Philipp Hildebrand: Money and monetary policy - the ECB experience
1999-2006
Comments by Mr Philipp Hildebrand, Member of the Governing Board of the Swiss National Bank, at
the Fourth ECB Central Banking Conference: The role of money: money and monetary policy in the
twenty-first century, Frankfurt/Main, 9 November 2006.
* * *
1. Introduction
Dear colleagues and friends. It is a pleasure to be here today. I am honored to have the opportunity to
discuss Money and monetary policy: The ECB experience 1999-2006 by B. Fischer, M. Lenza, H. Pill
and L. Reichlin in front of such a distinguished audience. The paper presents an overview of the
monetary analysis at the European Central Bank (ECB) since its inception. It provides market
participants with detailed information on how the monetary analysis has been deployed by the ECB
and how it has evolved over time.
A newly created currency presents formidable challenges to monetary policy. Arguably, this is
particularly true for the monetary analysis. Two challenges strike me as being paramount: first, policy
makers face a fundamentally rearranged financial environment and second, empirical estimates are
difficult to come by due to the invariably short sample period. A new financial regime implies potentially
unstable money demand equations; a short sample induces imprecise estimates. The presented paper
makes a valuable contribution in documenting extensively how the ECB has been conducting its
monetary analysis in such an environment.
It should be noted at the outset that the challenges addressed in the paper do not solely apply to a
new currency area. A case in point is my own institution, the Swiss National Bank (SNB). The SNB will
celebrate its 100th anniversary next year. The Swiss franc can therefore hardly be seen as a new
currency. Nonetheless, in the late 1990s, the SNB encountered very similar challenges to those faced
by the ECB and described in the paper. It had to cope with increasing instability in the demand for its
targeted money aggregates. In light of these parallels, allow me to complement my comments on the
presented paper by drawing on the SNB's experience with money and monetary policy. But before I do
so, let me briefly highlight the two aspects of the paper that strike me as particularly relevant.
2. Money and monetary policy: the ECB experience 1999-2006
First, and arguably most importantly, the empirical results presented in the paper suggest that the
information content of monetary aggregates improve the quality of inflation forecasts derived from
other models. In light of these results, research efforts directed at combining forecasts based on
different models and accounting for the additional information provided by monetary aggregates are
clearly worth pursuing.
Second, the paper documents the thorough analysis done at the ECB to take money demand shifts
into account when tracking M3. The result of this work is M3 adjusted by portfolio shifts, a new
monetary aggregate. It accounts for changes in financial market conditions. At times, this new
measure differs significantly from the traditional M3 measure. The paper shows that this new variable
has valuable information content in inflation forecasting exercises.
In many ways, the empirical work presented in the paper speaks for itself. Nonetheless, it seems to
me, there are at least two factors which limit the extent to which we can draw far-reaching conclusions
from the work presented in the Fischer et al. paper.
First, the analysis covers the years from 1999 to 2006. This period is characterized by remarkably low
and stable inflation. For a central banker, this is good news. Such prolonged periods of low and stable
inflation can, however, give rise to distortions in econometric analyses. An accurate evaluation of the
information content of a particular variable for future inflation becomes difficult when the volatility of
inflation is low. In such a setting it comes as no surprise that the random walk is a hard to beat
benchmark. Therefore, when inflation is low and stable for a protracted period, a low correlation
between money and inflation should not automatically lead us to conclude that money no longer
matters.
Second, the evaluation of the additional value of money in the paper is undertaken based on a
forecast horizon of six quarters. As the authors recognize themselves and as I will point out later on,
money appears to be particularly valuable to inflation dynamics of medium and long-term frequencies.
A mere six quarters could therefore simply be too short a time horizon to allow for money to begin
transmitting in any significant way its impact on inflation.
The Fischer et al. paper will prove to be particularly valuable if it encourages further research to
investigate the relevance and stability of its findings under different inflation regimes, in different
economies and over longer time horizons. In this context, let me now briefly turn to the Swiss
experience with money and monetary policy.
