John Hurley: The Eurosystem approach to monetary policy
Speech by Mr John Hurley, Governor of the Central Bank and Financial Services Authority of Ireland,
at the Conference "The Global Interdependence Center Abroad in Ireland", co-organised by the
Central Bank and Financial Services Authority of Ireland and the Irish American Business Chamber
and Network, Dublin, 11-12 June 2007.
* * *
1. Introduction
Ladies and Gentlemen,
Let me begin by saying how pleased I am to have the opportunity to participate in this conference. We
in the Bank have co-organised this event and we feel that the high quality of the speakers and
participants will ensure its success. It is both a networking exercise and an opportunity for participants
to exchange views and hopefully gain further insights into financial and economic issues.
I have been asked to speak on the topic of monetary policy in the euro area. The single European
currency project commenced towards the end of the 1980s and resulted in the adoption of the single
currency eight years ago. Although the euro area is comparable to the United States in terms of
population and GDP, it differs significantly in a number of respects. In particular, it is not accompanied
by political union, nor is there a common language. These factors have not presented major difficulties
and, by any standards, it can be said that EMU has been a success.
I will start by briefly recalling the background to the creation of the European single currency. I will then
talk on the monetary policy strategy of the European Central Bank as well as its communication
strategy. After briefly describing actual monetary policy since the launch of the euro, I will examine the
benefits of monetary union for the euro area economy. Finally, I will refer briefly to the effects of the
single currency on the Irish economy.
2. Background
The adoption of a single currency by eleven members of the European Union at the start of 1999 was
an ambitious and unprecedented event. It was a very challenging task for all concerned. Despite
considerable scepticism about the project in some quarters, it has been an undoubted success.
Reflecting this, it has attracted two new members, Greece in 2001 and Slovenia in 2007. It has also
resulted in the physical replacement of national currencies by euro notes and coin in 2002. At this
stage, the general public in the euro area has effectively altered its mindset to think in terms of the
euro rather than their previous national currencies.
How was this success achieved? One important impetus was the strong belief that the full benefits of
the single market could only be enjoyed if the single market was complemented by a single currency.
In 1992, the Maastricht Treaty set out a number of economic convergence criteria for the completion of
EMU. In May 1998, eleven EU Member States were deemed to have met these price stability, public
finance, interest rate, and exchange rate criteria and they proceeded to participate in the adoption of
the euro as their single currency.
The speed of nominal convergence of the economic performance of these Member States in such a
short period of time was very impressive. This occurred against a background of a crisis in the EMS
that subsequently led to a substantial widening of the fluctuation margins for the bilateral EMS central
rates. The fact that convergence occurred relatively quickly after such a turbulent episode was
indicative of not only the political will to complete the monetary union project but also the flexibility of
Member State economies.
3. The ECB's monetary policy strategy
The monetary policy strategy of the ECB comprises the following components:
•
a quantitative definition of price stability;
•
a medium-term orientation;
•
a comprehensive analytical framework, based on a two pillar approach.
To begin with, let me discuss the quantitative definition of price stability, which currently the Governing
Council defines as a euro-wide inflation rate of below but close to 2 per cent.
One of the primary reasons for adopting a quantitative definition of price stability was to anchor
inflation expectations for the euro area. There are, however, other benefits associated with an explicit
quantitative definition of price stability. It enhances transparency and facilitates the ECB in holding
itself accountable for achieving its mandated price stability objective. A different, less specific definition
of price stability could have led to uncertainty among economic agents, which in turn could have led to
higher inflation expectations, higher market interest rates and increased risk premia. Indeed, the
stability of market interest rates during the euro changeover period is testament to the success of the
ECB's strategy.
The second aspect of the ECB's monetary policy strategy is its medium-term orientation, whereby the
quantitative definition of price stability is to be achieved over the medium term.
This medium-term orientation reflects the fact that prices can be volatile in the short run for reasons
outside the control of the ECB, or indeed any central bank, such as changes in indirect taxes and
shocks to commodity prices, especially oil prices. It would therefore be sub-optimal for a central bank
to stick rigidly to its inflation objective over very short-term horizons. This medium-term horizon also
obviates the need for monetary policy to actively respond to short-term price developments or
temporary economic shocks. It also means that the time horizon over which price stability has to be
reestablished following a shock can be tailored to the circumstances prevailing at the time and the
nature of the shocks hitting the economy. In general, the horizon depends on a number of factors,
such as whether the shocks are temporary or permanent and on their potential for becoming
entrenched in pricing decisions. In any event, the central bank has to preserve its credibility, thus
ensuring that expectations remain consistent with the declared policy objective.
