumption in the euro area. While core measures of inflation that exclude the most volatile items are
also regularly monitored for the purpose of a comprehensive analysis, the headline HICP is the
variable on which we focus as our objective. The Governing Council also emphasised that price
stability has to be maintained over the medium term. This reflects the need for our monetary policy to
have a forward-looking, medium-term orientation. It also acknowledges that short-term volatility in
prices owing to non-monetary shocks cannot be controlled by monetary policy and that monetary
policy should therefore only be held accountable for price developments over a longer horizon.
It is important to recognise the role of the definition of price stability in the conduct of monetary policy.
The Governing Council attempts to set the ECB's interest rates in a way that makes, conditional on the
available information, the maintenance of price stability over the medium term in the euro area most
likely.
It is widely acknowledged that central banks are called on to operate in an environment characterised
by substantial uncertainty, not only with regard to current and future developments, but also
concerning the actual functioning of the economy. This is particularly true in the context of the euro
area where the regime shift entailed by the introduction of a single currency may affect economic
behaviour and institutional structures. Under these conditions it is crucial to ensure that policy
decisions be robust and all-encompassing. Therefore, the ECB not only acts with a forward-looking
orientation, but also relies on a number of models, approaches and on a judgement appraisal.
The ECB designed a two-pillar structure for its strategy, with the objective of capturing and providing
all of the relevant pieces of information on the euro area economy for the assessment of the
Governing Council, thus enabling it to take its monetary policy decisions on the basis of full
information. The first pillar foresees a prominent role for money, while the second envisages the
analysis of a wide range of other economic and financial indicators.
The ECB devoted the first pillar of its monetary policy strategy to the appraisal of monetary
developments and models that accord an important role to monetary and credit developments. This
recognises the fact that inflation is ultimately a monetary phenomenon and allows to take advantage of
the stability that characterises the relationship between broad monetary aggregates and the price level
in the euro area. As a form of visible public commitment, the ECB also announced a reference value
for the rate of growth of the monetary aggregate M3 that is consistent with its definition of price
stability.
The Governing Council regularly receives a comprehensive analysis of current developments in
monetary and credit aggregates. The information revealed by the analysis of monetary developments
has proved until now to be an important and reliable guide for monetary policy decisions.
Under the second pillar of its monetary policy strategy, the ECB regularly monitors a broad set of
non-monetary economic and financial variables, such as wages, unit labour costs, fiscal policy
statistics and financial market indicators like stock prices and exchange rates. Most of this analysis
focuses on cost pressures and on the interplay between supply and demand in the goods and labour
markets. It also helps to ascertain whether shocks to the euro area economy and the resulting risks to
price stability have an external or domestic origin, are of a temporary or permanent nature, and arise
from the supply or demand side. Within the framework of the second pillar, the Eurosystem staff also
produce macroeconomic projections which are published in the ECB Monthly Bulletin twice a year.
The macroeconomic projections elaborated by the Eurosystem staff do not represent the ECB's
predictions of the most likely macroeconomic outcomes, but are built on the assumption of unchanged
short-term interest rates and exchange rates of the euro. It is important to recognise that the
Eurosystem's projections are produced on the basis of models that do not assign a relevant role to
money and that there is also a host of other economic and financial indicators whose information could
not be adequately conveyed by a simple figure or a statistical range.
In its decision-making the Governing Council therefore assesses the staff's projections together with
all the other information under the second pillar, in conjunction with the monetary analysis developed
within the first pillar. It is important to understand that the process of monetary policy formulation of the
ECB is not centred on any forecast or projection and thereby departs from the practice followed by
inflation-targeting central banks. The monetary policy decisions of the ECB have not responded
mechanistically in the past, and will not do so in the future, to deviations of staff's inflation projections
from any numerical target. The Governing Council, moreover, does not take any responsibility for the
staff's projections which, as with forecasts produced by other institutions, are regarded as just one of
the inputs into its deliberations. Given the uncertainty and different views about the appropriate model
of the economy, it would not be productive for the Governing Council to produce its own single
projection. The Governing Council instead focuses directly on setting policy rates, taking into account
all information, and the uncertainty surrounding this information, in such a way that price stability can
best be maintained over the medium term.
The robust and cross-checking assessment of information which characterises our two-pillar strategy
has proved so far to be providing the Governing Council with the analytical support most suitable for
the conduct of monetary policy in the complex and dynamic euro area environment. It is in fact with
the pursuit of price stability under a forward-looking orientation that it can best safeguard and
guarantee the conditions for favourable economic development in the euro area.
The financial markets, well-known for their pitiless judgement, have been confirming the credibility of
our monetary policy. The developments of long-term interest rates have in fact been in line with our
objective of maintaining price stability. This is not an insignificant achievement and we are committed
to not putting it at risk.