Jean-Claude Trichet: Jackson Hole Conference - monetary policy and "credible
alertness"
Intervention by Mr Jean-Claude Trichet, President of the ECB at the Panel discussion "Monetary policy
strategies: a central bank panel", at the symposium sponsored by the Federal Reserve Bank of
Kansas City, Jackson Hole, Wyoming, 27 August 2005.
* * *
Dear Alan, dear ladies and gentlemen,
I had the privilege of participating with Alan in all meetings of the G7 Ministers and Governors over the
last 18 years. But there is one big difference between us! He participated in all these meetings as
President of the Federal Reserve, whereas my responsibilities changed three times during this period.
I was successively Undersecretary of the Treasury of my country, Governor of Banque de France and
then President of the European Central Bank. I could therefore look at the legendary exposition of
Alan in the G7 from three different angles, now not only with the benefit of a multiocular perspective
but also of hindsight. And I can say that in 3-D Alan's expositions in this intimate, restricted format are
incredibly sharp, profound and visionary. I personally share fully, in particular, the judgement of Alan
Blinder and Ricardo Reis on the lucidity of Alan as regards the early diagnosis of the productivity jump
in the US economy.
Not only in the United States, also in Europe as in the rest of the world, Alan has a very high
reputation. In some European quarters, he is even sometimes made the principal witness of monetary
policy activism, but I am not sure whether he himself would agree with such a role. Still, the issue of
the Fed's movements in interest rates and those of the ECB is frequently debated. Let me elaborate
on this debate somewhat further.
Since 1 January 1999, when the European Central Bank (ECB) officially became the monetary
authority of the euro area, the ECB has changed its policy rate 15 times. The easing cycle that started
in 2001 on both sides of the Atlantic saw a cumulative reduction in the euro area's policy rate of 275
basis points, accomplished over 7 moves. That cycle has not yet been reversed.
The fact that we have moved less frequently than the Federal Reserve, in particular over the last 2
years, has generated a very interesting discussion on central bank activism. The undisputed notion
that the central bank should react to the state of the economy goes a long way to explaining why
different currency areas have witnessed different degrees of central bank activism. Shocks of greater
magnitude and/or longer duration, and an economic system in which exogenous disturbances run their
course more strongly and speedily, can largely explain different policy responses, as measured by the
frequency of policy moves and the cumulative change in the policy rate.
So, different contingencies and economic structures - quite naturally - can result in a different conduct
of policy. And I could explain at length why in 2001 the highest rates in the euro area were only at the
level of 4.75%, when they were at 6.5% in the United States and why the cumulative reduction in the
easing cycle has been larger in the United States, only taking into account objective measures of the
differences of amplitude of the economic swings that have characterised both sides of the Atlantic.1
But I would like to share with you today some thoughts on a different sort of difference in "activism":
one that is not induced by the state of the economy, but rather one that finds deeper motivation in the
central bank's strategy.
It is the degree of activism that results from the way policymakers try to reconcile a fundamental
tension inherent in their profession. On the one hand, as a quite general principle of prudent monetary
governance, it pays to adopt a systematic policy focused on responding to the fundamental forces at
work in the economy in a predictable manner, disregarding the vagaries of expectations and markets'
fads. This policy would enhance markets' ability to anticipate the central bank's behaviour, favour a
smooth adjustment of the economy to disturbances, and prevent instability of expectations from
injecting volatility into monetary policy, and in turn into the economy. If successful, the degree of
activism displayed by this policy would be mainly related to the variability of the state of the economy.
On the other hand, a central bank does also need to recognise that misled expectations can amplify
and prolong the response of inflation and economic activity to an inflationary or deflationary shock.
This would in general imply that the central bank should embark on an aggressive policy action in
response to expectations instability. And, this will add to the degree of activism displayed by the policy
rate.
I will argue that, whilst the central bank must always be ready to take aggressive action if needed, a
well-designed institutional framework, which undisputedly assigns the central bank the primary
objective of price stability, and the adoption of a clear monetary policy strategy, which quantitatively
defines price stability and does not pretend to fine-tune directly the business cycle, can make the latter
type of policy activism unnecessary in many circumstances. The reason is that this framework reduces
uncertainty about the central bank's ultimate motives, provides a stronger anchor for inflation
expectations and makes it easier for the markets to map the expected path of the policy rate to the
evolution of macroeconomic conditions. This would reduce the likelihood that expectations might
overreact in the first place and, should expectation instability nevertheless occur, provides the central bank
with an additional viable option.
