Jean-Claude Trichet: The ECB's monetary policy strategy after the evaluation
and clarification of May 2003
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, delivered at the Center
for Financial Studies' key event, Frankfurt am Main, 20 November 2003.
* * *
It is a pleasure to address such a distinguished audience. I am particularly happy to be able to devote
one of my first public speeches as President of the ECB to a topic of fundamental importance for the
ECB: its monetary policy strategy. As you know, this is a topic which the Governing Council of the
ECB discussed at great length in the first half of 2003, when we conducted an evaluation of our
experience with the strategy. This review resulted in the confirmation of our strategy on 8 May 2003.
On the same day we also introduced some clarifications which have already proved very useful,
particularly in terms of presenting and communicating to the public the more complex aspects of our
monetary policy strategy.
My aim here today is not so much to explain the meaning and details of the recent clarification, but
rather to provide you with a description of the main features of the strategy. I will also address some
important differences between our concept and alternative strategies, and I will explain why I consider
the ECB's strategy to be perfectly suited to the monetary policy of the euro area. I will then say a few
words about the importance of sound public finances and structural reforms, particularly at such a
critical point in time.
1. The ECB's monetary policy strategy in a historic perspective
In the initial stages of Economic and Monetary Union (EMU) in the early 1990s, many observers
doubted that the single currency would ever see the light of day. Then, when they realised that it
would come, they speculated that only a few countries would be able to join.
Once it became clear that most EU countries were in a position to adopt the euro, some experts
argued that the quality of the euro as a new currency would converge only towards a sort of an
arithmetic average of the legacy currencies, rather than to the benchmark set by the stronger ones.
It is now clear that such bouts of scepticism were much overdone. Yet it was understandable that a
substantial number of observers were initially cautious with regard to the euro's chances of success.
After all, monetary integration in Europe was in itself an extraordinary innovation, which was
surrounded by a large number of uncertainties in the introductory phase.
On the achievements of the Eurosystem to date
But the facts have disproved those initial fears and have shown that most people underestimated the
resolve of European governments and central bankers to make EMU a large-scale success as well as
a huge step forward in Europe's history.
For nearly five years now we have had a single monetary policy conducted by the Eurosystem. Ever
since the start of Stage Three of EMU, the Governing Council of the ECB has had to confront
important challenges. We have witnessed two euro changeovers: the introduction of the euro first in
book-entry form and, second, in the form of banknotes and coins. These were not simple tasks. But
they both went very smoothly, thanks to the hard work of all those involved at the ECB and the
national central banks (NCBs), as well as in the private sector. Monetary policy has had to face a
number of shocks to the euro area economy over the past few years. For a large part of this time,
policy had to be conducted in a context of exceptional economic, financial and even geopolitical
uncertainty. But we kept a steady hand and did not overreact. Consequently, in spite of often difficult
circumstances, we kept inflation and inflation expectations low. And we have done so with pragmatism
and determination. Even in its infancy, the ECB showed itself to be a mature central bank.
These outstanding achievements underpin the rapid build-up of credibility in the ECB and the high
level of confidence enjoyed by the new currency.
The Governing Council of the ECB presented its monetary policy strategy in October 1998. The design
of the strategy had to be geared towards the special characteristics of the euro area economy. It
incorporated, in an integrated framework, many features of the successful monetary policies of the
National Central Banks of the countries adopting the euro. The strategy lays out the principles that
guide monetary policy decisions. Announcing the strategy has permitted the ECB to make clear its
commitment to the price stability objective. The strategy has also provided a framework in which to
organise and present to the public the information used in policy deliberations.
The 2003 review of the strategy: confirmation and clarification
In December 2002 the ECB announced its decision to conduct a comprehensive review of its strategy.
This decision was sometimes wrongly interpreted by observers as an implicit indication of
dissatisfaction with the experience thus far. In fact, the opposite was true. It was natural that, after
more than four years of experience, the Governing Council of the ECB wanted to look back and reflect
in a systematic way on the experience gained and the comments of external observers. Indeed, we
conduct monetary policy in a complex and changing environment. Undertaking such an exercise in
stock taking and reflection is essential to ensure a satisfactory evaluation of the strategy. As I will
explain, the result of this evaluation demonstrates that our monetary policy is based on a sound,
robust fundament.
