Mr. Hannoun discusses the operational framework for EMU and the
challenge of managing price stability Speech by the Deputy Governor of the Banque de
France, Mr. Hervé Hannoun, at the Financial Times European Economic and Monetary Union
Conference in London on 20/11/97.
I am delighted to take part in this discussion on the framework for the single
monetary policy in Stage Three. I will address what I consider to be the two main categories of
issues in this context: those related to monetary policy strategy on the one hand, and those
related to the execution of monetary policy operations on the other hand; in other words,
strategic and operational issues.
1. STRATEGIC ISSUES
What are the main strategic issues relating to the formulation of the single
monetary policy? I will consider in turn:
the final objective,
•
• the intermediate target,
• the role of the exchange rate as an indicator, and
• the starting level of interest rates in the euro area at the end of next year.
1.1. Final objective: a quantified definition of price stability
The final objective of the single monetary policy is clearly stated in the
Maastricht Treaty: according to article 105, "the primary objective of the ESCB shall be to
maintain price stability". Only a monetary policy geared towards the objective of price stability
can create the conditions for durable and sustainable growth. To reach this objective, three
conditions need, in my view, to be fulfilled:
• firstly, the monetary strategy should be set in a More generally,
medium-term framework.
the European policy mix should consist both of a medium-term stability-oriented monetary
policy and of a medium-term fiscal policy aiming at a balanced budget (or "close to balance"
as stated in the Stability Pact).1 This medium-term stability-oriented policy mix is the best
we can do to create the conditions for durable growth in the euro area. And it is now widely
agreed in the European Union that the policy mix should not give the illusion that it can fine
tune the economy;
• secondly, the strategy pursued should provide a clear anchor to inflation expectations.
This implies the public announcement of a of the final objective of
quantified definition
price stability; for instance, the Banque de France aims at an inflation rate not exceeding 2%;
• thirdly, the strategy should be based on a This is because the
forward-looking approach.
transmission of monetary policy decisions to the economy takes place with relatively long
lags. Estimates of these lags between interest rate changes and their effects on inflation vary
between one and two years. As a consequence, central banks have to look ahead before they
take monetary policy decisions. A case in point was the recent decision by several
continental central banks, including the Banque de France, to raise their main refinancing
rates on 9th October. This move was justified by the need to pre-empt inflationary pressures
early enough, although inflation remained low. In my view it is very important to
current
make the public aware of the concept of the "pre-emptive strike", which is at the heart of
central banking.
1.2. Intermediate target: more arguments in favour of monetary targeting, with a caveat
In order to provide an anchor to inflation expectations and to look ahead, central
banks make public an which they commit themselves to respecting.
intermediate target
Announcing an intermediate target also enhances the accountability of the central bank. This is
why Article 12 of the Statute of the ECB explicitly refers to decisions relating to intermediate
monetary objectives as one of the main responsibilities of the Governing Council of the ECB.
Two possible strategies have been selected by the EMI Council as potential candidates to be
recommended to the ECB, namely monetary targeting and direct inflation targeting.2 In the case
of direct inflation targeting, the made by the central bank can be viewed as
inflation forecast
fulfilling the role of the intermediate target.3
Let me dwell a moment on the choice the ECB will have to make between direct
inflation targeting and monetary targeting, unless it chooses to combine elements of both
strategies. stresses the responsibility of the ESCB for achieving and
Inflation targeting
maintaining price stability. However, there are some difficulties in the process of forecasting
inflation over the medium and longer term. As Mervyn King recently stated, "such a forecast
cannot be a single number. It must be presented for what it is, namely a probability
distribution".4 Furthermore, inflation targeting could imply more formal cooperation with the
Government since the latter is in a position to influence price developments. Finally, inflation
targeting has admittedly proven useful in progressing towards price stability, as the experience
of the United Kingdom has shown. Nevertheless, the track record of inflation targeting is fairly
short and has mostly taken place in a context of world-wide disinflation.
monetary targeting by the ESCB would be in continuity with the strategy implemented by the
Bundesbank since 1975 and by the Banque de France since 1976. However, this strategy hinges
on the stability of money demand. Preliminary research has shown that EU-wide money
equations often perform better than comparable national equations.5 Nonetheless, this may
provide no safe guidance for the starting period of EMU in so far as the move to Stage Three
constitutes a change of regime which might lead to breakdowns in empirical relationships.
1.3. Indicators: an important role for the exchange rate and long term interest rate of the euro
It is likely that, while avoiding a "looking-at-everything" approach, the ESCB
will closely monitor, in addition to the intermediate objective, a broad set of other economic and
financial indicators to help assess the risks to future price stability. In this set of indicators,
emphasis will probably have to be laid on the exchange rate and the long-term interest rate of
the euro, for at least three reasons.