The third aspect of the monetary policy strategy, and one which I will discuss in some detail, is the
ECB's strategic framework. An important element of this framework is the "two-pillar approach" by
which an economic analysis is cross-checked against an analysis of the development of monetary
aggregates. By taking a broad approach to the interpretation of economic conditions, the ECB's
strategy aims at adopting a robust monetary policy analysis in an environment that is typically
uncertain.
The first pillar of the ECB's monetary policy strategy is the economic analysis. In taking monetary
policy decisions, the Governing Council needs to have a comprehensive understanding of the
prevailing and the prospective economic situation and must be aware of the specific nature and
magnitudes of any economic developments threatening price stability. This analysis mainly focuses on
the assessment of current economic and financial developments and the implied short- to
medium-term risks to price stability, paying particular attention to the nature of shocks hitting the
euroarea economy and their effects on cost and pricing behaviour.
There is a wide range of indicators examined by the Governing Council for the economic analysis,
including product market indicators, financial market indicators, asset prices and exchange rate
developments, as part of its overall economic analysis.
One of the elements influencing the Governing Council's assessment of economic and inflation
prospects is the Eurosystem Staff Economic Projections. Macroeconomic models are used as inputs
in the preparation of these projections. Economic projections are prepared by the Eurosytem staff on a
quarterly basis and are based on a set of underlying macroeconomic assumptions. The Staff
Economic Projections are one of many indicators employed by the Governing Council in reaching a
decision on the stance of monetary policy.
The second pillar of the ECB's analytical framework is its monetary analysis, which complements and
acts as a cross-check on the economic analysis. The growth rate of broad money (i.e., M3) provides a
starting point for the assessment of monetary developments. However, given that the nature of the
relationship between money growth and inflation is a long-run one, the ECB sees no mechanical link
between short-run changes in the growth rate of the broad money stock and the monetary policy
stance adopted by the Governing Council. There are many factors that may influence changes in the
money stock in the short term. These may include, for example, portfolio shifts, financial innovations or
changes in the yield curve.
The monetary analysis consists of a comprehensive assessment of the liquidity situation based on
information about broad money growth along with its components and counterparts, especially credit
aggregates. This is helpful for extracting the signal being sent by monetary developments, which is
relevant for identifying the longer-run trend in inflation.
4. Communication
Transparency is a cornerstone of modern central banking. It serves two main purposes. First, it makes
central banks accountable to the public and this is particularly important in an era of increased central
bank independence. The second is related to the notion that monetary policy influences expectations
and financial markets more effectively if the public has a better understanding of monetary policy
objectives, procedures and decisions.
However, there are differences across central banks with regards to additional information provided on
the day of a policy rate decision. The ECB is unusual among central banks of the advanced
economies in holding a press conference on the day of a policy rate decision. The press conference
consists of two components:
1. an introductory statement that explains in depth the rationale behind the monetary policy
decision taken; and
2. a Questions and Answers session during which the President and the Vice-President are
available to answer questions from the attending journalists.
This enhances communications by allowing media representatives the opportunity to digest in real
time the information provided through the decision and the Introductory Statement of the ECB, to
compare it with their own prior information, and to ask questions on those issues that need
clarification.
Communication of the monetary policy stance and outlook for the economy is further supplemented by
a more in-depth analysis of economic, financial and monetary conditions in the Monthly Bulletin of the
ECB. Furthermore, members of the Governing Council regularly give interviews and speeches on the
monetary policy strategy, stance and economic conditions.
With the ECB operating across 13 different cultures and a large number of different languages, the
issue of communication brings many additional challenges than those that confront other central
banks.
5. Monetary policy actions of the ECB: a short history
Let me say something about the monetary policy actions since the start of EMU. I think it is useful to
distinguish four distinct phases.
The first phase, which was the early stages of EMU, was characterised by a combination of factors
that had already been affecting the countries joining the euro area in 1998, namely downward risks to
price stability. This led the Governing Council to reduce its monetary policy rate from 3 per cent to 2.5
per cent in April 1999.
The second phase was the period between late-1999 and late-2000 which was characterised by
strong inflationary pressures, largely through high oil prices and relatively rapid monetary growth. The
Governing Council undertook a series of monetary tightening measures during this period, raising
interest rates by a total of 225 basis points.