[The document entitled "Overview of the background studies for the reflections on the ECB's monetary
policy strategy" (8 May 2003) provides a detailed discussion of the issues considered in the Governing
Council's review of the strategy. It is available on the ECB's website in the section Publications.]
2. The elements of the ECB's strategy
2.1 The objective of price stability
The basis for the strategy is the ECB's mandate that the primary objective of monetary policy
should be to maintain price stability. This mandate, which mirrors the mandates of a very large
majority of the EU National Central Banks before 1998, is enshrined in the Maastricht Treaty, which
was signed by all governments of the European Union and ratified by all the parliaments. It is "written
in stone", if you wish.
It reflects the well established fact that price stability is a prerequisite for sustainable growth and the
creation of employment. Price stability preserves and bolsters consumers' purchasing power, thus
supporting consumption. It also enhances the efficacy of the market system in allocating resources.
Price stability is associated in particular with lower uncertainty and risk premia in financial markets,
facilitating financial transactions and ultimately implying lower medium and long-term interest rates.
This fosters investment. Lasting price stability is also an indispensable nominal anchor for wage
developments in line with productivity thereby contributing to preserve the competitiveness of the euro
area economy.
The evidence provided by experts and academics confirms and even strengthens the conclusion that
departures from price stability entail substantial distortions and welfare costs, which manifest
themselves thorough various channels. In short, maintaining price stability is the contribution of
monetary policy to sustainable growth, job creation and social cohesion. Price stability is a necessary
condition to attain those goals.
2.2 The ECB's definition of price stability
To make the Treaty mandate operational, the Governing Council of the ECB has provided a
quantitative definition of price stability. Price stability is defined as a year-on-year increase in the
Harmonised Index of Consumer Prices (HICP) for the euro area as a whole of below 2%. By referring
to increases in the HICP it was made clear from the beginning, in 1998, that deflation is excluded from
the definition of price stability. The Governing Council also specified that price stability is to be
maintained over the medium term.
In the light of past experience, it is clear that the announcement of the quantitative definition of price
stability was an extremely valuable element of the ECB's strategy.
First, the ECB's definition of price stability has been instrumental in enhancing the transparency of the
policy framework and thereby the accountability of the ECB.
The anchoring of long-term inflation expectations
Second, with its quantitative definition the ECB has made a very significant contribution to the firm
anchoring of inflation expectations. The definition of price stability permits all economic agents and the
public at large to build expectations of future inflation outcomes. By providing a benchmark for inflation
expectations, the quantitative definition of price stability has considerably facilitated the conduct of
monetary policy by the ECB. Indeed, if the public can trust the ECB, we can assume that the setting of
wages and prices will be compatible with the ECB's definition. This significantly reduces the likelihood
of temporary bouts of inflation triggering harmful wage and price spirals, as was the case in previous
decades.
In our evaluation of the strategy we analysed particularly closely the experience with euro area
inflation expectations. We were very pleased to see that the volatility of long-term inflation
expectations in the euro area is as low as in the best performing industrialised countries in this
respect. Since January 1999, medium and long-term inflation expectations, as measured by survey
data, have remained stable most of the time within the range of 1.7 to 1.9%, thus at a level compatible
with the definition of price stability.
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. In
mid-2000 the price of the Brent oil barrel denominated in U.S. dollar was four times higher than at the
start of the single monetary policy, in January 1999. Since then, average oil prices have stayed at a
considerably higher level than the average over the previous ten years. In 2001, when the indirect
effects of the earlier oil price increases were still exerting upward pressure on the HICP, some
EU countries were affected by livestock diseases. This caused exceptionally strong upward pressure
on unprocessed and, later, processed food prices. As a result of these shocks, HICP inflation has for
quite some time been above, and sometimes significantly above, the 2% mark. But, as I just said,
medium and long-term inflation expectations remained rather stable despite those shocks. As the
shocks gradually unwound, actual inflation rates always bounced back toward levels compatible with
price stability.
