Lucas Papademos: Monetary policy in a changing world - commitment,
strategy and credibility
Speech by Mr Lucas Papademos, Vice President of the European Central Bank, at the Fourth
Conference of the International Research Forum on Monetary Policy, Washington DC,
1 December 2006.
* * *
I. Introduction
It is a great pleasure for me to participate in this conference of the International Research Forum on
Monetary Policy. This is the fourth conference of its kind, and testifies to the increasing significance of
this forum, which brings together academics and policymakers from both sides of the Atlantic. This
year's programme confirms the previously established trend by including papers that address a broad
range of issues and which are highly topical and relevant for the practice of monetary policy. I would
like to congratulate the organisers for their judgement and hard work that has resulted in putting
together an exciting programme for this fourth conference. I find it intriguing that in many cultures the
number 4 symbolises the qualities of practicality, application and tenacity, and that it suggests
organisation and hard work. I have to say as far as this conference is concerned, the numerologists
have hit it right on the spot!
Since the forum provides an occasion for a transatlantic exchange of views, I would like to address
some monetary policy issues as viewed from the European perspective of the still relatively young -
though mature - European Central Bank. When Europe took the historic step of introducing a single
currency, it was a quantum leap into uncharted policy territory. Understandably, some had expressed
doubts about the prospects for success. And everybody fully recognised the great uncertainty and
potential difficulties that could be encountered. Eight years on, however, I think we can safely say that
the evidence confirms that the ECB's monetary policy has been a great success in terms of keeping
inflation under control and anchoring inflation expectations at a level in line with our quantitative
definition of price stability. I believe the effectiveness of our policy can be attributed to three key
features that characterise it: commitment, strategy and credibility. But let me add that we are fully
aware that we cannot be complacent. A central bank's job is "never done", especially in a rapidly
changing world. The ongoing changes in the external environment within which policy is conducted
and in the structure of the economy pose new challenges to us policy-makers.
In my presentation, I would like to address three challenges for monetary policy. They have in
common that they derive from ongoing changes in the structure and functioning of the economy that
have bearing on the conduct of monetary policy and the transmission of its effects, notably:
1. the process of globalisation;
2. technological advances and changes in productivity growth; and
3. financial innovation and development.
I will first address these three processes and their consequences for the inflation process. Afterwards,
I will discuss their common implications for the conduct of the ECB's monetary policy. Although these
issues are particularly important for us, I believe they are also of relevance for all monetary
policymakers - and for economic research that can help provide answers to as yet unresolved
questions.
II. The effects of globalisation
Generally speaking, globalisation can simply be defined as the process of increasing global economic
integration and, in particular, the growing internationalisation of trade in goods, services and financial
assets. Over the past 15 years international trade and foreign direct investment (FDI) flows have
expanded rapidly. The value of world exports of goods and services relative to world GDP has
increased by over ten percentage points in the last fifteen years or so, rising from 19% in 1990 to 30%
in 2006. [see Chart 1] Since the mid-1990s, the share of cumulated FDI flows (FDI stock) in world
GDP has increased at an even faster pace, particularly in non-Japan Asia and in the new Member
States of the European Union. [see Chart 2] The current wave of globalisation is largely related to the
integration into the global market economy of emerging Asia and of the former socialist countries in
central and eastern Europe. In fact, the share of both regions in world exports has essentially doubled
over the past 15 years to 22% and 4%, respectively.
Globalisation affects the functioning of the world economy and of the national economies through
many channels and in various ways. Today, I will concentrate on its effects on inflation, which are both
direct and indirect. The increasing economic opening up of many countries has led to the emergence
of two major and fairly direct effects on world inflation dynamics, which partly offset each other. On
one hand, raw materials and basic commodities, most importantly oil and other sources of energy,
have become scarcer relative to world demand, leading to substantial upward pressure on prices. [see
Chart 3] For example, Brent crude oil prices have almost tripled over the last three years, reflecting to
a very large extent the impact of rising demand, especially in emerging market economies [see Chart
4], although supply-side factors have also played a role during some periods.