I will argue that under some conditions the central bank can regain control of private expectations
without necessarily changing interest rates, but by being visibly and credibly "alert", explaining and
stressing its commitment to maintaining inflation at levels consistent with the price stability objective.
The threat to act will be more effective the more credible the central bank has been over time in
actually delivering price stability, as defined quantitatively. The paradox would be that this policy of a
priori "reinforced alertness" would make the central bank appear ex post less "activist" in terms of
changes to the policy rate. Importantly, as a side effect, this policy would better sustain economic
activity and minimise macroeconomic volatility.
In practice, the central bank would normally make use of all available options - as circumstances
dictate - to counteract situations that have the potential for undermining confidence and perturbing
market conditions for a lasting period. We have done that in the past and we will do it in the future. As
an example, under the chairmanship of my predecessor, Wim Duisenberg, whose passing away a
month ago has deprived our community of central bankers of a man of remarkable wisdom and lucid
judgement, we took immediate decisions after the dramatic events of 9/11, pouring very large amounts
of liquidity in euro, setting up a swap agreement with the Fed and decreasing rates. This has
demonstrated very clearly that the ECB was eager to act decisively and immediately when appropriate
and had absolutely no enshrined bias for waiting for the "slowest ship in the convoy". This observation
that all observers and market participants made was certainly important in reinforcing the credibility of
the Governing Council of the ECB when embarking on a "reinforced alertness".
In all situations, we have been aided in our task by our monetary policy strategy. Clarity about the
quantitative definition of price stability and about the framework we adopt to assess risks to price
stability has been particularly important for us to ensure a smooth start to Monetary Union in Europe.
Such clarity afforded considerable latitude for action in the early years of the decade, despite repeated
unfavourable shocks, and a remarkable leverage over market conditions.
The advantages of a rule-like behaviour
At first thought, a "discretionary" response to shocks might seem exactly what one would expect of a
professional central banker. After all, each economic contingency is a unique combination of
circumstances that, in its own way, is unprecedented, and will probably never repeat itself again in that
precise form. So, each new contingency would seem to command a different, tailor-made response on
the part of monetary authorities.
There is some grain of truth to this. But decades of reflections on the role of expectations in
macroeconomics have taught us that monetary policy is not a sequence of isolated policy actions.
When forming their expectations, agents seek to capture the general pattern of monetary policies, and
it is that pattern that matters in shaping their economic behaviour. Therefore, the relevant problem to
solve for central banks is not so much about the size and timing of a given interest rate move in
response to a particular contingency. It is more about the strategy for repeatedly adjusting the policy
instrument in response to the state of the economy, whatever this might be.
If the central bank is able to convince economic agents and markets participants of its analysis and
assessment of the outlook, and about the policy measures that it is going to take in response to it, this
mechanism of anticipation will act in self-equilibrating manner. As soon as the macroeconomic news is
released, expectations of the short-term interest rates will adjust in the equilibrating direction that
markets expect to see implemented by the central bank. Such a credibility asset can turn out to be
very beneficial in cases of major shocks and risks.
It is clear that a world in which central banks' inclinations and market views are perfectly aligned is
unlikely to emerge in reality. However, decades of academic reflection and central banks' quest for
stability have not past in vain. Our keen preoccupation with making ourselves understood by words
and deeds has established a new climate of mutual understanding with academics, investors, market
participants and public opinion at large. We have stepped up the number of gatherings in which we
document our strategies and carefully explain our actions to broad audiences. On the markets' side,
our constant drive toward a continuous and all-round exchange with the public has been tangibly
rewarded with high marks. The leverage of central bank pronouncements and actions over private
economic behaviour has strengthened to an extent that we could not have remotely imagined only a
decade ago.