In our reflections on the strategy, we discussed at length all the aspects related to the ECB's definition
of price stability. We scrutinised again the properties of the price index, the HICP. We assessed the
merits of the possible alternatives for expressing the price stability objective, that is, whether to
express it in terms of a single "point" or a "range". We also reviewed the factors determining the
"optimal" rate of inflation, to assess the adequacy of the 2% upper limit in the definition and the
appropriate aim of monetary policy. In this assessment we concluded that, on the grounds of both
conceptual considerations and practical experience, the ECB's definition is fully adequate.
The May 2003 clarification: "HICP inflation below but close to 2%"
At the same time, we felt the need to convey even more clearly to the public that the Governing
Council is not indifferent between all positive inflation rates below 2%. On 8 May 2003 we made it
clear that, in order to fulfil its price stability objective, the Governing Council aims to maintain HICP
inflation below but close to 2% over the medium term. This was fully in line with our past practice and
with medium-term market expectations. Thus, the announcement did not change inflation
expectations. We identified a number of arguments for aiming not at inflation close to zero but at a rate
close to 2%.
Rationales for aiming for positive inflation (1): the zero lower bound for nominal interest rates
The first argument is that maintaining a low positive rate of inflation reduces to very low levels the
probability that nominal interest rates will approach their lower bound at zero. The event of
nominal interest rates hitting the zero lower bound is linked to an increased uncertainty about the
effectiveness of monetary policy. If this event were to coincide with a strong decline in demand, such a
situation could complicate the central bank's ability to avoid a deflationary episode. Examples where
countries reached the lower bound for nominal interest rates are rare. And even if this event were to
materialise, a number of effective monetary policy actions are still possible at zero nominal interest
rates and various plausible solutions for escaping from a liquidity trap have been proposed. This
notwithstanding, prevention is better than cure and a safety margin for inflation rates above zero
proves helpful to avoid that the effectiveness of these alternative policies has to be tested in reality.
In order to calibrate the adequate safety margin for inflation rates in this respect, we took into account
the studies which have tried to assess the likelihood of nominal interest rates hitting the zero lower
bound for various levels of inflation objectives. Results in this area differ to some extent, as they
depend on a number of specific assumptions. But the available studies indicate that the likelihood
decreases to very low levels when the central bank aims at an inflation rate above 1%. We are thus
convinced that focusing on inflation of below but close to 2% provides a sufficient safety margin
against nominal interest rates hitting the zero lower bound.
Rationales for aiming for positive inflation (2): measurement error in the HICP
A second reason to aim for low positive inflation is that available inflation statistics may be subject to a
positive measurement error, which would imply that strict price stability, that is, zero inflation, as
measured by the price index would de facto mean a declining price level. In the specific case of the
HICP, the precise estimation of such a measurement bias continues to be surrounded by uncertainty.
But taking into account the continuous improvements implemented by Eurostat in the index, the bias is
likely to be small and to decline further in the future.
Rationales for aiming for positive inflation (3): inflation differentials within the euro area
Third, as regards the possible presence of sustained inflation differentials within a currency
union, I should note that such differentials are and should be considered a normal feature of any
currency area. Indeed, they are an integral part of the adjustment mechanism resulting from not fully
synchronised economic shocks in the various countries forming the euro area. The single monetary
policy cannot address such differentials, in the same way that in a single country monetary policy
cannot reduce inflation differentials across regions or cities. Depending on the causes of temporary
differentials, national remedies may be needed to prevent harmful developments in the country,
notably in connection with competitiveness. Overall, it is crucial that product and labour markets in the
euro area are sufficiently flexible to respond efficiently to supply and demand shocks. This assessment
was confirmed in a recent and comprehensive study by the Eurosystem's staff on inflation differentials
in the euro area. ["Inflation differentials in the euro area: potential causes and policy implications",
European Central Bank, September 2003, Publications.] This study noted, interestingly, that the size
of the inflation differentials within the euro area is broadly comparable to that in the United States,
although in the United States inflation differentials show somewhat lower persistence over time. This
study highlights the inadequacy of using monetary policy to address such differentials, which primarily
reflect transitory effects of monetary integration in Europe and also relate to the persistent differences
in economic structures across countries.
