Mr Noyer reports on monetary policy-making in Europe
Speech presented by Mr Christian Noyer, Vice-President of the European Central Bank, to the Spanish
Association of Corporate Treasurers (ASSET), held in Barcelona, on 19 November 1999.
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Ladies and gentlemen,
It is a pleasure for me to be here in Barcelona today. I should like to thank the organisers of this
congress very much for giving me the opportunity to speak to you on the subject of "Monetary
policy-making in Europe".
It is now nearly 11 months since the Eurosystem, consisting of the European Central Bank (ECB) and
the 11 national central banks (NCBs) of those EU Member States that introduced the euro on
1 January 1999, assumed its tasks, i.e. deciding and conducting the single European monetary policy.
11 months of practical experience is, of course, not long enough for a conclusive stocktaking exercise,
but it certainly seems appropriate, at this stage, to review some of the lessons we have learned.
Let me start by recalling what, in essence, monetary policy-making in Europe is about.
The Maastricht Treaty (formally the Treaty on European Union, which has now become part of the
Treaty establishing the European Community) assigns to the single monetary policy the primary
objective of maintaining price stability in the euro area. In order to achieve this goal successfully, both
a high degree of central bank independence and the prohibition of monetary financing by the
government are tenets of the monetary policy framework enshrined in the Treaty.
There is no doubt concerning the overriding importance attached to the primary objective of price
stability. By safeguarding price stability in the euro area over the medium term, the single monetary
policy is supposed to make the best possible and most lasting contribution to the achievement of other
Community objectives, such as high employment and sustainable non-inflationary growth.
Among central bankers and economists, the predominant view is that a long-run trade-off between
inflation and output growth does not exist. Attempting to use monetary policy to increase real
economic activity above its sustainable level will, in the long run, simply lead to higher inflation and
will not foster economic growth. Moreover, theoretical considerations as well as empirical evidence
over several decades suggest that high rates of inflation are clearly unhelpful - indeed detrimental - to
growth and employment in the long term. A large number of economic arguments point to the benefits
of price stability for economic growth and employment prospects. Stable prices eliminate or reduce
economic costs such as those arising from inflation as a result of uncertainty about the outcome of
investment decisions, the distortionary effects on the tax system, rising risk premia in long-term
interest rates and reduced allocative efficiency of the relative price mechanism and market systems.
Monetary policy must take into account the fact that the horizon for decisions by economic agents is
rather long-term in nature. By guaranteeing price stability, monetary policy provides an anchor for
economic decision-making. This clearly supports the efficient functioning of the price mechanism,
which is conducive to the best allocation of scarce resources. Price stability is hence a means of
promoting sustainable economic growth and the creation of employment, and of improving
productivity levels and living standards.
This discussion also sheds light on what is certainly the greatest economic challenge facing the euro
area at present, namely, the need to reduce the current unacceptably high level of unemployment in
Europe. In the light of this problem, we have to realise that even in an ideal situation where monetary
policy is very successful in maintaining price stability, the contribution of monetary policy to reducing
unemployment in Europe can only be a limited one. Many empirical studies show that the high
unemployment rate is mostly the consequence of structural rigidities within the European labour and
goods markets. The European unemployment rate has, indeed, been high or even rising over the
business cycles in the past decade. Only structural reforms, preferably of a comprehensive nature, can
therefore tackle the underlying impediments to employment growth.
When deciding on monetary policy, the Eurosystem must acknowledge the capabilities and limitations
of monetary policy implied both by general economic principles and by the structure of the euro area
economy. This is also reflected in the formulation of the Eurosystem's monetary policy strategy,
which is designed to maintain price stability in the euro area.
The strategy was announced by the Governing Council on 13 October 1998. It is designed to fulfil two
important functions. First, it structures the monetary policy-making process so that the Governing
Council of the ECB is provided with all the information and analysis it requires to take appropriate
monetary policy decisions. Second, the strategy ensures that policy decisions, including the economic
rationale on which they are based, can be presented in a clear, coherent and consistent way to the
public. By providing a stable framework for making and explaining monetary policy decisions, the
strategy bolsters the credibility and effectiveness of the single monetary policy.
In designing the monetary policy strategy of the Eurosystem, the Governing Council also had to
respect a number of practical issues and difficulties which arose because of the uncertainties created
by the so-called shift of regime associated with the transition to Monetary Union. Where there were
previously 11 open, generally small economies, there is now one large, relatively closed single
currency area. The challenges implied by this transformation in the landscape of monetary policy are
profound.