There is no shortcut to fully revealing a central bank's strategy. This disclosure - which we perform in
an ongoing process of interactions with a large and complex audience - helps to clarify the policy
environment and anchors expectations. But unless deeds support words, words will be unconvincing.
So, there is no better way to establish a reputation for actually following a strategy of monetary policy
than letting the public infer and recognise it from our repeated behaviour. Consistent behaviour is a
precondition for outsiders to understand our actions and believe our pronouncements. In synthesis, it
is a precondition for our credibility.
This capital of credibility is built over time and easily squandered. So, as a general principle, in
weighing up the arguments for and against such and such a decision, we should never fail to
appreciate that our behaviour has durable significance. It can add to the asset of credibility, or detract
from it in important ways.
A corollary: beware of false signals
In my view, the statement that a reputation for consistent behaviour is an asset carries an important
corollary with it. We should guard against over-reacting to indicators that might give a distorted picture
of economic reality and thus promote policies that might be regretted - and hastily reversed - in
retrospect.
To be more specific, in carrying out our strategies, we would ideally need accurate, quantitative,
contemporaneous readings of the current pertinent economic, monetary and financial data. For
instance, knowledge of the level of production that would be consistent with stable prices, the
socalled "natural" rate of output, would be an important tool for assessing whether the stance of policy is
broadly appropriate. However, estimates of the time-varying natural rate of output, and by implication
measures of economic slack, are notoriously very imprecise. Even in hindsight, different estimation
methods yield quite dispersed figures. Allowing for data revisions, that is re-appraising those synthetic
indicators by aggregating revised data, only makes the uncertainty surrounding those measures more
pervasive.
Now, acting too strongly on such indicators, only to be forced to reverse gear soon thereafter as new
estimates become available, risks the danger of an erratic policy process. Importantly, it confounds the
markets, which look back on our record and try to make sense of our past behaviour using the wisdom
that is only available in hindsight. If this gives indications that differ markedly from those which could
be reasonably inferred in real time, outside observers might extract a distorted picture of our
intentions. Even prudent policy conduct could appear ex post - and be deplored - as evidence of
incorrect decisions. This could drain the central bank's stock of credibility.
All this is not new and revives memories of the 1970s. Were the spectacular policy mistakes of that
unfortunate decade due to poor economic theory, poor policy or a biased representation of the
economy? It was probably a blend of all of these factors, with the last one carrying substantial weight.
Advances in theory since the 1970s and more sophisticated econometrics have not immunised the
policy process from these potential pitfalls. And here is a concrete example of what I mean. The first
estimates of the output gap are typically available during the reference year, and are then revised over
subsequent years. It is important to note that the final estimate is not available for a very long period of
time: 1999 estimates, for example, were still revised by non-negligible amounts in 2004. Revisions are
also large: they can often affect the sign, as well as the magnitude of the estimates. In the case at
hand, for example, the revised output-gap measure available to us today is positive in almost all
estimates for 1999, 2000 and 2001, but it was estimated to be negative in real time [as shown in
2
Chart 1.]
Uncertainty is even higher for output gap projections, which are the only measures of output gap
existing at the beginning of each year. For example, the real-time estimates of the output gap for 2005,
published in spring by the European Commission, the IMF and the OECD, differ on average more than
25% from the output-gap projections that these institutions made at the end of 2004. And, if we add to
the real-time measures of the output gap for 2005 the average size of revisions observed in the past,
we can conclude that it may ex post turn out to be anything between -3.6% and +0.8%.
Clearly, output-gap measurement issues are not a fact of the past. Central banks also need to cope
with this problem at present. I take this as a warning that the central bank should not rely on any
simple indicator of economic slack in taking its policy decisions. To conclude this point I would say that
there are, undoubtedly, great differences in terms of monetary policy strategy between us at the ECB
and, to use Alan Blinder terms, the Greenspan's Fed. We consider the public display of our arithmetic
definition of price stability essential to the success of our strategy. We equally deem that the
communication to the markets of our two-pillar monetary policy concept is important and has been of
great help in the actual implementation of our policy. It is true that, in that sense, we belong to two
different schools of thoughts on each side of the Atlantic.