The third phase was the period May 2001 to June 2003 when the euro area found itself in a period of
subdued economic growth following a number of global shocks. With inflationary pressures abating,
the Governing Council reduced interest rates by a total of 275 basis points between May 2001 and
June 2003. This was followed by a lengthy period of slow economic recovery and market uncertainty.
Expectations for economic growth remained moderate with the Governing Council leaving interest
rates unchanged at 2 per cent until December 2005.
The fourth phase was the period since then which has seen uncertainty in global markets dissipate
and the outlook for economic activity improve. The Governing Council has raised interest rates by 25
basis points on eight occasions between December 2005 and June of this year.
Remarks on current monetary policy stance
Let me now turn to the current monetary policy stance. Our assessment throughout the last year and
one-half was that the outlook for economic growth had improved and that the recovery would
strengthen and broaden. This indeed has been what has happened. Another of our consistently
repeated messages has been the need to guard against inflation risks coming from various sources,
such as high and rising oil prices, increased pass-through to consumer prices, the risk of stronger than
expected wage developments and, in the medium- to longer-term, strong money and credit growth.
Our actions, in raising rates eight times, including the most recent increase, have been consistent with
these messages.
With respect to the outlook for interest rates, I would emphasise that our future decisions are not
predetermined and there is no pre-commitment to any future policy action. Our position is clear and
has been consistent over time. As we indicated last week, we will monitor developments closely and
act, as necessary, to ensure that risks to price stability over the medium term do not materialise.
The euro area economy has gone from strength to strength over the past 18 months. The economy
expanded at its fastest pace for six years in 2006, and the medium-term outlook for growth remains
favourable. The information we have for the first quarter of 2007 suggests that growth remained
healthy. Looking ahead, the conditions are still in place for the euro area economy to grow solidly.
External demand, while moderating, should still provide some support, while domestic demand seems
set to maintain good momentum. Our assessment is that the risks to the outlook for growth are broadly
balanced in the short term. However, over the longer term, there are some downside risks from oil
price movements and global imbalances.
While inflation remains below 2 per cent, the rise in oil prices in recent months has meant that the dip
in inflation that was expected in the first half of 2007 has not occurred. Over the remainder of the year,
base effects are expected to push up the headline rate of inflation from September onwards. With
regard to the medium- to longer-term outlook, upside risks remain. These risks are well known and
relate to oil prices, the potential for increased pass-through and wage growth in a stronger economic
environment and, in the case of the longer-run outlook, vigorous money and credit growth. The
Governing Council has signalled that close monitoring of all these developments is essential to ensure
that risks to price stability over the medium term do not materialise.
6. Benefits of EMU
The successful implementation of the stability-oriented monetary policy of the ECB has been of
undeniable benefit to the euro area economy, both directly by maintaining price stability and indirectly
from the lower volatility in real economy variables that price stability facilitates. The introduction of the
common currency has also promoted increased financial and economic integration between the
Member States of the euro area, thus increasing economic efficiency and providing fresh impetus for
the deepening of the European Single Market.
The performance of the ECB in regard to its price stability mandate has been successful. In particular,
long run inflation expectations have been within the ECB's definition of price stability. This underlines
the credibility that the ECB has achieved since taking control of monetary policy. The volatility of
inflation has also fallen. It nearly halved during the convergence period before the inception of the
euro and has continued to fall since the adoption of the euro, despite the major economic shocks
hitting the euro area economy during this period. There has also been a large fall in the average
volatility of long-term consensus inflation expectations.
Monetary integration in the euro area has also been accompanied by, and given rise to, increased
financial and economic integration. For example, the integration of money markets is complete and
average overnight lending rates have fallen dramatically since the start of the convergence process.
This high level of integration is also visible in related markets, such as the interest rate derivatives
markets. The euro government bond market has also achieved a high level of integration with a large
degree of convergence in yield spreads. Government bond yields in the Member States are now
largely driven by euro-wide factors with marginal differences related to perceived credit risk. In addition
to integration in these two markets, there is also significant evidence that euro area corporations are
taking advantage of the possibility of raising funds from the full range of euro area investors, as
evidenced by the growth in the euro corporate bond market.
7. Ireland and EMU
As regards Ireland's participation in EMU, there is a widespread view that this has been beneficial to
the country. The European Commission's Eurobarometer survey shows that in Ireland over 70 per
cent of respondents were of the opinion that the euro was beneficial. This view is buttressed by the
fact that a strong performance of the economy has been associated with Ireland's membership of
EMU.
