Axel A Weber: Challenges for monetary policy in EMU
Text of the Homer Jones Memorial Lecture by Professor Axel A Weber, President of the
Deutsche Bundesbank, at the Federal Reserve Bank of St Louis, St Louis, 13 April 2011.
* * *
1. Introduction
President Bullard
Ladies and gentlemen
First of all, let me thank you for the opportunity to speak here today. It is a real pleasure and
a great honour for me to give this year's Homer Jones Memorial Lecture, all the more so as
this lecture series is named for such a prominent monetary economist. In his capacity as
research director and senior vice-president of the St. Louis Fed, Homer Jones played a
significant role in shaping this institution's monetarist reputation.
Four years ago, I was invited to give a speech in Paris. Its title - "From academic to
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policymaker" referred to the fact that I started out as an academic.1 I began that speech by
mentioning a number of other academics who went on to become central bankers: Mervyn
King, Ben Bernanke, Janet Yellen, Bill Poole and Otmar Issing, to name but a few.
I continued by analysing why there are so many academics in monetary policy. James
Bullard, by the way, is another case in point, whom I did not mention at the time because he
was not yet in his current position. One of the main reasons why, over the past years,
academic researchers have been taking up leading positions at central banks is that
monetary policy itself has been heavily influenced by the findings of academic research.
During the financial crisis, monetary policy and economies across the world have benefited
significantly from these insights, since they have helped us to swiftly apply the appropriate
policy responses to contain the crisis. Conversely, the crisis has also raised important issues
for academic research, in monetary economics as well as in other fields.
As of next month, after seven years as a policymaker, I shall be taking up the position of a
faculty member of the University of Chicago Booth School. In spite of this upcoming
transition "from policymaker to academic", my remarks today on the challenges for monetary
policy in EMU will be given from the policymaker's perspective.
2. The financial crisis and its lessons for monetary policy
The crisis has brought the "monetary policy consensus" formed in the years prior to the crisis
under scrutiny.2 The framework of monetary policy differed significantly from one central
bank to another. Nevertheless, across the board their primary objective was price stability -
defined as a stabilisation of the inflation rate at around 2% across a horizon of approximately
two years. Steering short-term interest rates was considered a sufficient means of achieving
this target. Central bank forecasts played a key role in monetary policy decision-making, with
monetary aggregates increasingly taking a back seat in many forecast models.
Furthermore, capital markets were mostly assumed to be efficient, meaning that financial
imperfections and their potential macroeconomic effects were not taken into account.
Temporary inefficiencies, such as asset price bubbles, were considered possible, but the
majority view was that monetary policy could do little to counteract such developments.
Microprudential supervision was regarded as a sufficient means of containing risks in the
financial sector. Monetary policymakers should intervene only after a financial crisis had
occurred, minimising the macroeconomic damage through resolute interest rate cuts.
Even though monetary policy proved indispensable and highly successful in containing the
crisis and in preventing a meltdown of the financial system, events have cast doubt on this
consensus. The question now is whether, and to what extent, monetary policy should take
account of financial market developments before a crisis occurs.3 Let me elaborate on some
aspects of this in greater depth.
2.1 A stronger role for financial markets in monetary policy analysis...
Given the genesis of the crisis, it is undeniable that monetary policy with too short a policy
horizon can fail to take account of financial imbalances that eventually spill over to the real
economy, thus jeopardising price stability. So, how should monetary policy incorporate the
experience of the crisis into its decision-making process?
In the pre-crisis phase, monetary policy decisions were often based on models in which the
financial sector played only a minor or no role at all. Therefore, an obvious and important
lesson from the crisis is that the theoretical and empirical foundations of monetary policy
must place a greater emphasis on both the banking sector and financial imperfections.
