Willem F Duisenberg: Challenges to the ECB's monetary policy
Speech by Dr Willem F Duisenberg, President of the European Central Bank, upon receiving the
European Banker of the Year Award on behalf of the Governing Council of the ECB, Frankfurt,
16 May 2002
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Introductory remarks
Lady Mayor, Karl-Otto, Andrew, distinguished guests, ladies and gentlemen,
On behalf of the Governing Council of the European Central Bank, may I say that it is a special honour
to receive the European Banker of the Year Award for 2002. The Council, which in two weeks' time will
have been directing monetary policy for three and a half years, is proud to be the recipient of this
prestigious award.
Since it was set up in June 1998, the Governing Council has discussed and deliberated in an
atmosphere of collegiality and consensus. The search for broadly shared resolutions within the
Council has ensured that a balanced judgement could be reached regarding the true state of the euro
area, which covers a vast geographical area and comprises highly diverse national economies. The
Council's consensual approach has fostered a long-term perspective and preserved continuity with our
past. Seeking and obtaining a broad consensus on policy decisions and then explaining them carefully
to the public on the basis of euro-area aggregate evidence has a threefold effect. It shields Governing
Council members from pressures originating in their home countries; it imposes a discipline on
monetary policy by having a continuous, multilateral check of time consistency and policy direction
within the Council; and it counters any public suspicion that a national bias may inform policy
decisions.
Internal governance has been an essential tool in the response to the many challenges confronting the
ECB since its earliest days. At the start of Economic and Monetary Union we were faced with the
extraordinary task of having to conduct policy with limited area-wide data, with several conventional
statistical indicators still under construction and, of course, with the euro area undergoing a major
regime shift. Moreover, we were hard pressed - following the Asian and Russian crises in 1997 and
1998 - to handle a difficult and unpredictable situation which some thought would spiral further
downwards. And at the same time we had to attend to the unique task of laying the foundations for our
future action, thereby completing the work that had been initiated by the European Monetary Institute.
The ECB had to be guided towards full possession of the necessary economic details about a new
and unique monetary area with an economic weight comparable to that of the United States.
So it must have come as a surprise to many that the birth of the euro in January 1999 went so well.
Indeed, it was a resounding success. The transition to the euro was virtually free of technical faults.
We created almost overnight a unified money market, which, despite the formidable transaction
overload, functioned smoothly from the very start. Short interest rate volatility remained well contained,
and the main refinancing operations, along with the standing facilities and the reserve requirement
system with averaging provisions, have since guaranteed that money market developments remain
closely in line with the ECB's intentions.
The arrival of euro banknotes and coins on 1 January this year also went very smoothly. We supplied
300 million people with a new means of payment which in sixty days replaced, without technical
failures or psychological regret, currencies that had served for centuries. Exchanging the old national
banknotes and coins for the new euro denominations was a massive operation requiring enormous
technical effort, perfect logistical co-ordination and economic wisdom. Its success, again, exceeded
the expectations of many - and perhaps even our own dreams. From the outset, the people of Europe
have been enthusiastic about the euro and have quickly adopted their new money.
Key factors behind a successful monetary policy
But let me move on to my main subject today: the key institutional factors underlying the Governing
Council's policy. I shall also consider the many challenges - in addition to the changeover - which we
have faced since the inception of the single monetary policy.
First, the well-designed institutional framework of EMU was a key factor setting the stage for a
successful monetary policy. The Treaty establishing the European Union assigned to the ECB
unambiguous responsibility for the maintenance of a stable scale of value which agents can internalise
in their expectations. And it has shielded monetary policy from political interference.
Price stability diminishes investment risk, reduces the cost of capital and lengthens the horizon over
which lenders and borrowers wish to engage in credit arrangements. This multiplies the opportunities
for agents to exercise their entrepreneurial spirits, to pursue and spread technological advances and
to contribute to the well-being of society at large. Technological factors and agents' attitudes towards
consumption, savings and work combine with government thrift and legislation to determine the real
basis for economic well-being. Any attempts by a central bank to change this balance of real forces in
the short run at the expense of the stability of the currency can only be futile and self-defeating.
Today, there is a broad consensus among economists that monetary policy is not a suitable tool for
fine-tuning economic developments. Any attempts to sacrifice the medium-term goal of price stability
to efforts to meet short-term objectives will ultimately weaken the stability of a currency. To prevent
monetary policy itself disrupting the economy, it needs to be made and kept independent of pressures
arising from short-term political and electoral objectives.