Among the possible structural factors underlying lasting inflation differences, the Balassa-Samuelson
effect has been often singled out. The Balassa-Samuelson effect relates inflation differentials to
differences across economies in the relative sectoral productivity trends between the tradable and
non-tradable sectors. Empirical studies indicate that the magnitude of the Balassa-Samuelson effect is
very limited in the group of countries forming the euro area. Furthermore, the size of the
BalassaSamuelson effect for these countries is diminishing over time, given that there has been substantial
convergence among countries in terms of per-capita GDP and productivity levels. The size of the
Balassa-Samuelson effect could well be more important for the acceding countries. However, its
overall impact on the euro area should be limited, not least on account of the relatively small size of
these economies. Moreover, it should be recalled that, in order to adopt the euro, the acceding
countries will have to fulfil the Treaty convergence criteria, which in particular require the sustainability
of a low inflation environment. All this points to a more limited impact of the Balassa-Samuelson effect
than is sometimes claimed.
In sum, aiming for inflation rates below but close to 2% offers an additional safeguard against the
rather remote but undesirable event that nominal interest rates could hit their lower bound at zero. At
the same time, it is also fully sufficient to cover the possible presence of a measurement bias in the
HICP and the implications of inflation differentials of a structural nature within the euro area.
The format of the price stability objective
As regards the form in which our inflation objective is expressed, I am aware that here in
Germany some observers recently called for the ECB to adopt a specific "point target" for inflation. As I
mentioned before, this option was considered carefully by the Governing Council. However, after
examining thoroughly all the arguments and available evidence in our review of the strategy, the
Governing Council deemed it preferable to avoid this option and to announce that we aim at HICP
inflation below but close to the upper bound of the range in the definition.
With our decision we convey to the public the important message that the control of inflation is
inherently imperfect.
As regards the theoretical advantages of referring to a specific rate of inflation as the objective, it has
sometimes been argued that, in principle, it provides a more precise focal point for forming inflation
expectations and taking forward-looking decisions. We therefore looked at the evidence on the
experiences in various countries in this respect. We concluded that, above all, there is no unique or
best way to firmly anchor inflation expectations. The crucial aspect appears to be a credible and
consistent conduct of monetary policy. In this respect the ECB has been very successful - as is
demonstrated by surveys and the "jury" which is bond markets.
The medium-term orientation of monetary policy
Another very important aspect of our monetary policy, which was also emphasised at the start of
Stage Three of EMU, is that it aims to maintain price stability over the medium term. The
mediumterm orientation clarifies that there is no fixed time horizon over which price stability has to be
re-established. The medium-term orientation embodies several important general principles of the
strategy. First, the explicit acknowledgement that, given the long and uncertain lags in the
transmission of monetary impulses, central banks cannot steer short-term price developments with
high precision. Second, it also reflects the idea that monetary policy should react differently to different
forms of economic shocks. Notably, supply-side shocks, for example those to oil prices, often require a
much more gradual monetary policy response than shocks on the demand side of the economy or
shocks coming from labour cost developments. By adapting the appropriate monetary policy horizon to
the nature of the shock, the ECB helps to avoid unnecessary volatility in output growth.
In sum, the focus on the medium term in the ECB's monetary policy strategy embodies a commitment
to avoid overly activist and ambitious attempts to fine-tune inflation outcomes, while reinforcing the
credible anchoring of our definition of price stability in the medium and long-term expectations of
economic agents and markets.
2.3 The two pillars
A further element of the strategy relates to the analyses and economic perspectives of the risks to
price stability, which are founded on a two-pillar framework. The two-pillar approach permits
conveying to the public the notion of a diversified analysis and of ensuring robust decision-making
based on different analytical perspectives.
These two perspectives are referred to as "economic analysis" and "monetary analysis". The
Governing Council has emphasised the lively and dynamic nature of the analyses under the two pillars
of the strategy: over time, the analyses under both pillars have been deepened and extended, in line
with increasing data availability and continuous improvements in technical tools. Obviously, this
process of improvement of the analysis will continue in the future.