As regards the Eurosystem's monetary policy strategy, the monetary pillar already contains
major elements of such an approach. In the more recent past, the Eurosystem has stepped
up its efforts to continually enhance its monetary analysis.4 The aim is to identify irregularities
in the patterns of a number of variables, since an unusual pattern in loan developments and
monetary aggregates can provide valuable indications of excessive credit growth. This
requires, among other things, an extension of the usual decision-making horizon, as financial
distortions often build up over a fairly long period of time. As a result, monetary policy should
become more symmetrical over the financial cycle and can thus make a key contribution to
financial stability.5
2.2 ... but a separate toolkit is needed for financial stability ...
However, this alone is insufficient to ensure financial stability. Until the crisis, the majority
view had been that asset price bubbles are difficult to identify in a timely manner and that
interest rates are too blunt a tool to burst such bubbles at an early stage. These reservations
have not been invalidated by the crisis and, therefore, the debate on how to better prevent
financial crises turned to the specific incentives within the financial system and the existing
supervision, which focuses primarily on individual institutions, as these may have
encouraged the build-up of debt-financed imbalances. Thus, a greater emphasis should be
placed on macroprudential analysis and regulation.6 The aim of macroprudential policy is to
contain systemic risk, thus strengthening the resilience of the financial system as a whole.
This is designed to ensure that externalities within the financial system, notably the
procyclicality and interconnectedness of financial institutions, can be addressed
appropriately.7 Consequently, existing supervisory tools must be expanded or adjusted so as
to prevent systemic risk from arising in future and to considerably reduce the likelihood of
credit and asset price bubbles.
2.3 ... and price stability remains the primary objective of monetary policy
Against this background, monetary policy and its tools must remain focused on price stability
and should not be overburdened with other objectives. In fact, the credibility of monetary
policy depends not only on the clarity of its objectives but also on transparency regarding its
limitations. Adopting financial stability as an additional, independent monetary policy
objective runs the risk of arousing unrealistic expectations about the effectiveness of
monetary policy tools. Nevertheless, central banks as institutions may still be given the
additional task of pursuing financial stability, as long as they also have the appropriate set of
additional independent tools available to them. Indeed, central banks' expertise constitutes a
forceful argument for them continuing to play a prominent role in analysing and assessing
financial stability. The advantage of having independent tools for price stability and financial
stability is evident when there is a need for monetary and macroprudential policies to be
adjusted in different ways. Nevertheless, as developments in money and financial markets
are of key importance for both monetary policy and macroprudential policy, there are likely
interdependencies between them that should be taken into account. For example, banks'
lending is not only important for the monetary transmission process but is also a link for
macroprudential policy. This opens up the opportunity for policy decisions in both spheres to
complement each another, but it also harbours the danger of them counteracting each other
or even cancelling each other out.
There is no single answer to the question of how necessary or advantageous a coordination
of policy areas would be.8 Recent research has provided some initial clues and corroborates
the view that the inflation rate can be stabilised quite well if macroprudential policy has its
own tools and works alongside monetary policy.9
However, harmful effects with respect to inflation rate volatility can arise if monetary
policymakers ignore the impact of macroprudential tools on the financial markets.10 If central
banks take decisions regarding both macroprudential and monetary policy tools, additional
fluctuations in the inflation rate compared with the monetary policy status quo can be virtually
ruled out, and such fluctuations could even be reduced overall.11
These preliminary results should be interpreted with caution. First, the underlying dynamic
stochastic general equilibrium (DSGE) models only approximately reproduce the complex
interactions between the real and the financial sectors. Second, such research is only in its
infancy; at present, only a few models allow a simultaneous analysis of monetary and
7
A range of tools aimed at curtailing both procyclicality and network risk is currently under discussion. See BIS
(2010), 80th Annual Report; G Galati and R Moessner (2011), Macroprudential Policy: A Literature Review,
BIS Working Paper, No 337.
8
See Committee on the Global Financial System (2010), Macroprudential instruments and frameworks: a
stocktaking of issues and experiences, CGFS Paper 38.
9
See, for example, D Beau, L Clerc and B Mojon (2011), Macro-Prudential Policy and the Conduct of Monetary
Policy, Banque de France, mimeo; I Christensen, C Meh and K Moran (2010), Bank Leverage Regulation and
Macroeconomic Dynamics, Bank of Canada, mimeo.