But there is an important point on which on the contrary we share exactly the same views. We both
want to be as comprehensive as possible in our analysis. We both do not want to neglect any
information, any in-depth appreciation of a particular situation. We both do not want to rely exclusively
on a single particular model of the economy, as sophisticated as it may be. I have myself said several
times that the Governing Council of the ECB has no intention of being the "prisoner" of a single system
of equations. We both highly praise "robustness". There is no substitute for a comprehensive analysis
of the risks to price stability that pays due attention to all relevant information. It stands better chances
of anchoring policy and - through that channel - expectations in a durable fashion.
Responding to risks of instability
It is to expectations and the way their dynamics should be factored into policy that I now turn.
Why should expectations be a problem within a credible policy environment? Because the economy is
never at rest. Agents have to catch up with the continuous change in their environment by an ongoing
process of learning. When shocks are moderate, or the underlying evolution of the economic structure
proceeds at a slow pace, imperfect information and learning do not excessively complicate our
interactions with the private sector. But there are times in which stormy perturbations and accelerated
structural change make uncertainty more acute. These are times in which a perpetual process of
learning on the part of economic agents can have implications for the overall stability of the economic
system - to some extent, independently of the monetary policy regime that is in place. If agents do not
possess rational expectations, but have to re-estimate continuously the coefficients of an unknown
model of the economy, using rolling windows of new observations, it can well happen that a shock of
sufficiently serious magnitude can unsettle expectations, even under credible monetary institutions.
The reason for this is simple. It might become impossible for private forecasters quickly to form a
reasoned guess about the scale of the shock, its duration and persistence, and the likelihood that it
might not be easily washed away, so that it would become, in their eyes, embedded in the
fundamental relations regulating the functioning of the economy for some time to come. Long-term
expectations thus may over-react to the shock. They may drift endogenously reflecting the impact that
the unprecedented disturbance exerts on agents' own re-assessment of the key structural features of
the economy.
These are times in which, typically, there is a disconnection between private views about the
macroeconomic outlook and the central bank's own internal forecasts. The expectation of the most
likely outcome entertained by the median agent in the economy is likely to depart from the central
scenario that is considered most plausible, given the conditioning assumptions, for purposes of the
central bank's own internal assessment of the macroeconomic outlook. As agents' expectations shape
the market reaction to new economic data and to the central bank's own policy actions, they embed
information that the central bank cannot neglect or grossly underrate in its own analysis.
The difficulty lies in devising a prudent way to factor such situations into policy. And here is where the
fundamental tension inherent in our profession comes in. On the one hand we want to keep our eyes
on the fundamentals and avoid being misled or intoxicated by what could well be noise and unfounded
overreactions. On the other hand, excess endogenous volatility in private expectations could indeed
provide advance warning of pending risks that the central bank should take into account. Misled
market expectations can prolong the dynamic response of inflation and real activity to an inflationary or
deflationary shock of sufficiently great potency. This might entail serious risks of instability. Recent
work done at the Federal Reserve Board by Athanasios Orphanides and John Williams3 shows that, in
these circumstances, a rise (or fall) of private inflation expectations beyond (or short of) those implied
by perfect knowledge should elicit a more aggressive response than could be expected in normal
conditions. The optimality of such a response is corroborated in a study by Vitor Gaspar, Frank Smets
and David Vestin4[4] at the ECB. They argue that when agents perceive inflation persistence to be
high, inflationary - or deflationary - shocks can easily become entrenched, because agents suspect
that these forces will be perpetuated by the economic structure.
An aggressive policy adjustment in reaction to detected signs of expectation instability can help head
off the risks that one might see associated with the manifestation of such phenomenon. It might be an
effective way to prove that the central bank is perceptive to changing circumstances - even to
changing views about circumstances, present and prospective - and ready to act pre-emptively.
However, any unexpected and possibly unprecedented action that the central bank takes in response
to these risks might disorient the market. So, the process by which market participants price
longdated securities and assets in general might be impaired, as investors might misinterpret the central
bank's intentions. As a consequence, asset prices could be driven far away from fundamental values
and confidence could be undermined.