Economic analysis
The economic analysis focuses mainly on the assessment of current economic and financial
developments, their likely future dynamics, and any implied short to medium-term risks to price
stability.
To fully assess the economic situation and the outlook for price stability, the Governing Council must
be able to call on a variety of tools and models. However, judgement is also needed, particularly in
assessing the likelihood of certain hypothetical scenarios eventually materialising. The Eurosystem
staff macroeconomic projections constitute one important input into the monetary policy decision as a
way of organising a large amount of information and helping to create a consistent picture of possible
future developments. However, they cannot be made the sole tool for the conduct of monetary policy:
economic forecasts never encompass all the relevant information, and they can never be a substitute
for the judgement that is needed on the part of the policy-maker.
A further important aspect of economic analysis is a thorough assessment of economic shocks and
dynamics. In addition, expectations held by the private sector of future inflation and activity as well as
economic forecasts provided by international organisations are analysed regularly.
Monetary analysis
As regards the analysis under the monetary pillar, the ECB decided from the outset to single out
money from the set of selected key indicators that it would monitor and study closely. To mark the fact
that, in the medium and long run, inflation is indeed a monetary phenomenon, the Governing Council
announced a reference value for the growth of a broad monetary aggregate.
These decisions were made in recognition of the fact that monetary growth and inflation are closely
related in the medium to long run. Indeed, assigning money an important role underpins the medium
and long-term orientation of the strategy. It helps policy-makers to see beyond the more transient
impact of the various shocks affecting the economy and to implement the adequate gradual course for
the conduct of monetary policy.
To underline the medium to long-term orientation of the analyses under its monetary pillar, the ECB
has always emphasised the fact that there would be no strict link between short-term monetary
developments and monetary policy decisions. Monetary policy would not, therefore, react
mechanically to deviations of M3 growth from the reference value. Rather, the reference value
performs an important role as a medium to long-term quantitative benchmark for assessing monetary
developments. It constantly reminds the central bank of the fundamental principle that, while
responding to economic developments, it must never lose sight of the fact that, over sufficiently
extended horizons, the rate of money growth must be consistent with the price stability objective.
The ECB knew from the beginning that it is difficult in practice to extract information on price trends
from the short-term movements in money. Developments in M3, which is our key monetary aggregate,
can always be affected by smaller or larger shocks which are not necessarily related to inflation. In this
respect, the period since 2000 has been exceptional. We have seen an unprecedentedly long period
of stock market declines. This persistent weakness in global stock markets drove investors away from
equity and induced a reallocation of portfolios of euro area non-MFI investors towards low-risk assets.
As a consequence, for a rather long period of time, M3 growth has been distorted upwards without this
necessarily signalling inflation risks. However, we thus far have little reason to assume that we have a
breakdown in the long-term stability of money demand.
The May 2003 clarification: the role of money in the strategy
In its recent review of the strategy, the Governing Council of the ECB further emphasised the
mediumterm orientation of its monetary analyses and clarified the role of monetary analysis in the strategy.
On 8 May 2003, the Governing Council decided to discontinue its earlier practice of reviewing the
reference value for M3 on an annual basis. In the past, at the end of each year, the Governing Council
had reviewed the assumptions about the medium-term trends in potential output growth and the
income velocity of M3 underlying the derivation of the reference value for M3. The decision to
discontinue the regular annual review is more in line with the medium and long-term nature of the
assumptions underlying the computation of the reference value. It may also help to dispel occasional
misperceptions in the public that the former practice implied a reference value that was specifically
applicable - like a monetary target - to the year ahead. The Governing Council will, however, continue
to monitor the validity of the conditions and assumptions underlying the reference value and
communicate any changes to the underlying assumptions as soon as they become necessary.
On 8 May 2003 the Governing Council also clarified the way in which it integrates the indications
stemming from these two complementary analyses as it seeks to come to an overall judgement on
the risks to price stability. In particular, it emphasised that the monetary analysis mainly serves as a
means of cross-checking, from a medium to long-term perspective, the short to medium-term
indications coming from the economic analysis.