10
See, for instance, P Angelini, S Neri and F Panetta (2010), Grafting Macroprudential Policies in a
Macroeconomic Framework: Choice of Optimal Instruments and Interaction with Monetary Policy, Banca
d'Italia, mimeo.
11
See P Angelini, S Neri and F Panetta (2010), op cit; C Bean, M Paustian, A Penalver and T Taylor (2010),
op cit.
macroprudential policy.12 Nevertheless, the results confirm that there should be a clear
allocation of objectives and tools in order to achieve the aims of both policies. Assuming that
there will be a satisfactory exchange of information between both monetary and
macroprudential policymakers in the future, the existing studies give no cause to fear that the
objective of price stability will have to be compromised.
2.4 Price stability should still be understood to mean low inflation rates
Even though the pre-crisis consensus regarding price stability as the primary objective of
monetary policy remains valid, it can be asked whether experience of the crisis should have
implications for the specific form that the objective of price stability takes. Specifically, there
have been concerns that the credible commitment to ensure a low rate of inflation might
restrict the leeway for monetary policy stabilisation, since, in the event of the massive interest
rate cuts, the lower bound for nominal interest rates would be hit quite quickly. Two
competing approaches have been suggested to deal with this alleged shortcoming: A higher
inflation target,13 and a switch to targeting the price level or, more precisely, the price-level
path.14 Neither of the two alternatives convinces me.
As regards a higher inflation target, it is not only the substantial and ongoing welfare losses
accompanying a rise in the inflation target that argue against this proposal but also, above
all, the loss of credibility for monetary policy associated with such a discretionary measure.15
The resulting destabilisation of inflation expectations would make it significantly more difficult
for the central bank to achieve its (possibly higher) inflation target and to safeguard
macroeconomic stability.
Compared with a strategy of inflation targeting, price-level targeting does display a number of
advantages, at least in theory. It opens up the option of influencing private sector inflation
expectations and thus of combating deflationary risks in the event of a crisis. However, it is
doubtful whether a change in the target specification in the event of acute deflationary risk
would be suitable for achieving the desired positive effect on private sector inflation
expectations.16 A more serious problem is that a strategy of price-level targeting is
associated with a few additional drawbacks compared with optimal monetary policy, casting
doubt on whether such a change of strategy would be beneficial.17
All in all, this means that neither raising the inflation target nor switching to price-level
targeting would be appropriate from an economic stability point of view. Instead, this problem
must be tackled at root; the existing wrong incentives and regulatory loopholes must be
eliminated in order to make crises less likely and less severe. It is, in any case, questionable
whether the leeway available to monetary policy at the lower bound of the nominal short-term
money market rates actually was that limited. Central banks' experience of the effectiveness
12
See also D Beau, L Clerc and B Mojon (2011), op cit.
13
See J C Williams (2009), Heeding Deadalus: Optimal Inflation and the Zero Lower Bound, Brookings Papers
on Economic Activity 2, pp 1-37; O J Blanchard, G Dell'Ariccia and P Mauro (2010), Rethinking
Macroeconomic Policy, Journal of Money, Credit and Banking 42, pp 199-215.
14
Eggertsson and Woodford already proposed price-level targeting in connection with the deflation experienced
in Japan; see G B Eggertsson and M Woodford (2003), The zero bound on interest rates and optimal
monetary policy, Brookings Papers on Economic Activity 1, pp 139-211.
15
See A A Weber (2010), Der IWF spielt mit dem Feuer (The IMF is playing with fire), Financial Times
Deutschland, 25 February, 2010 (available in German only).
16
See C Walsh (2010), The future of inflation targeting, University of California, Santa Cruz, mimeo.