Becoming a member of a monetary union was not a new experience for Ireland as we were already
well versed in the functioning of monetary unions. Under the monetary arrangements with the UK,
which lasted from 1922 to the end of 1978, the Irish pound remained tied to sterling on a one-to-one
no-margins basis. Sterling was exchanged at parity in all banks with no charge and sterling circulated
freely within Ireland.
When Ireland joined the European Monetary System when it was established in 1979, adherence to
the Exchange Rate Mechanism of the EMS provided more flexibility, particularly under the wider
bands, but nevertheless monetary policy remained relatively constrained. Moreover, fluctuations in the
bilateral rate of the Irish pound with sterling frequently created uncertainty and consequently
introduced short-term fluctuations in interest rates. Thus to a large extent joining EMU for Ireland was
not as sharp a change in the monetary regime as is sometimes assumed.
Membership of EMU conferred immediate credibility on Ireland's macro-economic policy framework.
There is little doubt that the cost of attaining such credibility would have been higher if Ireland had
remained outside the euro area. Notwithstanding asymmetric shocks which could raise adjustment
issues, it is probably true to say that the ECB provided a better policy response than that which would
have prevailed under independent but uncoordinated monetary policies of individual countries.
The crucial issue for Ireland, as a regional economy in EMU, remains the manner in which it copes
with the challenges of asymmetric shocks. In the last decade Ireland has had to face up to some such
challenges. Notwithstanding these, the macroeconomic performance of the Irish economy in EMU has
been very good. Since the adoption of the single currency, the average annual growth rate of real
gross domestic product in Ireland has been the highest in the euro area. The annual growth rate over
the period 1997 to 2006 was 7.2 per cent, some 5 percentage points per annum above the euro area
average. This strong performance is in large part a result of high rates of growth of the capital stock
(related in part to a reduction in risk premia), increases in the working age to population ratio, and
improvements in labour and total factor productivity.
The challenges for Ireland in EMU remain the maintenance of a high level of living standards, ensuring
the continuing competitiveness of the economy and adjusting to shocks originating outside the euro
area. Ireland's economy and living standards have converged on those of the most advanced
countries. However, there is a widespread consensus that lower productivity growth than that
experienced in the last decade or so will lead to a slower growth in output over the medium term. This
poses issues for containing domestic inflationary pressures. The social partners have a role in this by
ensuring that pay increases take due account of productivity developments. Policies that promote
competition, continue the development of the country's infrastructure, and that provide a framework
that fosters research and development, innovation and entrepreneurship are all important for limiting
inflationary pressures. Fiscal policy also has an important role to play in containing domestic demand.
On the question of shocks originating from outside the euro area, the resilience of the economy
depends on the capacity of both the product and labour markets to be flexible.
8. Conclusion
Before I finish, I would like to reiterate several elements that I believe to be of particular importance.
Firstly, I would like to emphasise the broadly-based, multi-dimensional approach of the ECB's
monetary policy strategy, encompassing a monetary analysis that is used to crosscheck the evidence
from the economic analysis, and the ECB's commitment to a quantitative definition of price stability.
The communication strategy of the ECB is also a noteworthy aspect of the overall monetary policy
framework. The ECB has been innovative in communicating its monetary policy decisions to the
financial markets and public in general, it being the first major central bank to outline policy decisions
in real time through the monthly press conference that follows Governing Council meetings.
As I have indicated, the ECB has been successful in delivering low inflation and keeping inflation
expectations in line with the quantitative definition of price stability. It has also been successful in
lowering the volatility of inflation and inflation expectations, which has helped reduce volatility in other
economic variables. The onset of monetary union has also provided momentum for further economic
and financial integration in the euro area, thus deepening the single market.
With regard to the Irish economy, the euro has, to date, reduced risk premia and brought lower interest
rates. These factors have contributed to Ireland's strong economic growth over the last decade but, on
the downside, have also been associated with rapid credit growth and rising house prices. The key
challenges for Ireland in the years ahead are to maintain its competitiveness so as to protect and
sustain living standards and to deal with the effects of any asymmetric shocks hitting the euro area. In
that regard, it will be necessary to continue to have flexible labour and product markets and to use
domestic policy tools, insofar as is possible, to meet those challenges.
I would like to thank you all for your kind attention today and I will conclude by passing you back to
Kathleen Hays.