3. SNB experience using information from monetary aggregates
With the collapse of the Bretton Woods system, the SNB had to search for a new policy framework.1
From 1974 until the end of the 1990s the SNB announced monetary targets; first for M1, and
eventually for the monetary base. In 1978, the SNB abandoned its monetary target for a short period
in favor of a nominal exchange rate target.2 During the second half of the 1990s, the monetary base
became instable. The SNB faced increasing difficulty using a money target for MO, let alone to
communicate through them. Finally, the SNB decided to adopt an altogether new monetary framework
in an effort to increase the clarity, transparency, and flexibility of the conduct of its monetary policy.
The new concept, introduced in January 2000, is based on three elements: an explicit definition of
price stability, an inflation forecast as the main indicator for policy decisions, and a range for the
3-month LIBOR as the operative target. In contrast to the ECB's two-pillar strategy, the SNB decided
at the time to adopt an integrated approach. For the purpose of today's discussion, I would like to
highlight two important elements of the SNB's monetary framework.
First, communication considerations were an important element in the design of the new framework.
Clearly inspired by the early inflation targeters, a definition of price stability and a quarterly inflation
forecast became the primary communication tools with regard to monetary policy. These were
considered to be clearer than the alternative of attributing a specific role to monetary aggregates. In
other words, the two pillar model of the ECB was rejected primarily on the grounds of communication
considerations.
Second, the new monetary framework was deliberately designed to allow sufficient room for judgment
and flexibility in the conduct of policy. The inflation forecast as the main indicator for policy decisions is
derived from a "portfolio" of models and indicators. Some of these models contain monetary
aggregates; others don't. The weights assigned to different models and indicators are allowed to vary
over time as their reliability and applicability may also vary across different economic situations.
Empirical studies backed the "portfolio of models" approach. Empirical evidence drawing on six years
of Swiss data suggests strongly that combining inflation forecasts from different models and
specifications improve the forecasting accuracy of the SNB's inflation forecasts.3
Of course, the SNB does not claim to have solved the fundamental problem of linking monetary and
non-monetary analyses. The Governing Board feels strongly, however, that there are significant
advantages in aggregating the information from our different models and indicators in an internal
process and subsequently publish a single SNB inflation forecast. Let me simply mention the most
obvious one. In the SNB's integrated approach, the Governing Board avoids the potential
communication problem of conveying the impression that fixed weights are attached to the monetary
and non-monetary analysis in the conduct of monetary policy. The biggest challenge the SNB
Governing Board has so far faced with regard to the integration of both the monetary and
nonmonetary views was in 2003. While monetary aggregates rose significantly, negative output gap
measures suggested a disinflationary risk. Similarly to what is described in the Fischer et al. paper, the
monetary and non-monetary signals were reconciled through an analysis of portfolio shifts driven by
the near-zero interest rate policy at that time.
Understandably, some of you might be concerned that not giving a prominent and distinct role to
monetary aggregates could lead to relegating money to an insignificant role in the decision making
process. This is not the case. To the contrary, I would argue that the SNB's "plurality of approaches"
concept guarantees that money will retain an important role in policymaking, as long as money
provides useful information for subsequent inflation fluctuations. There are theoretical as well as
empirical studies which indeed suggest that money provides useful additional information for
subsequent price developments.4 Using Swiss data, empirical work conducted at the SNB show that
money growth rates and deviations from an estimated money demand equilibrium contain useful
information for both short- and long-term Swiss inflation developments.5 Similarly, a more recent
study, again drawing on Swiss data, finds that money growth adjusted for changes in the equilibrium
interest rate has a significant and proportional influence on subsequent inflation developments relative
to information in output and interest rates.6
4. Money and long-term financial imbalances
Let me conclude by stressing a final point, which strikes me as being worth emphasizing more
prominently in the Fischer et al. paper: the role of money beyond a medium-term inflation forecast.
Clearly, the relevance of money extends beyond the medium-term. Several recent studies have
discussed the relationship between monetary aggregates and asset prices.7 Today's economic
models are unable to produce reliable inflation forecasts with a horizon beyond at most three years. I
doubt this will change going forward. Nonetheless, developments in monetary aggregates can play a
useful role in helping to identify potential imbalances in financial markets which could, in time,
undermine economic and price stability.