17
See Deutsche Bundesbank, Price-level targeting as a monetary policy strategy, Monthly Report, January
2010, pp 31-45; C Gerberding, R Gerke and F Hammermann (2010), Price-level targeting when there is
pricelevel drift, Deutsche Bundesbank Research Centre, Discussion paper, Series 1, No 23/2010.
of unconventional measures during the crisis give no cause for viewing the lower bound of
the interest rate as a binding restriction on the effectiveness of monetary policy.
3. Particular lessons for monetary policy in the euro area
All the issues I have been talking about up to now concern more or less all central banks and
every monetary policymaker. For the remainder of my speech, I would like to focus on the
particular challenges for monetary policy in the euro area. These arise from the sovereign
debt crisis, which is the major challenge for economic and monetary union. The
circumstances surrounding the debt crisis are aggravating the conduct of the Eurosystem's
common monetary policy, which is geared towards maintaining price stability in the euro area
as a whole.
3.1 Heterogeneity as a challenge for monetary policy
One of the aggravating factors is heterogeneity in terms of growth, inflation and
competitiveness. With regard to the euro-area countries' economic performance, we are
currently observing a widening divergence. Broadly speaking, there is a considerable growth
gap between the core and the periphery, or to put it more precisely, some peripheral
countries of the euro area.
In my view, the economic heterogeneity of the euro area is a non-issue. Why should
heterogeneity be a problem for the single monetary policy? After all, the dispersion of growth
rates, as measured by the weighted standard deviations of quarterly growth rates, is not
significantly greater than in the first years of EMU. With regard to inflation variance, we see
even lower values than then. Furthermore, the US economy is characterised by considerable
heterogeneity, too, and that does not impede the Federal Reserve's monetary policy, either.
And in much the same was as the FOMC is focused on the US as a whole, the Governing
Council of the ECB has to take a euro-area-wide perspective: While national developments
have to be taken into consideration, monetary policy cannot be tailored to the specific needs
of individual member states.
The real problem with heterogeneity, and that is a concern to me, is that a number of
countries have obviously failed to meet the obligations and requirements of a currency union.
The persistent problems of countries in refinancing their debt are only the symptoms of the
problems, not the problem itself. The financial crisis has revealed unsustainable
developments in some member countries - developments which were already in existence
before the crisis: too much public spending, unproductive use of capital inflows, losses of
competitiveness. Those were just some of the shortcomings which had been carelessly
neglected, not least by the financial markets. Painful adjustment processes, including
structural reform and budget consolidation, are essential to restore the ability of the countries
concerned to live up to the demands of the single monetary policy.
3.2 Fiscal stabilisation measures were necessary but they undermined the basic
founding principles of EMU
Ensuring financial stability in the euro area required and justified fiscal aid for Greece and the
establishment of a temporary stabilisation mechanism. Nevertheless, these particular
measures have undermined the foundations of EMU.
The establishment of EMU was based on principles that were deemed necessary in order to
make the euro a stable currency. According to the principle of subsidiarity, economic policies
other than monetary policy remain the responsibility of national governments. With regard to
fiscal policy, rules and institutional arrangements were established to ensure sound fiscal
policies in the member states. Furthermore, a "no bail-out" clause stipulated national
responsibility of each country for repaying its own public debt.
Rules for sound public finances are of particular importance in a monetary union since the
incentives for excessive borrowing are even greater in a monetary union than they are
anyway. Excessive borrowing can also place a strain on the conduct of a stability-oriented
monetary policy. Unsound public finances are the Achilles heel of a monetary union of
independent states.
Purchases of government bonds for monetary policy purposes, for example, harbour the risk
of blurring the boundaries between monetary and fiscal policy, particularly given high
government deficits and debt levels. This might harm the credibility of monetary policy. A little
earlier I said that monetary policy must remain focused on price stability and should not be
overburdened with other objectives. This principle applies not only with respect to financial
stability, but also fiscal policy.