For the time being, relatively little is known about the details of the transmission of monetary policy
measures to the real economy in the euro area. It is possible that the shift of regime has changed the
behaviour of economic agents, and hence, the structure and functioning of the euro area economy.
Consequently, together with experts at the NCBs, the ECB has embarked on an intensive programme
of analysis and research on these issues.
One obvious impediment in this respect is the limited availability of harmonised statistical data for the
euro area. This is only natural, given that the euro area did not exist as a single currency area before
January 1999. In the last couple of years the European Monetary Institute (EMI) and the Statistical
Office of the European Commission (EUROSTAT) together with central banks and statistical offices
in EU Member States have put a lot of effort into developing harmonised statistical concepts for
monetary and economic indicators. By the beginning of this year, when Stage III of EMU started, a lot
had already been achieved in this respect. The quality and availability of statistics on the euro area has
increased significantly over the past few quarters, particularly in the areas of money and banking and
balance-of-payments statistics, but also across a wide range of economic statistics. This process of
improving the quality and the availability of statistical data covering the euro area will continue.
Against the background I have just described, the Governing Council has selected a monetary policy
strategy that embodies a new and distinct approach, which reflects the unique circumstances and
institutional environments faced by the Eurosystem. The design of a clear, credible and effective
monetary policy strategy for the Eurosystem required an appreciation of the environment in which the
Eurosystem operates. This environment imposes certain constraints on monetary policy in the euro
area, which the Eurosystem's strategy must acknowledge and respect. The stability-oriented monetary
policy strategy therefore avoids "mechanistic" monetary policy responses to only a few indicators or
forecasts. As the environment of monetary policy is complex and the interpretation of the indicators
difficult, there is no simple rule for monetary policy.
The Eurosystem's strategy consists of three main elements that were announced a year ago.
First, the primary objective of monetary policy has been quantified with the publication of a definition
of price stability, which serves as a guide for inflation expectations and against which the Eurosystem
can be held accountable. Price stability is hence defined as annual increases of below 2% in the
Harmonised Index of Consumer Prices (HICP) for the euro area. This definition illustrates that both
inflation and deflation are regarded as being incompatible with price stability. It was also announced
that price stability is to be maintained over the medium term, imparting a forward-looking orientation
to the strategy as a whole.
Second, in order to maintain price stability according to this definition, money is accorded a prominent
role. Monetary developments are closely monitored and analysed, in particular in relation to a
quantitative reference value for monetary growth. In December 1998, the reference value was set at an
annual growth rate of 41⁄2% for the broad monetary aggregate M3. In line with the medium-term
orientation of the strategy, this reference value was based on assumptions concerning the
medium-term developments in prices, real GDP and the velocity of circulation.
Third, in parallel with this monetary analysis, a broadly based assessment of the outlook for price
developments in the euro area is being undertaken. This assessment encompasses a wide range of
indicator variables, including macroeconomic projections produced both within and outside the
Eurosystem.
Using the information obtained from this analysis, the Governing Council of the ECB comes to a
decision on the level of short-term interest rates that will best serve the maintenance of price stability
in the euro area as a whole in the future.
The decision of 4 November to raise the ECB interest rates demonstrates the forward-looking
character of our strategy. Owing to the lags in the transmission mechanism, our monetary policy could
not wait until inflation stood at 2% or above. The Eurosystem raised interest rates in order to counter
the upward trend of the balance of risks to future price stability, which was observed during the
summer. This policy move should help to stabilise inflation expectations safely at below 2%. By
maintaining a favourable outlook for price stability, this decision also contributed to making economic
growth in the euro area sustainable over the medium term. In fact, a monetary policy that reacts too
late to emerging inflationary pressures runs the risk of being forced to take much stronger measures at
a later stage. Eventually, such a policy would only exacerbate cyclical fluctuations without enhancing
the long-term potential of the economy.
Let me now turn to a number of criticisms of the Eurosystem's monetary policy which have been
raised since the strategy was first announced. I should like to address some of these concerns in the
remaining part of my presentation.
Some observers have argued that the strategy is "asymmetric" and that the Eurosystem will be more
concerned about inflation than it is about deflation. These assertions are often based on the perceived
lack of a precise lower bound to the definition of price stability, which is contrasted with a clear upper
bound of 2%. Critics point out that such asymmetry will impose a drag on the overall performance of
the euro area economy and risks, under certain circumstances, triggering a deflationary spiral.