Firstly, the euro exchange rate and long-term interest rate will play an important
role in shaping monetary conditions within the euro area, together with the level of short-term
interest rates that will be steered by the ESCB. Secondly, although the degree of openness of the
euro area will be much lower than is currently the case for any EU Member State, with "foreign"
trade representing roughly 9% of GDP for the EU as a whole, the area will remain totally open
to foreign capital flows. In that regard, I would like to stress that current holdings of French and
German securities by non-residents, including cross-holdings, amount to 1,200 billion dollars.
This highlights the importance of keeping a high level of confidence in the euro. Thirdly, in
spite of the fact that the ESCB will inherit credibility from the participating national central
banks, the ECB will have no track record of its own in targeting money or inflation. It will thus
have to build up its reputation and pay due attention to those indicators that reflect most directly
the level of confidence placed by investors in the euro.
Of course, as underlined above, the external value of the euro will not have the
status of an intermediate objective and the ECB's strategy will not be based on exchange rate
targeting.6 However, any depreciating trend of the euro would feed domestic inflation through a
rise in import prices and, by undermining investors' confidence, would contribute to the building
of risk premia into the euro yield curve. This would have negative consequences for investment,
competitiveness, growth and employment in the euro area. So there cannot be any "benign
neglect" with respect to the exchange rate. A stable and strong currency contributes to lowering
long-term interest rates, which play a crucial role in the financing of the economies in
continental Europe.
All these reasons point to the need for a strong and stable euro, a currency that
will be as credible as the franc, the guilder or the Deutsche Mark. The euro must be, and will be,
rock solid. Therefore the exchange rate of the euro, even if not targeted as such, will
undoubtedly play an important role as an indicator in the conduct of the single monetary policy.
1.4. The starting level of key interest rates in the euro area
Let me say a few words on another strategic question: what will be the starting
level of key interest rates in the euro area thirteen months from now?
Futures contracts on short-term interest rates reflect the market's expectations on
this issue. But of course don't expect a central banker to answer this question, one year in
advance. I will just mention the Banque de France view on the rationale that should be behind
the determination of the starting level of the euro area short-term rates.
As you know, we currently observe interest rate differentials between the "core"
and more "peripheral" currencies participating in the exchange rate mechanism. Although these
spreads have been dramatically reduced in the past two years, due to the remarkable
convergence of inflation rates throughout the European Union, some interest rate differentials
still exist. They can be attributed partly to differing positions in the business cycle, and partly to
differences in credibility.
within the potential euro area should not be overestimated.
Cyclical differences
There is, all in all, a relatively high degree of synchronisation in the business cycle in continental
Europe. The convergence criteria laid down in the Maastricht Treaty certainly played an
important role in fostering this synchronisation. Moreover, in the future, differences in cyclical
developments will gradually be reduced as policies, structures and behaviour will become more
and more similar. Lastly, some persisting differences may well be tolerated as is currently the
case between the various regions of the same country or, for instance, between the various
member states of the USA.
between "core" and "peripheral" currencies result from
Credibility differences
the different lengths of the track records in terms of stability-oriented policies. It is not the same
to have reached an inflation goal of less than 2% for one year as for ten years. One of the
benefits that the "peripheral countries" could reap from participating in the first wave of
monetary union is to achieve the level of interest rate of the most credible currencies without
having yet built up a very long track record.
I would like to underline that in Europe, we are not converging towards a kind of
average of the market interest rates of the potential euro area. One has to understand that the
philosophy of EMU is to organize the convergence of the European countries towards the best
possible level of monetary credibility and therefore towards the benchmarks in terms of interest
rates. As Mr. Trichet recently stated, not an
"convergence is a benchmarking concept",
averaging process. Convergence does not mean that the "core" currencies' interest rates should
go up towards irrelevant "average levels", but that the interest rates of more "peripheral"
countries should progressively converge towards the benchmark level.
This benchmark level is currently given by the intervention rates of the
Bundesbank and of the Banque de France, both at 3.3%. But of course the benchmark level one
year from now could be different from 3.3%.
2. OPERATIONAL ISSUES
How will the ESCB operate? As you know, central banks implement their policies
through the creation and destruction of central bank reserves, of which they are monopoly
suppliers. This is done in the framework of domestic credit operations as well as foreign
exchange interventions. Credit operations are conducted at maturities that extend overnight or
beyond, to implement monetary policy, or on an intraday basis, to provide liquidity to payment
systems. Therefore, I will consider in turn monetary policy operations, intraday credit operations
and foreign exchange operations. I will focus on the following issues:
As regards monetary policy operations, how will a single money market rate be
attained and what will be the degree of interest rate volatility that the ESCB will be willing to
accept? As regards intraday operations, how to cope with the risk of spillover from intraday
credit into overnight credit? As regards domestic credit operations as well as foreign exchange
operations, how will the principle of operational decentralisation be applied within the ESCB?