During the financial crisis, the Eurosystem - like the central banks of other major economic
regions - took unconventional monetary policy measures on an unprecedented scale. The
ample provision of liquidity was effective in offsetting the consequences of the abrupt decline
in market liquidity, in maintaining monetary policy transmission, and, ultimately, in helping to
prevent the real economy from sliding into a prolonged depression. On the other hand,
unlimited provision of central bank liquidity to banks without a sustainable business model
cannot be a long-run solution. Again, monetary policy should not act as a substitute for tasks
of other policy areas. In particular, monetary policy should not and cannot persistently
replace the repair of banks' balance sheets. The phasing-out of non-standard measures has
to be continued; the objective is to return to the pre-crisis operational framework which has
proven its effectiveness and flexibility during the crisis.
3.3 Economic governance in the euro area needs reform
Since the fiscal stabilisation measures in favour of euro-area peripheral countries have
undermined the basic principles of EMU, it is obvious that there has to be a fundamental and
far reaching reform of economic governance in the euro area. The European leaders agreed
that the fiscal rules have to be tightened since their application in practice had proven to be
too weak. They agreed, secondly, that macroeconomic imbalances should be addressed
earlier and more effectively. The crisis demonstrated that sound public finances are a
necessary, but not sufficient condition for financial and economic stability. Ireland, for
instance, was among the least indebted countries of the euro area before the crisis erupted.
Finally, the leaders agreed to establish a permanent stabilisation mechanism since it is an
illusion to believe that a reform of economic governance might prevent the reoccurrence of
fiscal crises in the future.
In March, the leaders agreed on what they view as a comprehensive package. The
measures it contains certainly represent a step in the right direction, but they are not a
"quantum leap towards strengthening the institutional framework of EMU"18 which is required
to reinforce economic governance in the euro area. Ultimately, the future success of EMU
will hinge crucially on the member states' willingness to comply with the tighter set of rules.
4. Conclusion
Tomorrow, it will be 17 years ago to the day since Helmut Schlesinger, one of my
predecessors as President of the Bundesbank held the Eighth Homer Jones Memorial
Lecture. In his speech on "On the Way to a New Monetary Union" he explained to the
audience in St. Louis the historic dispute between "monetarists" and "economists".19 In the
particular context of European monetary integration, these terms had a totally different
meaning to our general understanding. "Monetarists", he explained, "believed that monetary
integration has to start first and that economic and political integration would follow."
"Economists", however, "believed that economic convergence between the national
economies must occur before ... a monetary union."
The "monetarists" prevailed, but they erred in their belief that the introduction of the single
currency would automatically act as a locomotive for the political union of Europe. There is
no political union so far and there is little expectation that this might change significantly in
the foreseeable future. Therefore, national executive and legislative branches will remain
responsible for economic and fiscal policies over the medium to long term. Intergovernmental
fiscal transfers beyond the rather moderate and earmarked payments from the EU budget
(approximately 1% of GNP) are hardly acceptable; overburdening the financial solidarity of
the people might jeopardise the idea of European integration.
The "economists", on the other hand, had a point in demanding more economic
convergence. Their worries were, by the way, taken into account by the implementation of
convergence criteria that have to be fulfilled before a country can join the euro area. The
underlying problem of the current crisis is, however, not a lack of convergence ex ante or
heterogeneity per se; rather it is the lack of willingness on the part of a number of member
states to meet the requirements of the membership in a monetary union. If they fail to correct
these deficiencies swiftly and thoroughly, stability oriented monetary policy in EMU will
become increasingly difficult, all the more so as monetary policy has been profoundly
challenged by the financial crisis.
The major lessons that central bankers in the euro area and elsewhere should take to heart
are the following: Firstly, monetary policy has to consider the implications of financial
instability for price stability; monetary and credit aggregates can provide helpful information
in this regard. Secondly, since the policy rate remains too blunt a tool to tackle financial
imbalances, the objective of financial stability requires its own, macroprudential set of tools,
whereas maintaining price stability should remain the primary objective of monetary policy.
Thirdly, price stability should continue to be seen as a stable and low inflation rate.
Finally, without stability oriented prudent fiscal policy monetary policy will find it increasingly
difficult to ensure price stability at low interest rates.
Thank you for your attention.