Let me put it bluntly: I do not share this view. First, I should like to draw your attention to the fact that
the use of the word "increases" in the definition sets the floor at zero for the lower bound. The absence
of a specific numerical value for the lower bound reflects, in the first place, the uncertainties we face
concerning the existence and magnitude of the so-called measurement bias in the HICP. This bias
arises mainly from changes in spending patterns and quality improvements in those goods and services
that are included in the basket used to define a specific price index. Such biases cannot always be fully
corrected in the construction of price indices. The measurement bias typically causes CPIs to overstate
the "true" rate of inflation. Although the HICP is based on a concept that puts considerable emphasis
on reducing or eliminating the measurement bias, some overstatement cannot be excluded. Second, we
need to keep in mind the fact that the ceiling of 2% leaves sufficient room for small increases in the
price index, thereby minimising the risk of falls in the price index. I should like to emphasise the fact
that the Governing Council of the ECB has already demonstrated that it would deem neither inflation
nor deflation in the euro area to be consistent with the maintenance of price stability. The two interest
rate decisions taken on the basis of the Eurosystem's strategy in April and November are clear
examples of this commitment.
Another criticism of our strategy that is sometimes voiced concerns the "prominent role for money",
reflected, in part, by the announcement of a reference value for M3 growth. Here we can differentiate
between two camps. Some of these critics argue that M3 growth should not influence monetary policy
decisions by the Governing Council. However, others criticise the Eurosystem for not basing monetary
policy decisions almost exclusively on deviations of M3 growth from the reference value, as they are
convinced that money is the best indicator for monetary policy.
I reject the criticisms of both camps. Let me explain why. First, I disagree with the view that money
should play no or only a small role in the ECB's strategy. Empirical studies show that M3 for the euro
area has a stable relationship with the price level over the medium term. Such a stable relationship
with price developments has not been found for any other indicator variable at this place in time.
Moreover, there is evidence that monetary aggregates contain useful information for future
macroeconomic developments. This is the reason why monetary growth is analysed very closely by
the Governing Council.
At the same time, I do not think that the ECB should focus uniquely on money. The problem with
doing this is that in the short run, the relationship between money and prices can be distorted by
portfolio shifts and institutional factors. Short-term developments in money therefore need to be
analysed very carefully. Against this background, the Governing Council of the ECB has always
communicated to the public that it cannot and will not react mechanically to deviations of actual
monetary growth from the reference value. Let me also point out that the Governing Council has, from
the very beginning, rejected the idea of being held accountable for failing to keep monetary growth
close to the reference value every year. In this sense, the concept of the Eurosystem's strategy is
different from monetary targeting in the traditional sense. For this reason, the Eurosystem's strategy is
based on two pillars. Monetary policy should always react to all the information available with a view
to maintaining price stability in the medium term.
This is also the answer to those critics who argue that the ECB disregarded high money growth when
it lowered interest rates in April, but put much emphasis on high money growth when it raised interest
rates in November. In fact, in both situations we based our decision on both pillars of the strategy and
also assessed the prevailing monetary developments at the time in the light of other information
available. When we cut interest rates on 8 April, only two months of monetary data for 1999 were
available. At that point in time, the three-month moving average for M3 stood at 5.1%. Let me recall
that we had always emphasised that "substantial or prolonged deviations from the reference value
under normal circumstances signal risks to price stability in the medium term". However, the data
showed that M3 growth was only slightly above the reference value then and that there was not
evidence as yet of a prolonged deviation. By contrast, there were several indications that M3 was
temporarily distorted upwards in early-1999 as a result of the changeover to Stage Three of Economic
and Monetary Union (EMU), also against the background of historically low long-term rates. Thus, at
that point in time it was difficult to see whether M3 growth in early-1999 would reveal upside risks to
price stability. At the same time, the information from the second pillar of our strategy showed clear
downside risks to future price developments in April. The situation was different in November. Here it
was clear that monetary growth had increased considerably over the course of 1999. The three-month
average stood at 5.9% for the period from July to September 1999. Even when we corrected the data in
accordance with the somewhat specific movements of M3 in January and February, we could see that
the annualised figure for M3 growth from March to September was 6.1%. All this took place in a
significantly different economic environment compared with April. I think that this comparison
between the two decisions to change ECB interest rates in April and November is very useful. It shows
that we do not react mechanistically to individual indicators, but always interpret the movements and
signals in all of the indicators evident in both pillars in conjunction with each other. As we can see,
this is a more reasonable approach than relying on a simple indicator, given that we are living in a
complex world.
There is another line of argument which is that the monetary policy of the Eurosystem focuses too
closely on cyclical developments. This would be inconsistent with the public commitment to a
medium-term orientation. This body of opinion often refers to the explanations delivered on the
occasion of the interest rate cut in April 1999. These critics claim that this move was mainly intended
to support employment and growth prospects in the short term.