On the other hand, the integration of an enormous reserve of low-cost, skilled labour in the
international economy and the increasing production of manufactured goods in emerging market
economies have put downward pressure on import prices of manufactured goods as well as on wage
demands in industrial economies. As a consequence, the prices of a wide range of manufactured
goods have been declining since 2000. This is reflected in the unit value of imports of manufactured
products in the euro area which in mid-2006 was virtually at the same level as in the year 2000. [see
Chart 5]
The counteracting effects of these global price pressures on euro area inflation can be observed more
clearly if we take a look at the development of the overall Harmonised Index of Consumer Prices
(HICP) and selected components (energy and non-energy industrial goods). [see Chart 6] The prices
paid by consumers for energy products, which account for approximately 9% of euro area private
consumption, have surged at an average rate of 5.4% per annum following the series of sharp oil price
increases since 1999. However, the prices of other consumer goods, such as non-energy industrial
goods, which account for over 30% of total private consumption, have increased at a more moderate
rate of 0.7% per annum on average since 1999.
In an environment of significant changes in relative prices, some price increases, for example those of
energy goods, may be more visible to consumers than the relatively stable prices of many other
consumer goods, and may as a result affect inflation expectations. Consequently, it is particularly
crucial for monetary policy to anchor inflation expectations to price stability, in order to minimise the
likelihood of second-round effects of energy price increases.
The impact of globalisation on HICP inflation excluding energy products also reflects its indirect effects
on the cost of labour as well as the increased competition it has entailed. Euro area labour cost
developments have remained moderate in recent years despite the strong increase in energy prices.
[see Chart 7] There are two major reasons for this welcome development. First, the successful
anchoring of inflation expectations has helped contain possible second-round effects on wages from
energy price increases. Second, globalisation and the increased openness of the euro area economy
have influenced labour demand as a result of increased competition and outsourcing and through
higher real wage elasticity of labour demand due to a reduction in the bargaining power of workers. It
is interesting to note that all labour cost measures increased at a decelerating rate starting in early
2002 until late 2005. Recently, however, a pick-up in the rate of change of some labour cost measures
has been observed.
What is the overall net effect of globalisation on the dynamics of euro area inflation? Attempts to
quantify the extent to which the globalisation process has helped contain inflation in the euro area over
recent years are subject to substantial uncertainty, for the fundamental reason that it has been difficult
to identify all the effects of globalisation on inflation dynamics and disentangle them from the
influences of other factors, for example those that have contributed to wage moderation and
productivity growth in recent years. More specifically, moderate wage developments in the euro area
partly reflect such factors as the threat of relocation of production owing to global competitive
pressures or "social pacts" that take into account competitiveness objectives. They also reflect,
however, the favourable effects on inflation expectations resulting from a credible monetary policy, the
reduced bargaining power of labour unions due to changes in workers' preferences and a larger share
of part-time and short-term labour contracts, and the refocusing of bargaining on non-wage elements,
such as working hours and benefits. Similarly, it has not been easy to isolate the impact of
globalisation on competition and productivity growth and separate it from the effects of other factors.
One conclusion that has some empirical support is that domestic inflation is no longer determined
predominantly by domestic demand and supply constraints, but seems to depend more on the degree
of global economic slack. This can be illustrated if we examine the relationship between domestic
inflation and capacity utilisation in the G10 economies, which was rather close until the mid-1990s, but
has essentially broken down over the past decade.1 [see Chart 8]
Against the background of all these uncertainties, it is even more difficult to predict the impact of
globalisation on inflation in the future. The favourable influence of globalisation on inflation can be
expected to continue in the future as a result of its direct effects on the prices of imported
manufactured goods from low-cost countries and, more importantly, as a consequence of its indirect
effects on wages and productivity, reflecting the increased competition in labour and product markets.
At the same time, this disinflationary impact of globalisation may be partly offset - or more than offset
- by global inflationary pressures in energy and commodity markets. The available evidence for the
euro area as a whole suggests that the overall effect of globalisation on inflation has been very
modest, or almost negligible, in recent years, although global factors have been a main source to
short-term inflation volatility.2 Of course, long-term inflation will ultimately be determined by monetary
policy in line with the ECB's price stability objective. Nevertheless, the dynamics of inflation, especially
over the short to medium term, are likely to be more influenced by global factors and to be surrounded
by greater uncertainty than in the past.