This would suggest that action may not always be advisable. Sometimes, more optimal behaviour
consists in appropriately communicating the central bank's assessment of the fundamental state of the
economy and its prospects in order to regain control of inflation expectations. In the long term, the
advantages of having systematically avoided hasty reactions outweigh the benefits that might be
apparent in the short term. By maintaining a steadier posture, the central bank embracing this policy
views its role as that of a lighthouse or, more accurately, a lightship, in a storm. In this respect,
building a reputation for a calm and firm management of the events can pay off.
The viability of this approach - and its efficiency - is enhanced when the central bank operates within
a clearly defined institutional framework. In policy-making regimes that feature a primary,
sharplydefined objective - reinforced by a precise numerical definition of the central bank's notion of price
stability - the likely evolution of the economy vis-à-vis that objective gives clear indications as to the
most likely future stance of policy. This is supposed to diminish the odds that expectations might start
diverging in the first place. And, if expectation instability should develop nonetheless, being able to
refer in communication unambiguously to that objective can - at times and under certain
circumstances - provide an effective substitute for tangible action, provided "credible alertness" of the
central bank is undisputed by market participants.
Action and vigilance
All in all, the art of central banking involves finding a fine balance between action and words in order to
react to changing market expectations. The easing cycle that started in 2001 and the instability in
inflation expectations that occurred in 2003 represent 2 episodes that illustrate how the ECB has in
practice devised its own way to address these issues.
In early 2001 the ECB started an easing cycle. At the time, on the heels of significant adverse supply
shocks and rather strong wage dynamics, inflation rates were high at levels unseen since the late
phases of convergence to the new currency in the euro area. However, we equally saw an upcoming
worsening of the outlook for economic activity, as indicated by the rapid decline in several confidence
measures. This lowered the risks to inflation coming from wages, and inflationary pressures more
generally.
While we assessed that the information coming from monetary trends was consistent with price
stability over the medium term, we took the view that the upward inflationary pressures were of a
temporary nature and warranted looking through the shocks that had caused them to emerge. We held
the view that a protracted period of weak economic activity, and the increasing odds that the recovery
would not materialise soon, would eventually facilitate a downward adjustment in price and
wagesetting behaviours. The easing cycle, which we readily initiated, registered a cumulative decline in the
policy rate of 275 basis points over 2 years, moving the policy rate down to 2%, which was below the
lowest intervention rates of the central banks over a century for an overwhelming majority of countries
that are members of the euro area, including Germany.
Let me stress a point which is often underestimated. What looks perfectly appropriate with the benefit
of hindsight, moving down interest rates to such low levels - exploring secular uncharted waters - was
indeed bold ex ante for a new institution, which in mid 2003 was exactly 5 years old - and for a new
currency - that at that time was 41⁄2 years old. It had not been done to that extent by either the Fed or
the Bank of England! In retrospect, we have been bold and equally lucid. There is no doubt that the
Governing Council used appropriate judgement in granting high weight to the decrease of inflationary
pressures stemming from the downside risks to economic activity. And there is also no doubt that the
resolute action of the ECB, based on its own inflationary analysis, not only permitted to stabilise
inflation and inflationary expectations, but also helped to forestall a much deeper slowdown in the
economy.
The behaviour of inflation expectations brings me to the other episode I have mentioned. Long-term
inflation expectations, which had remained well anchored at levels in line with the ECB definition of
price stability from the outset of Monetary Union in January 1999, started displaying signs of upward
instability in the second half of 2003 after the last decision to decrease rates. The ten-year Break-Even
Inflation Rate (BEIR) suggested an incipient rise in longer-term inflation expectations [see Chart 2].
Survey-based data also revealed that the probability assigned to inflation outcomes being above our
definition of price stability at long horizons was rising [see Chart 3a].