A second key factor behind a successful monetary policy is the macroeconomic policy framework laid
down in the Treaty. While preserving the value of our currency is our primary occupation, the Treaty
recognises that the ECB does not operate in a vacuum. So, it has created a harmonious institutional
structure in which areas of shared responsibilities across policy domains are carefully avoided, and the
single monetary policy finds a standing safeguard in the virtuous principles disciplining its policy
counterparts. The Stability and Growth Pact is a central component in this structure. The past three
decades have taught us that fiscal laxity, far from enhancing collective prosperity, has only made
endeavours by central banks to preserve the value of money costly and painful. The principles
underlying the Pact have restrained and ultimately reversed what appeared an unrelenting growth in
public liabilities. This has reduced the long-term cost of borrowing and made easier the task of the
single monetary authority.
Within the framework of the Treaty and the provisions set in place to implement the Stability and
Growth Pact, national governments exchange views, agree on general guidelines and policy
recommendations, and share frank assessments. For its part, the ECB accepted the invitation to
participate in an informal dialogue with governments and other political actors. This was done on the
clear understanding that the purpose was to share information and insights, not to receive guidance or
instructions on matters of monetary policy.
The institutional balance upon which this dialogue rests, while adequate and balanced, is delicate and
at times fragile. We thus take note with increasing alarm that the voices calling for co-ordinated action
by the monetary and fiscal authorities have become louder and more authoritative recently. According
to these voices, the 'policy mix' should be improved, and the monetary and fiscal authorities should
agree on 'common standards that define general principles' guiding policy conduct over time. We note
these ideas with concern. If such steps were taken, they would undermine the independence granted
to the ECB in pursuing its mandate. They would alter the incentives of economic actors to discharge
their respective duties to the best of their ability. They would blur policy responsibilities and instil the
perception that monetary policy may have become subservient to the needs and logic of the political
cycle. Not least, they would, by implication, severely damage central bank credibility, which in turn
would cause painful costs, in terms of higher interest rates.
The exchange of information and advice, notably across policy domains, and more explicitly between
fiscal and monetary jurisdictions, should never turn into reciprocal interference. The success of
monetary policy fundamentally depends on central bank credibility. Central bank independence, a
fundamental principle of modern monetary governance, should never be challenged.
A third key factor behind a successful monetary policy is the ECB's monetary policy strategy and the
communication of its policy to the public. The Governing Council has clearly stated the ECB's
objective and the framework used to guide its actions. The Governing Council is also very transparent
about its assessment of the current economic situation and the risks to price stability involved. There
are no ambiguities as to how monetary policy would respond to possible changes in the economic
environment and in the balance of risks to price stability. All this provides sufficient information for
other policy actors to take the steps they deem necessary. At the same time, these policy actors also
know how the ECB will react to their decisions.
When setting up the ECB, a major challenge for the Governing Council was to devise a monetary
policy strategy. This strategy, which was announced in 1998, is a new one, specially designed for the
euro area. And compared with the strategies of other central banks, it is perhaps a more complex one.
It was therefore not surprising that it has led to many discussions. In fact, the ECB has sometimes
been criticised for not adopting a strategy focusing on one, or at most two indicators. Some observers
claimed that the ECB, by having adopted its two-pillar strategy, might eventually downgrade the
importance of the reference value for broad money growth. In their view, this would spell the danger of
falling back into discretion. Other observers, meanwhile, were advocating a central - virtually
all-encompassing - role for inflation forecasts.
As is now evident, we were well advised not to yield to either of these calls. It would have been unwise
to base our policy on any privileged indicator or a single forecast, to the exclusion of all other pieces of
information, in a changing world in which statistical inference is such an elusive guide to our real-time
perception of reality. We chose to broaden, rather than narrow, our perspective of the economy.
Forced to decide, we chose to err, if anything, on the side of more evidence than needed, rather than
disregarding key information; we opted to be inclusive rather than exclusive.
This choice has ruled out the use of simple rules for both internal use and external communication. A
central bank does not want to mislead its public with the elementary logic of a two term linear reaction
formula, only to surprise them whenever circumstances demand. So observers should never succumb
to the easy temptation of blaming a central bank for failing to obey a simple rule. More fundamentally:
they should never lose sight of the complexity of the 'economic story' behind the conduct of monetary
policy in a world of uncertainty.