III. The impact of changes in productivity growth
Productivity growth is an important determinant of aggregate output and inflation dynamics, and has
significant implications for the conduct of monetary policy. Long-term or trend productivity growth,
which reflects the average pace of technological advances, is a key determining factor of the
economy's growth potential. In the short to medium term, changes in labour productivity growth can
affect the dynamics of inflation and its response to an adjustment of the monetary policy stance.
Therefore, measuring productivity developments, assessing their nature, and estimating their likely
impact on the economy is important for the effective conduct of monetary policy.
In the euro area, productivity growth developments have been unsatisfactory over the past ten years,
compared to Europe's productivity performance in previous decades and the productivity growth
recorded in the United States since the mid-1990s. [see Chart 9] Specifically, labour productivity
growth (as measured by real GDP per hour worked) in the euro area declined from an average annual
growth rate of 2.3% in the period 1980-1995 to just 1.2% in the most recent ten-year period
1996-2005. By contrast, there was a marked improvement in the productivity performance of the US
economy, where average annual productivity growth rose significantly from 1.3% in 1980-1995 to
2.3% in 1996-2005.3 This reversal of the relative productivity growth performances of the euro area
and US economies since the mid-1990s is striking and it is also symmetric. Moreover, it is
independent of whether productivity is measured by GDP per employed person or per hour worked.
The key issue is, of course, to what extent the remarkable rise in productivity growth in the US, and
the relative decline in the euro area, are of a fairly temporary nature, or whether they represent a more
permanent trend. With regard to the US, it has been argued that, while the increase may partly reflect
cyclical factors, the apparent resilience of US productivity growth during the recent downturn and the
significant further pick-up over the last two years supports the thesis that the mid-1990s marked a
structural improvement in US productivity growth. In the euro area, the trend decline in labour
productivity growth has been partly related to higher levels of employment of relatively low-skilled
workers, but it also reflects an insufficient use of new productivity-enhancing technologies especially in
the services sector.
Partly as a result of these developments, estimates of the potential output growth in the euro area
have been revised downwards over the past few years and are now close to the lower bound of the
range of 2.0 % to 2.5% of potential growth, published by the ECB in 1998, just before the launch of the
euro.4 [see Chart 10]
However, annual productivity growth (per person employed) in the euro area has increased more
recently, rising from 0.4% in early 2005 to 1.4% in the second quarter of 2006, and we expect this
level to remain broadly stable over the coming quarters. This improvement is confined to the industrial
sector, which is more affected by cyclical developments. In the services sector, labour productivity
growth has remained subdued, with an annual rate of growth of only 0.6% in the second quarter of
2006. Nevertheless, these recent developments may turn out to be the initial signs of an overall
improvement of the euro area's productivity performance.
What are the policy implications of the observed recent improvement in productivity growth in the euro
area? The crucial question is whether this recent improvement is temporary, influenced by the current
upturn in the cycle, or permanent. To disentangle temporary and persistent changes in productivity -
and to do so in real-time - is a formidable challenge for policymakers who have to make
forwardlooking assessments. But we have to face this challenge, because temporary and persistent shocks to
productivity growth may have opposite effects on inflation developments. If the decline in productivity
growth is temporary, its effect on aggregate demand is likely to be limited because the lifetime
incomes of households are not significantly affected. At the same time, the aggregate supply of output
will be temporarily depressed. The resulting excess demand is likely to have an inflationary impact. If,
by contrast, the productivity decrease is considered to be persistent, (perceived) wealth and aggregate
demand are likely to decline, leading to a situation of excess supply that will have a negative impact on
inflation.
Incorrect perceptions or estimates of underlying productivity developments can easily lead to policy
errors and costly adjustment processes. The inflationary episodes of the 1970s provide telling
examples in this respect and research at the Federal Reserve clearly highlighted the potential risks.5
Research carried out at the ECB confirms these findings and suggests that imperfect information
about potential output growth can have substantial adverse effects on macroeconomic outcomes.