This is, in my view, an unfortunate miscomprehension of the facts and I shall try to be clear on this
point. Our monetary policy has had, and will continue to have, a forward-looking medium-term
orientation, with the maintenance of price stability in the euro area as our focus. As mentioned, in
April 1999 our thorough review of monetary, financial and economic developments revealed
downward risks to price stability stemming basically from the cyclical slowdown that occurred in the
aftermath of the financial turmoil in emerging markets during mid-1998. Both the forward-looking and
medium-term orientation of the single monetary policy made it necessary for the Governing Council to
take action: interest rates were cut.
The focus on the primary objective of price stability driving the decision in April does not exclude the
fact that in many cases the policy action required to maintain price stability helps to stabilise real
activity in the short term. Risks to price stability are very often related to cyclical developments and
these policy aims are therefore complementary rather than conflicting. At the same time, I should like
to point out that we must not give the false impression that the short-term impact of necessary
monetary policy actions on real activity will always be favourable. Situations may occur, for example
when wage settlements jeopardise price stability, or when there is a short-term trade-off between
adverse developments in real activity, on the one hand, and deviations from price stability on the
other. In this case, it is important that the overriding priority of maintaining price stability is absolutely
clear. Any ambiguity on this point would simply endanger the credibility, and therefore the
effectiveness of monetary policy.
Last but not least, I should like to make a few remarks with regard to the most frequently expressed
criticism, namely that the Eurosystem is a secretive institution that does not meet the required
standards of transparency and clarity.
Key features of the ECB's communication policy are our Monthly Bulletins and the monthly press
conferences given by the President of the ECB and myself. The press conferences usually directly
follow the first Governing Council meeting of each month. During these press conferences, the
President makes an introductory statement summarising the Governing Council's discussions and
conclusions before answering questions from journalists. As the statement is agreed beforehand, in
substance, with all the Governing Council members, it is similar to what other central banks call
minutes. I am convinced that informing the public of such a united position in the Governing Council
is more valuable for establishing credibility and reducing uncertainties in the markets than publishing
details of a Governing Council discussion, which would naturally be difficult to assess for those not
present at the meeting.
Moreover, the press conference provides prompt information in an even-handed way, and it offers the
opportunity for immediate two-way communication. As far as I am aware, no other central bank
regularly communicates with the public in such a prompt and open manner immediately after its
monetary policy meetings. We are convinced that this contributes to transparency and thus gives
important and clear guidance.
These press conferences are a tangible expression of the Eurosystem's commitment to being open,
transparent and accountable in its conduct of monetary policy. Obviously, journalists, financial
markets and the public are still learning about the new monetary policy strategy in the euro area and,
over time, the Eurosystem will further improve its communication.
In this respect, it has also been argued that we do not release sufficient information about our analysis.
More specifically criticism has been expressed to the effect that the Eurosystem is currently not
publishing its inflation forecasts. May I remind you, therefore, that the inflation forecast is not a key
element of our strategy? An inflation forecast is just one of the many pieces of information which we
use. Its importance should not be exaggerated. Our quantitative definition of price stability is not an
inflation target in the same way as those of other central banks, nor are we targeting an inflation
forecast. In our view, a single forecast is not a sufficient statistic given the complexity of economic
relationships and the existing uncertainties about the future. We are living in a complex environment
in which policy decisions cannot be simply related to a few or even one information variable. There is
also the risk that we are chasing our own tail. In fact, our monetary policy always aims to respect the
definition of price stability. The advantage of publishing a forecast would be that it would make one
more piece of information, which plays a role in the decision-making process, transparent. That being
said, the Governing Council will have to reconsider the issue once our macroeconometric models are
deemed to be sufficiently reliable. This may still take some time. Let me now conclude by saying that
I am happy to contribute to a project of such historical dimension and so are my colleagues in the ECB
and those at the NCBs belonging to the Eurosystem. Monetary Union has had a successful start and
the monetary policy strategy of the Eurosystem, on the basis of which the Governing Council has
taken and will continue to take its monetary policy decisions, has contributed to this success. At the
same time, we should recognise the fact that monetary policy alone cannot tackle all of the economic
challenges facing the euro area. In particular, it cannot reduce the euro area's unacceptably high level
of structural unemployment. The main contribution the single monetary policy can make to the
welfare of the people in the euro area will be the maintenance of price stability in the medium term.
Although monetary policy-making in Europe is not an easy task, I am confident after the experience of
the first 11 months that the Eurosystem is both determined to assume this task and is well equipped to
do so.