Jürgen Stark: Enhancing the ECB's monetary analysis - what have we
learnt?
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank,
at the conference "The ECB and Its Watchers" XII, Frankfurt am Main, 9 July 2010.
* * *
Ladies and gentlemen,
The title of this session asks: "should money and credit play a greater role in central bank
strategies?"
Money has always played a distinctive role in the ECB's monetary policy strategy. From our
perspective, it would be more natural, therefore, to ask: "how should monetary developments
be analysed in practice" and "how can monetary analysis reflect the role it has been
assigned in our strategy?".
The distinctive role of money
First, let me briefly recall the benefits of assigning a distinctive role to money when
formulating monetary policy decisions.
There is overwhelming consensus regarding the empirical long-run relationship between
money and prices. As such, money provides a reliable nominal anchor for monetary policy.
What is more, monetary developments can signal risks to price stability beyond the business
cycle. In turn, such signals support the medium-term orientation of monetary policy, guarding
against an excessive focus on short-term developments in inflation forecasts, as well as
misguided attempts to fine-tune economic developments.
This commitment to conducting a monetary analysis provides us with an insurance device.
It disciplines decision-making.
It ensures that risks to price stability are assessed on the basis of a comprehensive set of
information.
It compels policy-makers to consider trends in money and credit growth, which may exert an
influence on price developments beyond that identified by a purely conjunctural or output-gap
view of the world.
On the basis of these considerations, over the dozen years since the creation of the ECB, we
have continued to employ and develop new tools for monetary analysis. We did this even in
the face of vocal criticism from a significant camp of economists. They questioned whether
money and financial frictions had a role to play in the inflation targeting frameworks that they
had identified as "best practice" for central banking.
Money has been ignored. In the canonical New Keynesian macro-model on which the
intellectual foundations of inflation targeting rests, money has been considered a redundant
element in the monetary transmission mechanism. At best, money is seen as a useless
appendix to the model, serving only to confuse and distract any policy-maker misguided
enough to consider it.
Now that the financial crisis has exposed the fault lines underlying this model;
now that it has been recognised that the inflation targeting approach focused unduly on
short-term cyclical developments in the real economy;
now that economists agree that insufficient attention has been paid to financial imbalances
and vulnerabilities, critics of the ECB have acknowledged the benefits of monetary analysis.
Yet, they tell us that we have pursued such analysis for the wrong purpose!
The right purpose, they tell us, is to support a broader view of our mandate, paying more
attention to risks to financial stability in formulating our policy decisions. It is a little bit as if
they are telling us to forget about monetary policy in principle.
Of course, the tools of monetary analysis can support an assessment of risks to financial
stability. However, we cannot deny their intrinsic value for monetary policy by limiting their
role to episodic and extreme events.
Of course, owing to their influence on financial stability risks, monetary trends impinge on the
outlook for price stability, although not exclusively. The interaction between monetary trends
and the macroeconomy is multifaceted.
Not all historical episodes of private sector money and credit balances going off track have
been followed by threats to financial stability. But, every major economic crisis in the 20th
century was preceded by the emergence of monetary imbalances.
There is no need to dwell on the obvious case of hyperinflation. However, the Great Inflation
of the 1970s was also fundamentally of a monetary nature. It is widely documented that it
was caused by confusion, not only about what drove inflation, but also by denial that central
banks bear ultimate responsibility for price developments. The inability to assess the
monetary policy stance in the light of monetary trends was highly damaging.
The Great Depression is another case in point. It is certainly true that the banking crisis
brought about by the failure of central banks to understand their role as a lender of last resort
under the gold standard was detrimental. But equally detrimental was the sheer unavailability
of monetary data that could have signalled the need, given the collapse in money and credit,
for monetary policy to be accommodative much earlier on, to a higher degree and for much
longer.
Although various scenarios exemplify how monetary trends are transmitted, not all of them
involve risks to financial stability.
Benign scenarios for transmitting shifts in monetary trends tend to mostly reflect structural
changes in liquidity preference. In this case, shifts in monetary trends may be re-absorbed
without posing any risks to price stability.
Another scenario sees such trends as harbingers of changes in spending on goods and
services, thereby affecting price developments.
Yet another scenario could be that increased money holdings may be associated with
increased purchases of assets and higher asset prices. If sustained, wealth effects would
ultimately exert upward pressure on consumer prices. If this is not sustainable, a subsequent
bust is likely to create downside risks to price stability.
Only in this latter sub-case would we be confronted with financial stability issues too. But in
all cases, the long-run relationship between money and prices is preserved.
Enhancing monetary analysis
Let me turn to the more central questions. Recognising the distinctive role that money plays
in the economy does not tell us how we should conduct monetary analysis. In the light of our
analysis, how does the transmission from money to prices work and how precisely is it
supposed to inform the policy-maker?
I cannot provide you with a static toolkit to answer these questions. As in any other field in
economics, we have continuously refined and updated the tools in the face of constant
structural change.
In spring 2007 the Governing Council endorsed the pursuit of an agenda to enhance the
ECB's monetary analysis. Why did we start this? How did we come to organise it? Finally,
what have we achieved over the past three years?
1. Reasons for enhancing monetary analysis
Looking back, I must say that the timing was most opportune. M3 had persistently been
growing, far in excess of the reference value, and had actually started to increase by
doubledigit rates compared with a year earlier.
What was going on? Did this reflect an underlying trend? How would this end? These
developments seemed to expose a number of shortcomings in our analysis.
The expert's judgement was that between 2001 and 2003 portfolio shifts into M3 owing to
heightened economic and financial uncertainty had pushed M3 headline growth above its
underlying trend. But this was not fully reflected in our modelling tools.
Over the past decade as a whole we have experienced a continual process of financial
innovation and structural change. We have constantly needed to adapt, refine and update
our tools.
In addition, these tools could not describe the multifaceted way in which monetary trends
may transmit to the economy. Until then, we had relied mostly on partial equilibrium,
reduced-form models. They served us well in forecasting, but failed to capture structural or
behavioural interpretations of monetary trends. This would have helped us to understand
how the observed shift might, or might not, unwind.
2. Avenues
Given the challenges we faced in understanding how monetary trends impinge on risks to
price stability, we drew up an agenda to enhance monetary analysis and structured it along
the following four broad avenues:
(1) improving money demand models;
(2) developing money-based indicators of risks to price stability;
(3) incorporating money and credit into structural general equilibrium models; and
(4) further exploring the link between monetary variables, financial imbalances and
asset prices, to support cross-checking between the ECB's economic and monetary
analyses.
3. Achievements
In mapping out these avenues our intention was not to imply that specific tools would fall
exclusively into any of these categories. In fact, in many respects we have experienced
convergence across avenues. We have been increasingly analysing money and credit in the
context of macroeconomic systems. To this end, to complement the partial equilibrium
money demand specifications, we have developed models with a more coherent causal
structure. We have started to use a structural general equilibrium model with a fully
articulated banking sector, incorporating an active role for money and credit. This work is not
limited to a single avenue, but has a bearing on the agenda to enhance monetary analysis as
a whole.
The sum of papers that have so far been published under the enhancement agenda provide
us with a variety of tools for different purposes. Unfortunately, time will not allow me to go
through this list in detail.
Given our constant striving for comprehensiveness, we have not sought to condense the
information stemming from monetary analysis into one, easily tractable indicator, comparable
perhaps to a fan chart for inflation.
Of all the available tools, I will focus on two specific examples. First, the reconfirmation of a
stable relationship between money and key macroeconomic variables. Second, the
identification of underlying trends in money used to assess risks to price stability.
Money demand models, for example, have been improved to restore our ability to explain
monetary developments in a coherent, statistically stable money demand framework - and
therefore to have a better understanding of the causes of monetary growth. This has been
made possible through the modelling of money demand in the context of a broader portfolio
choice framework. It entails systems comprising a richer set of explanatory variables, notably
wealth and a broader set of opportunity costs including yields on foreign assets. Likewise,
modelling money demand across sectors with different motives and persistence in portfolio
behaviour has strengthened our ability to detect underlying trends in money.
To define "historical regularities" in the monetary data we now rely on a comprehensive set of
state-of-the-art tools, exploring a wider set of variables, including financial spreads and yields
and providing a richer representation of MFI balance sheets.
To further support the identification of underlying monetary trends, we have developed a
whole range of indicators signalling risks to price stability. In the past we have relied mostly
on bivariate models, which proved relatively robust, but were hard to interpret. We have
complemented these tools by non-linear models, providing an estimate, based on money
growth, of the probability of staying in an inflation regime that is consistent with price stability.
Here, the identification of underlying trends in money is supported by the persistence of
these regimes.
Looking at the toolkit as a whole, we have made progress on three levels:

first, bringing institutional knowledge to bear formally on money demand
specifications;

second, technically refining existing tools;

and third, interpreting monetary developments in a more structural manner.
Expanding our set of models and indicators has helped to formalise the multifaceted ways in
which monetary trends are transmitted to the economy. But challenges remain. Structural
equilibrium models, for example, capture economic developments in terms of unobserved
deviations from trend rather than in terms of how they are measured.
While the structural models provide a coherent view across various sectors of the economy,
they do not offer a definitive view of how money affects the economy. Although they have the
capacity to bridge the real and the nominal sphere, they should not be construed as creating
a single fat pillar, in the sense of economic and monetary analyses being merged into one
analytical framework.
Our experience has shown that while progress has been achieved in improving the analytical
toolbox for monetary analysis, no single model can integrate all elements of the monetary
analysis simultaneously. We will therefore maintaining a plurality of tools in monetary
analysis.
Concluding remarks
The timing of this work in 2007 to enhance monetary analysis was most opportune. Having
faced excessive money growth for years, we were indeed perceiving severe challenges. The
calls we received at the time were to simply ignore them. We did not find reassurance in
these calls. We remained uneasy, but we had no idea ex ante how the excesses in money
and credit would eventually unwind.
At the time, we issued warnings about upside risks to inflation. Eventually the imbalances
manifested themselves in successive asset price collapses, a systemic banking crisis, a
sharp deceleration in money and credit growth, and a precipitous fall in output.
Despite our humble performance as economists in forecasting this specific sequence of
events, no one can credibly claim that what actually materialised was the most likely among
a range of possible scenarios. I think it is fair to say that in order to contain risks to price
stability - whether to the up or the downside - there was a pressing need to head off these
excesses, instead of dealing with them after the fact.
Irrespective of the conjunctural assessment, of how these excesses might eventually unwind
and of whether or not this process might affect the financial system, such a response was
clearly needed. Being agnostic about monetary developments would not have been
appropriate.
To conclude: the improvement in our tools has been evolutionary, rather than revolutionary.
A high degree of continuity has been maintained, as our results support the monetary policy
strategy. Progress has been achieved through the pursuit of our enhancement agenda, but
open questions remain.
Because of the current financial stability issues, we have been applauded for the monetary
analysis, but we are again called to limit its scope. Previously we were asked to plug
monetary information into an inflation forecast. Now we are being asked to plug it into the
emerging framework for macro-prudential analysis. As a by-product, monetary analysis may
both help and be helped by the analysis of bank balance sheets for macro-prudential
purposes. However, we do not want to limit monetary analysis to this end. We need to
maintain a comprehensive view of the transmission of money to the economy and to focus
on pursuing price stability, in line with our mandate.