Even if central banks continuously update their estimates of potential output and, in doing so, they fully
exploit all available information, misperceptions of potential output growth can be substantial and
persistent ex post.
Of course, "to make no mistakes is not in the power of men; but from errors and mistakes the wise and
good learn wisdom for the future" - as Plutarch once remarked. Heeding his counsel, it appears
advisable for us policymakers to account for and address the uncertainties that are inherent in
identifying the underlying productivity pattern by employing an appropriate and robust policy
framework and implementing policy in a consistent manner.
IV. The influence of financial innovation and development
Structural changes and associated uncertainty about the stability of structural and behavioural
relationships are not confined to the real economy. Financial markets and institutions have been
undergoing a remarkable transformation over the past 20 years as a result of deregulation, advances
in information technology and financial innovation. The pace of financial development and innovation
has markedly increased in recent years. Let me just give you one figure that exemplifies the
dimensions of this phenomenon: in the first six months of this year, the global derivatives market
(according to the Bank for International Settlements) increased by almost 25%, reaching 370,000
billion US dollars. That's 370 and twelve zeros! New financial instruments are continuously being
introduced, and non-bank financial institutions are playing a more prominent role in the intermediation
process than in the past.
There are various consequences of these developments for economic efficiency, financial stability and
monetary developments. Let me focus on the latter which are pertinent for the conduct of monetary
policy. As a result of financial innovation and the introduction of new financial products, coupled with
changes in payment technologies and practices (e.g. internet banking), the demand for monetary and
financial assets as well as the characteristics of available financing instruments have been affected.
Consequently, the interpretation of developments in monetary and credit aggregates and the
extraction of information for the assessment of the risks to price stability require more detailed
analysis. Let me give an example. How do we ascertain the effects of the development of deeper and
more liquid securities markets and the increasing importance of non-monetary financial intermediaries,
other than insurance corporations and pension funds (other financial institutions, or OFIs), on
monetary developments? [see Chart 11] The OFI sector comprises a variety of financial firms, such as
investment funds, corporations engaged in securitisation, lending and factoring, or clearing houses,
which maintain specialised relationships with banks and whose operations may affect monetary
developments in several ways. For instance, if changes in the money holdings of clearing houses
reflect a shift in former interbank business to electronic trading platforms, this could affect the indicator
properties of M3 for future price developments. However, discarding money holdings of OFIs
altogether when assessing the information content of M3 - on the grounds that these holdings reflect
portfolio considerations and are not directly related to the demand for goods and services - would be
premature. After all, OFIs' money holdings are likely to mirror to a very large extent developments in
private sector wealth, and may thus help explain the more complex relationship between monetary
growth and future developments in economic activity and prices.
This is just one example of how financial innovation can influence the information content of monetary
aggregates - and I could mention others - but it points to the need for a deeper and more refined
monetary analysis that separates the "noise" from the "signals" in monetary aggregates which contain
relevant information with regard to risks to price stability. This example also suggests that it may be
intrinsically difficult to determine the extent to which the observed monetary developments reflect the
effects of financial innovation that can be characterised as noise - that is, shocks that may "distort"
money demand. In a low interest rate environment, the fast pace of financial innovation and the
increased importance of OFIs might also reflect the so-called search for yield rather than a structural
change in fundamental market relationships. Moreover, another pertinent issue is the extent to which
new innovative derivative products held by households and non-financial firms have liquidity and risk
characteristics that would justify their inclusion in a broad monetary aggregate, such as M3. These
observations underscore the importance of further research to enhance our understanding of the
implications of ongoing financial innovation for the analysis of monetary developments and the signals
they provide about the risks to price stability.