According to a recent study, since 1980, the value of global financial assets excluding real estate has
grown from an amount roughly equaling the global GDP to more than three times its size.8 In light of
the growing importance of financial assets, central bankers have an incentive to consider longer-term
price risks more thoroughly. In a global economy increasingly affected by the effects of rising and
falling asset prices, it seems to me that the role of money and credit aggregates in signaling potential
long-term financial imbalances will become more important. Here I would like to refer to Mervyn King
who recently said: "Monetary policy will, therefore, need to be alert to the information contained in a
wide range of asset prices, to be forward-looking in its aim of maintaining low and stable inflation, and
to be ready to respond to changes in the signposts."9
In practice, it is often difficult to consider money in the conduct of policy. Nonetheless, it allows us to
address some of these important issues at least at first approximation. In that context, both the ECB
and the SNB conduct a careful analysis of monetary aggregates partly in an effort to assess the risks
of long-term financial imbalances. Moreover, acknowledging the monetary source of long-term inflation
helps avoid the build-up of excess liquidity in the first place. In closing, let me therefore repeat that the
Fischer et al. paper could benefit from focusing more extensively on the admittedly complex but
nonetheless important link between money, asset prices and long-term inflation perspectives. In the
4
For example, Nelson (2003) argues that movements in monetary aggregates provide useful indications regarding different
yields usually not incorporated in economic models
5
Baltensperger, Jordan and Savioz (2001), Jordan, Peytrignet and Rich (2001)
6
Reynard (2006)
7
For example, Issing (2002) provides evidence of a close relationship between excess money growth and real asset prices, a
relationship that does not appear by looking at a standard Taylor rule as a measure of monetary policy stance. Similarly,
Friedman (2005) showed that pre- and post-financial market crash evolutions of stock prices and gross domestic products
were strongly related to the pre- and post-market crash evolutions of monetary aggregates. White (2006) pointed to the
need of pushing further the frontiers of economic research in the direction of incorporating financial variables to assess
longer-term macroeconomic developments.
8
McKinsey (2005, 2006)
9
King (2006)
BIS Review 107/2006
case of the SNB, the flexible nature of the policy framework and the importance attached to money
and credit variables means that in an effort to avoid potential long-term financial distortions from
emerging, the Governing Board could conceivably tighten monetary policy even if our inflation forecast
signals no imminent inflation threat.
5. References
Baltensperger, Ernst, Thomas J. Jordan and Marcel Savioz, 2001. The Demand for M3 and Inflation
Forecasts: an Empirical Analysis for Switzerland. Weltwirtschaftliches Archiv, vol.137 n.2, pp.244-272.
Fischer B., M. Lenza, H. Pill and L. Reichlin (2006). Money and monetary policy: The ECB experience
1999-2006.
Friedman, Milton, 2005. A natural experiment in monetary policy covering three episodes of growth
and decline in the economy and the stock market. Journal of Economic Perspectives, vol.19 n.4,
pp.145-150.
Issing, Ottmar, 2002. Monetary Policy in a Changing Environment. Contribution to the Jackson Hole
Symposium on "Rethinking Stabilization Policy", Federal Reserve Bank of Kansas City.
Jordan, Thomas J., Michel Peytrignet, and Georg Rich, 2001. The role of M3 in the policy analysis of
the Swiss National Bank. In: Klöckers, H.-J., and C. Willeke, eds., Monetary Analysis: Tools and
Applications, European Central Bank, pp.47-62.
Jordan, Thomas, und Marcel Savioz, 2003. Sind Kombinationen von Prognosen aus VAR-Modellen
sinnvoll? Eine empirische Analyse mit Inflationsprognosen für die Schweiz. Quartalsheft der SNB, 4,
Dezember 2003.
King, Mervyn, 2006. Speech at the Dinner for Kent Business Contacts, Ashford, Kent, United
Kingdom.
McKinsey & Company. 118 Trillion and Counting: Taking Stock of the World's Capital Markets,
February 2005, and Mapping the Global Capital Market 2006, Second Annual Report, January 2006.
Nelson, Edward, 2003. The future of monetary aggregates in monetary policy analysis. Journal of
Monetary Economics 50, pp.1029-1059.
Nelson, Edward, 2006. Ireland and Switzerland: The jagged edges of the great inflation. Federal
Reserve Bank of St. Louis Working Paper Series 2006-016A, May revision.
Reynard, Samuel, 2006. Money and the great disinflation. Swiss National Bank Working Paper Series,
2006-7.
White, William R., 2006. Is price stability enough? Bank for International Settlements Working Papers
n.205.