In its interactions with the public, the ECB has never departed from an honest and faithful - if at times
seemingly unwieldy - account of this complex reality. We have shared with the public the evidence
reaching the Governing Council ahead of policy discussions. We have described in detail the
economic rationale behind policy decisions. Those decisions are explained in the press conference
after the first meeting of the Council every month, in the Monthly Bulletin, in numerous speeches by
members of the Council and in my testimonies to the European Parliament. Just listening to what I say
about the current state of the economy and its direction can save all that time and effort devoted to
uncovering the alleged secrets of central bank thinking, or the individual views of members of the
Governing Council.
Experience after four years
How did these three key factors setting the stage for a successful monetary policy have an impact on
the functioning of the Governing Council and on the ECB's monetary policy? Looking back over the
past years, I can see that the mutually reinforcing viewpoints of the two pillars have served as a
balanced and comprehensive basis for analysis prior to monetary policy decisions. At the same time,
the complex process of cross-checking information gathered from each of the two pillars has
sharpened - rather than diminished - our awareness of the changing conditions in our economic
environment.
When confronted with new developments in the economic environment, the Governing Council has
never hesitated to take resolute, timely action to pursue a policy stance which best serves the purpose
of maintaining price stability over the medium term.
Regarding the conditions for maintaining price stability, in January 1999, the single currency was born
into an environment of inflation rates hovering around 1%, below the upper limit of the range
considered to be consistent with price stability. At that time, there were some signs of risks of deflation
in the context of a depressed global economy and the financial distress following the Asian and
Russian crises. We responded by cutting interest rates by 50 basis points in April 1999.
When, in the remainder of 1999 and in 2000, our analysis indicated that external shocks, namely the
sharp rise in oil prices and the depreciation of the euro, were increasingly putting pressure on prices,
and our assessment of monetary and credit aggregates signalled the existence of generous liquidity
conditions in the euro area, we raised rates on seven occasions. Between November 1999 and
October 2000 interest rates were increased by a total of 225 basis points in order to counteract the
emergence of risks to price stability in the euro area.
In early 2001, our analysis started to signal declining inflationary pressures over the medium term. But
in 2001 price developments were affected by a surge in food costs driven by an unprecedented health
crisis which had disrupted important segments of the primary sector. At the same time, the lower
actual and prospective economic growth was one factor supporting an outlook in which inflation rates
approached levels in line with our definition of price stability. It is worth noting that the first decision to
lower our policy rates was taken in May 2001, that is, when actual consumer price inflation was at its
peak in the euro area. This is a clear indication of the medium-term and forward-looking orientation of
our policy. Between May and November 2001, we lowered our policy rates by a total of 150 basis
points.
In order to forestall imbalances that may not have been visible or evident at first sight, we have rarely
been caught off guard by events. On the one occasion when we were - after the terrorist attacks in the
United States on 11 September - we did not lose our nerve. We reacted without hesitation and moved
swiftly to ensure that financial markets continued to function effectively.
By and large, we can claim that we have maintained a firm course of action in the day-to-day
business, guided by our monetary policy strategy, and that the shocks we have experienced have
received a timely and appropriate monetary policy response. Inflation has been kept under control
even in the face of substantial adverse shocks.
Concluding remarks
In conclusion, I believe that all the institutional preconditions for a stable currency and macroeconomic
success are in place in Europe today. The institutional construct of the Treaty has paved the way for a
single monetary policy in Europe to be a lasting success. The ECB - through its strategy - has
successfully implemented the framework within which it pursues its mandate. And in the daily
execution of its policy, the ECB displays a firm hand and a clear sense of direction in countering
inflationary risks as they emerge.
Markets seem to acknowledge this achievement. Continuous adverse price shocks have done little to
shake the conviction of most Europeans that the statute and the competence of the ECB will
indefinitely and effectively contain any inflationary or deflationary forces. This has constantly been
reflected in well-behaved inflation expectations. Despite the fact that the recent increase in oil prices
currently tends to slow down the fall in HICP inflation, long-term expectations of inflation have been
remaining below 2%.
Certainly, we are less than entirely satisfied about recent price developments. Recently published
inflation forecasts, developments in indicators of inflation expectations and recent trends in wages
neither clearly confirm nor entirely defuse the risk of an entrenchment of upward tendencies in prices.
At this juncture, it is therefore particularly important to remain vigilant with regard to the further
evolution of the key factors determining future price developments. While we have to acknowledge
that monetary policy cannot affect inflation developments over the short-term, we are determined not
to put our achievements at risk.