V. Implications for monetary policy
The three processes I have examined - globalisation, productivity developments, and financial
innovation - pose challenges for monetary policy for two interrelated reasons. First, they influence the
functioning and dynamics of the economy in ways that may affect the assessment of the outlook for,
and the risks to, price stability as well as the transmission of the effects of monetary policy. Second,
and more importantly, a common feature of these three processes is the considerable uncertainty
associated with the size and nature of their effects on the economy over time, particularly on price
developments, and the difficulties we face in sufficiently accurately measuring these effects in real
time. As policymakers we have to take into account and assess the ongoing stochastic changes in the
structure and functioning of the economy. Moreover, we must do this on the basis of data that may be
revised significantly and of indicators whose informational content may be impaired by noisy signals.
Using the technical jargon of our economic profession, we face not only the "usual" type of uncertainty
resulting from unanticipated shocks to demand and supply, but also model, parameter and data
uncertainty.
What are the implications of all this for the formulation and implementation of monetary policy? There
are several conclusions pertaining to the assessment of the risks to price stability, the overall
monetary policy strategy, and the actual conduct of policy. Let me elaborate on these issues with
particular reference to the ECB's monetary policy.
A first conclusion that emerges from the ongoing changes in the real economy and the financial
system is that we must deepen our analysis and sharpen our statistical tools so as to better
understand these phenomena, improve the measurement of their development and impact in real
time, and thus enhance our assessment of their implications for the risks to price stability. The
uncertainty we face makes it advisable to use insights drawn from various modelling approaches, and
to avoid any exclusive dependence on a single approach which may primarily rely on certain structural
relationships, as these may be suffering from instability. In this context, it should be noted that
globalisation and productivity developments affect the functioning of labour and product markets and
the stability of the "generalised Phillips curve relationship". In other words, they affect the workings of
the real economy which is at the centre of the economic analysis of the inflationary process. Financial
development and innovation, on the other hand, impinge on the functioning of the financial system and
the stability of the demand for money and its counterparts - and therefore affect our analysis of the
monetary factors determining price developments.
The ECB's monetary policy strategy which relies on both economic and monetary analysis allows us to
use all available information in order to extract, in a comprehensive manner, signals concerning the
risks to price stability that are as meaningful as possible. Our analytical framework permits us to
crosscheck the assessment derived from our economic analysis, which (given the current state of models
and statistical tools) is more pertinent for short to medium-term horizons, with the assessment
resulting from our monetary analysis, which can be especially relevant over the medium to longer
term. This cross-checking, which may also lead to an averaging out of possibly "noisy" signals or
persistent prediction errors that may be associated with a particular analytic approach, contributes to a
more robust assessment of the evidence available and the risks to price stability. It is therefore
conducive to robust decision-making in the presence of heightened uncertainty. Our experience has
shown that the ECB's strategy has proven effective because it has employed all available information
to reach a comprehensive assessment of the medium to long-term economic outlook and inflation
risks. This has been essential for taking decisions on the appropriate monetary policy stance.
However, the effectiveness of the ECB's monetary policy also depends on other features of its
strategy and its conduct. Let me therefore now turn to two elements which characterise the ECB's
monetary policy: commitment and credibility. The ability of any central bank to maintain inflation
expectations well anchored depends crucially on these two notions which concern the central bank's
intentions and the perception of these intentions by the markets and the public. For monetary policy to
be effective, especially in a world of changing economic structures and heightened uncertainty, it is
essential that the central bank has a well-defined objective and that it expresses clearly and
unambiguously its commitment to do everything that is needed to achieve that objective. Yet by itself
this may still not be sufficient, as this commitment must also be perceived as credible by all the actors
affected by the decisions of the central bank. I think that almost eight years since the introduction of
the single European currency, it is fair to say that the ECB has been successful in demonstrating this
type of credible commitment.
For this success, it was instrumental that the ECB decided early on to adopt and announce a
quantitative definition of price stability, namely to keep HICP inflation below but close to 2% over the
medium term, as a clear yardstick which serves two purposes. On one hand, it clarifies and quantifies
the notion of price stability, as mentioned in the Maastricht Treaty, which, therefore, represents the
benchmark to assess our performance over the medium term. On the other hand, the quantitative
definition of the price stability objective guides and helps to anchor private sector expectations of
future inflation rates to a clearly defined objective.