2.4 The ECB's strategy and inflation-targeting strategies
The two-pillar framework, in conjunction with the medium-term orientation of the ECB's monetary
policy conduct, has over time become the hallmark of the ECB's strategy. These features, among
others, distinguish the ECB's strategy somewhat from the approaches implemented by some other
central banks, in particular from inflation-targeting strategies. The notion of inflation targeting has
changed over time and it is not a clearly defined concept. It is nevertheless true that the ECB's
monetary policy concept and the "inflation targeting" concept are relatively close in some respects: in
particular the quantitative setting of the inflation target in the latter is close, without being identical, to
the quantitative definition of price stability in the ECB's concept. In both cases there is a level of
transparency and of accountability unequalled by other monetary policies. However, inflation targeting
is sometimes seen as a framework that makes macroeconomic forecasts the main, or even the sole,
all-encompassing tool of the policy-making process and of the external communication of policy
decisions. In fact, in some, admittedly more extreme characterisations, inflation targeting is seen to
imply a simple policy rule whereby changes in interest rates should feed back from the deviation
between a conditional inflation forecast and the inflation objective at a specific fixed time horizon,
typically around two years.
I have already explained why it is our conviction that limiting attention to an ex ante fixed horizon
would be arbitrary and could induce sometimes short-sighted, sometimes delayed reactions. I should
mention the recent tendency seen in some inflation-targeting central banks towards relaxing their
emphasis on a fixed horizon, in favour of the more flexible medium-term notion. In this respect, we
may see those central banks as moving closer to the approach adopted by the ECB.
Our monetary policy framework acknowledges the need to flexibly take into account the nature of
shocks hitting the economy and the prevailing economic circumstances. Monetary policy needs to
focus on the period covering the whole transmission process, bearing in mind that this may sometimes
span a protracted period of time.
This flexibility, together with the special emphasis on a medium to long-term perspective for economic
developments, imparts a fundamental robustness to the ECB's policy. As I mentioned already, the
longer-term perspective of our policy is also underpinned by the emphasis on medium to long-term
monetary analysis.
As an important side effect, the regular examination of monetary trends might help to detect financial
imbalances. There is often a strong positive correlation between credit growth and rapid rises in asset
prices in the run-up to a speculative bubble. The emergence of such long-run disequilibria in the
economy has to be taken into account in setting monetary policy. Such fundamental imbalances may
cause problems for the economy well beyond typical inflation forecast horizons. I note that this point of
view is increasingly also considered by other central banks. Our framework, with its emphasis on
monitoring money and credit developments and the sustainability of macroeconomic developments, is
in this respect well equipped to take into account the implications of exceptionally strong dynamics in
the financial markets in terms of potential risks to price stability over the long run.
Limitations of economic forecasts
As regards the role of forecasts and projections, it is our view that an exclusive focus on an inflation
forecast would neither do justice to the intrinsic complexity of the decision-making process, nor would
it provide a transparent means of communicating this complexity. An articulated analysis of the
economic forces at work in the economy is always preferable to the use of a single summary indicator.
In practice, inflation forecasts and projections, but also other model-based exercises, are often subject
to a number of well-known limitations, notably as regards the problem of model misspecification. The
possible presence of model misspecification is something that economists and econometricians
sometimes have difficulty in acknowledging. However, we are very well aware that every model we
develop contains shortcuts and approximations. This uncertainty is exacerbated by the fact that
economists do not agree upon a proper, commonly accepted approximating model. This implies that
the appropriateness of a monetary policy strategy cannot be evaluated by means of just one particular
model or class of models. Rather, a good candidate strategy needs to perform well across a variety of
empirically plausible models, and it has to allow for the judgement of policy-making bodies.
There is no doubt that inflation forecasts, while being useful, even indispensable ingredients of
monetary policy strategy, cannot be the only input into monetary policy-making. The same inflation
forecast figures can be associated with quite different states of the world, commanding quite different
reactions on the part of the central bank. For this reason too, the appropriate monetary policy for
maintaining price stability should always be made conditional on the circumstances and the nature and
magnitude of the threat to price stability. For example, it would depend on whether a shock is
temporary or permanent, on whether it has emerged on the supply or the demand side, or on whether
it is of domestic or external origin.
2.5 Conclusions on the strategy: continuity with th