2.1. Monetary policy operations: a short-term money market rate as operational target
To implement the single monetary policy, the ESCB will pursue an operational
target that will normally be a short-term money-market interest rate. Two issues deserve close
attention in that regard: the singleness of the money market on the one hand, and the volatility of
the interest rate that will be targeted on the other hand.
2.1.1. Single money market rate
The single monetary policy will be characterised by the singleness of interest rate
levels in the interbank market: from the 1st January 1999 on, a single money-market interest rate
will apply throughout the euro area for a given maturity. The issue is, thus, how to attain this
single interest rate level. Two requirements will have to be met for that purpose. The first
requirement is that, in the context of a single monetary policy that will be implemented in a
decentralised manner, there should be a very high degree of harmonisation of instruments and
procedures. The EMI and central banks are working relentlessly to this aim. The second
requirement lies in the integration of interbank markets and payment systems.
As far as are concerned, two factors should play a key role:
interbank markets
• the first factor relates to the various rules market operators have to abide by. These rules
apply to counterparts, market makers, brokers, rating agencies and market enterprises such as
clearing houses. They take the form of codes of conduct, regulations, master agreements and
market standards. An appropriate degree of harmonisation of these market rules should be
reached under the aegis of central banks and prudential authorities;
• the second factor, the use of a single range of reference interest rates would guarantee the
transparency of the euro money market. In this respect, short-term maturities are of special
interest to central banks. This justifies that they intervene to some extent in the process of
elaborating these indicators. As a matter of fact, the EMI has recently agreed that the ESCB
should sponsor the computation of an
overnight reference rate for the euro area.
As regards the TARGET system will also contribute to the
payment systems,
rapid emergence of a unified money market throughout the euro area. TARGET will connect the
domestic real-time gross settlement (RTGS) systems operated by the national central banks. It
will enable participants to make totally safe cross-border settlements in euro, in real time and at
a low cost, thereby facilitating interest rate arbitrage. All large-value payments related to
monetary policy operations will have to process through TARGET. A common closing time for
domestic RTGS and the harmonisation of conditions under which intraday liquidity will be
provided by national central banks within the euro area should also help prevent any risk of
segmentation of the single money market.
2.1.2. Interest rate volatility
The EMI has described in various publications the
set of monetary policy
that will be made available to the ESCB.7 This set will comprise
instruments open market
It should fulfil two basic functions:
operations, standing facilities and minimum reserves.
firstly, to enable the ESCB to control efficiently its operational target; secondly, to signal the
ESCB monetary policy stance. It should also be consistent with the requirement laid down in the
Maastricht Treaty that the ESCB should act in accordance with the principle of an open market
economy with free competition, favouring the efficient allocation of resources.
In practice, the concrete design and use of monetary policy instruments will
depend crucially on
the degree of volatility of the short-term rate chosen as the operational
This volatility will in turn depend on several
target that the ESCB will be willing to accept.
factors:
• the defined by the two standing facilities available to absorb or
width of the corridor
provide liquidity (the deposit facility for the floor and the marginal lending facility for the
ceiling). Under normal circumstances, the two facilities will bound the overnight interest
rate. They will operate at the overnight maturity and will be accessible at the discretion of
counterparties and for unlimited amounts, provided, in the case of the marginal lending
facility, counterparties can supply adequate collateral. A very narrow corridor, allowing very
little room for the functioning of the money market, would not be strictly in line with market
principles. On the other hand, a very broad corridor would not help contain excessive market
volatility. As a consequence, the width of the corridor is likely to be set pragmatically
(currently, it is around 2% for most central banks that operate an interest rate corridor similar
to the one planned for the ESCB);
the could be a more discriminating factor for interest
• frequency of fine tuning operations
rate volatility. Very frequent intervention of the ESCB in the money market would not, in
my view, be fully consistent with market principles. Moreover, excessive intervention might
complicate the extraction of information from movements in market interest rates, especially
at the maturity at which the ESCB would intervene. Intensive recourse to fine-tuning
operations might also deprive regular refinancing operations and standing facilities of their
signalling effect and be conducive to a centralisation of monetary policy operations;
• provided they are set at a sufficient level, and include an averaging provision,
reserve
constitute an efficient buffer against liquidity shocks ; this would help
requirements
stabilize short-term interest rates over the maintenance period. In turn, setting a fairly high
level of minimum reserves might require remunerating them in order not to induce
significant delocation or disintermediation;
• enhancing the signalling effect of the main refinancing operations should also contribute
to lowering interest rate volatility. This may best be achieved through the normal conduct of
which send clear signals to the market, rather than variable-rate tenders.
fixed-rate tenders,
The latter may nevertheless be useful in certain circumstances where the ESCB wishes to
gauge market sentiment;
• finally, the communication policy of the ESCB could also play a role in smoothing interest
rate volatility. The ESCB will have to publish weekly a consolidated balance sheet. It will
also publish the results of its tender operations. It could equally wish to release daily
aggregate data on the reserve holdings, if averaged reserve requirements are in place, and on
the use of the two standing facilities, as measured in both cases at the end of the previous
day.