Movements in these indicators of long-term inflation expectations possibly reflected concerns that the
policy stance was incompatible with the inflationary impact of the surge in oil prices, accompanied by a
pick-up in economic activity and protracted conditions of ample liquidity, which could be seen as
favouring spending propensities and granting firms increasing pricing power.5[5]
The rise in inflation expectations was considered very carefully by the ECB's Governing Council. It
was of utmost importance to regain control of these expectations. For all reasons that would be
common to all central banks plus three which were peculiar to the ECB. First, as I have already
explained, we had been bold in exploring new territory in the lower side of interest rates, and we had
to dissipate any wrong sentiment in the markets that we could have neglected our main objective,
namely price stability. Second, we also had to eliminate the risk that part of the market might be
tempted to regard the single currency as embedding the average features of the constituent
currencies, rather than inheriting the characteristics of the best performing monetary regimes that
constituted its legacy: that the euro, since its inception, has been, was and will be at least as credible,
as stable and as good a store of value as the most credible national currencies were, was a
fundamental goal of Monetary Union, remarkably marshalled with the greatest success at the time of
the transition. And, third, because our analysis was that market participants - by possibly
overassessing medium and long-term inflationary expectations - were pushing up medium and long-term
market rates at a moment when it was not necessarily advisable in our own judgement.
Our concern about rising inflation expectations was signalled to the market from autumn 2003 in the
press conference. Over time, our communication became increasingly "alert", signalling our vigilance
to the upside risks to inflation which grew at the time. We made it clear in our June 2004 policy
statement, stating that such an upward trend in inflation expectations called for "particular vigilance",
and in September the expression of concern was reinforced with a statement of "strong vigilance",
making it crystal clear that the ECB was ready to take whatever action necessary to eliminate the drift
in expectations and restore stability.
It is of course difficult to isolate the effect of our renewed emphasis on our objective and on the
determination with which we would enforce it. But what we could observe from the second quarter of
2004 onwards was that measures of inflation expectations stabilised, then started to edge down and
the probability assigned by survey respondents to inflation outcomes being higher than our price
stability objective declined. We also observed a decline to unprecedented low levels in the standard
deviation of individual respondents' point forecasts, the "disagreement", revealing increased alignment
of private sector expectations around a focal point - which was coherent with our notion of price
stability [see Chart 3b]. As the stabilisation of inflation expectations and their following decline coincide
with the display by the ECB of its constant alertness as a key feature of the central bank's policy, it can
probably be argued that the market had become increasingly aware of the ECB's readiness to act, and
therefore that the ECB's communication was one of the main factors driving expectations. An
argument supporting this view is that the decline in Break-Even Inflation coincides with a sharp rise in
oil prices. This constituted a major break from the past, when rises in oil prices regularly led to higher
Break-Even Inflation rates. However, other factors also may have contributed to the fall in expected
inflation, such as technical market factors, dampened dynamics in labour costs and increasing
weakness in leading indicators of economic activity. Of course, while communication can play a
decisive role in steering expectations, it is in the end the actual conduct of monetary policy and its
success in maintaining price stability that over the longer run will determine inflation expectations.
Further insights about this episode can be obtained by looking at developments in inflation
expectations at different horizons [see Chart 4a]. The short-term Break-Even Inflation Rate (derived
from instruments with maturity 2008) was not lastingly affected by the ECB's communication of 2004
and remained at values slightly above the ECB's definition of price stability all along 2004 and up to
June 2005. As should be expected, its dynamics were more closely associated to movements in actual
inflation and short-term indicators of inflationary pressure, such as oil price dynamics. However, the
implied forward Break-Even Inflation Rate (referring to the period 2008-14) - which one would expect
to reflect much more closely central bank's credibility - exhibits a downward trend that starts in
mid2004. These patterns are even more striking if compared to the experience of other countries with a
long track record, such as the United States. Over the same period, indicators of short and long-term
inflation expectations in the United States display a tighter association [see Chart 4b], and, in turn,
they are more closely correlated with actual inflation and developments in oil prices.6
Over the last 2 years, stability in long-term inflation expectations was restored without engineering
policy actions. The easing cycle that started in 2001 has not been reversed yet and the ECB has kept
the policy rate constant at 2% since June 2003. During this period, the ECB has stressed that its policy
assessment is conditional to macroeconomic conditions and this seems to be well understood by the
markets. Changes in economic conditions and concomitantly in the ECB's assessment of these
conditions and their implications for the prospects, and the associated risks, for economic activity and
inflation have allowed market participants to read signals about future changes in the policy rate. This
is evident in movements in money-market forward rates, which are mainly driven by expectations of
future policy rates: although the ECB has maintained constant its interest rat