2.2. Intraday operations: the spillover from intraday credit into overnight credit as a borderline
case
To ensure the smooth functioning of the TARGET system, the national central
banks will provide intraday liquidity to participants in the real-time gross settlement systems.
This will be done in the form of fully collateralised intraday credit operations, in the sense that a
credit extended during the day falls due before the end of the day. From a monetary policy point
of view, such operations create the risk of a spillover of intraday credit into overnight credit that
would undermine the control of the ESCB over the euro monetary base. In other words, the
spillover of intraday credit into overnight credit in the books of the central bank can be viewed
as a borderline case between payment systems and monetary policy issues.
Within the euro area, this risk will be limited as end-of-day debit positions will be
automatically considered to be a request for recourse to the marginal lending facility, i.e. an
ESCB monetary policy instrument that bears a penalty interest rate.
Outside the euro area, a problem arises as the RTGS systems of non-participating
countries will be connected to TARGET, whereas no central bank currently gives non-residents
access to its monetary policy instruments. As a consequence, different mechanisms are being
prepared in order to prevent intraday credit, if granted to non-euro area NCBs, from spilling
over into overnight credit. These mechanisms include the limitation, possibly to zero, of the
amount of intraday liquidity non-euro area NCBs could receive, a system of penalties and
sanctions applied in case of overnight overdrafts and an early closing time for participants in
RTGS systems in non-euro area countries. The decision on which mechanisms to implement will
be taken by the ECB.
2.3. Foreign exchange operations
Foreign exchange operations include foreign reserve assets management on the
one hand, foreign exchange intervention on the other hand.
The ESCB will hold and manage two different types of foreign reserve assets:
• those that will be transferred from the national central banks to the ECB; according to the
Statute, the ECB shall be provided with such foreign reserve assets up to an amount
equivalent to euro 50 billion;
• and those that will be kept by the national central banks; the management of these foreign
assets will be subject to guidelines issued by the ECB to ensure that the operations of
national central banks do not interfere with the monetary and exchange rate policies of the
euro area. These guidelines will include prior approval by the ECB for transactions
exceeding thresholds to be specified and will also apply to member states' transactions with
their foreign exchange working balances.
The ESCB will have the technical capacity to conduct, if need be, foreign
exchange intervention in order to counteract excessive or erratic exchange rate fluctuations of
the euro against the major non-EU currencies (e.g., the US dollar).
The need for intervention could also arise either in the context of G7 concerted
operations or within the framework of the ERM II. To this end, the ESCB will use the pool of
foreign assets transferred from the NCBs to the ECB.
The framework that has been designed for domestic as well as foreign exchange
operations allows the ESCB to build on the expertise that NCBs have acquired over the years
and to make an extensive use of existing operational capacities in NCBs (dealing room, front
office, back office). Common sense dictates making use of equipment, human resources and
expertise currently available at NCBs.
2.4. A decentralised execution of operations
A key feature of the single monetary policy is indeed that it will be decided in a
centralised manner, by the Governing Council of the ECB, and executed in a decentralised
manner, by the national central banks. In my description of operational issues within the context
of the single monetary policy, I have made numerous and concrete allusions to this reliance of
the ECB on the national central banks, in the areas of monetary policy, payment systems and
foreign exchange operations. This organisation scheme of the ESCB is in line with the principle
of subsidiarity laid down in the Maastricht Treaty. According to this principle, the ESCB shall
have recourse to the national central banks to carry out its operations, to the extent deemed
possible and appropriate. Consistently with this principle of decentralisation in the execution of
the ESCB's operations, the counterparties (credit institutions) will keep their accounts with the
NCBs.
Operational decentralisation within the ESCB will be in the very interest of the
System. In this regard, let me quote the President of the EMI, Mr. Duisenberg: "Reliance on the
infrastructure and operational experience built up by the national central banks will prove a
valuable asset. Given that the ESCB needs to be cognisant of differences between financial
market participants and structures in the EU, operating through the national central banks will
ensure that it has the best possible knowledge of market conditions throughout the euro area".8
The credibility of the ECB as the decision-making centre will by no means be
undermined by this decentralised scheme. It will not depend on the technicalities in the
execution of operations. The credibility of the ECB will crucially depend on its ability to
adamantly pursue its strategy aiming at price stability and on its fortitude in resisting any
pressure to deviate from this strategy.