The commitment to pursue a publicly announced explicit price stability objective is important for a
successful monetary policy. However, it is not on its own sufficient. It will lead to the appropriate
anchoring of expectations only if policy is implemented in a credible manner, that is, in such a way that
markets and the public are convinced of the central bank's commitment and ability to conduct policy
effectively. In other words, ex ante commitment must be confirmed ex post. This requires the central
bank to respond in a timely and determined manner to shocks to price stability, and to effectively
communicate its policy actions, so that markets and the public understand the rationale behind these
actions and their consistency with the objectives and the strategy adopted. In an environment of
increased uncertainty and structural change, the potential for making mistakes increases. An
undesirable, and possibly substantial, decoupling of inflation expectations from the central bank's
objective can occur if the policy response to inflation is not sufficiently determined - or is perceived not
to be. If inflation expectations were to become "unanchored", a much tighter monetary policy would
have to be pursued to secure price stability, and high inflation is likely to be accompanied by an
economic slowdown or recession. These arguments are supported by analysis concerning the optimal
conduct of monetary policy under uncertainty and imperfect knowledge.6 Credibility is established over
time on the basis of the policy outcomes achieved, and as the public understands and learns that
policy actions are consistent with the central bank's quantitative objective and strategy.
Increased uncertainty about the economy's structure and functioning and its response to a change in
monetary policy may have another implication for its conduct. As pointed out a long time ago by
William Brainard (1967) and subsequently by other economists7, this type of uncertainty suggests that
it is prudent for a central bank to adopt a more cautious attitude in responding to shocks, leading to a
more "gradualist" approach in the conduct of policy. This conclusion seems to imply that structural
uncertainty and imperfect knowledge about the effects of monetary policy may pose a trade-off
between a cautious, gradualist response to shocks, and the need for timely and determined action.
Addressing such a potential trade-off will require reliance on the most comprehensive and high-quality
analyses as well as judgement. But under most circumstances, prudence, timeliness and
determination are not likely to be conflicting, but rather complementary, attributes of an effective
monetary policy. The commitment to an explicit price stability objective, the adoption of a well-defined
strategy, and the credible conduct of policy in line with this commitment should enhance its
effectiveness: it calls for determined and prompt action, though without unwarranted activism in
responding to shocks and noisy signals.
What does the available evidence tell us about the effectiveness and credibility of the ECB's monetary
policy? Euro area long-term inflation expectations, as measured in surveys or derived from financial
market data, have remained remarkably well-anchored to price stability during a period characterised
by numerous and sizeable inflation shocks.8 [see Chart 12] This conclusion is clearly supported by the
findings from the surveys conducted by Consensus Economics and from the ECB Survey of
Professional Forecasters. Alternative measures of long-term inflation expectations can be obtained
from the so-called breakeven inflation rates, derived from index-linked bonds, which are often referred
to as "inflation compensation" in the United States. Breakeven inflation rates have been higher -
occasionally considerably higher - than our definition of price stability and much more volatile. But this
concept does not represent a pure measure of inflation expectations because the breakeven inflation
rate incorporates inflation-risk and liquidity premia which may affect its level and time profile. Recent
ECB studies have constructed quantitative estimates of euro area inflation-risk premia based on
socalled macro-finance and affine models of the term structure of interest rates. If corrected for such
premia, long-term inflation expectations derived from breakeven inflation rates appear to be fully
consistent with those derived from survey data and in line with our definition of price stability (as
shown in Chart 13).
Finally, I would like to point out that the credible commitment of the ECB to price stability and the
effective communication of its readiness to act when necessary to achieve this objective have
favourably influenced inflation expectations during certain periods, without making it necessary to
change the policy stance in response to shocks or temporarily deteriorating expectations.9 This is
illustrated in Chart 13, which shows that inflation expectations, as measured by the consensus inflation
forecast as well as by the five-year forward breakeven inflation rate, adjusted to take into account the
inflation-risk and liquidity premia, have remained firmly anchored or have rapidly converged to price
stability, even during the two-year period when the policy rate of the ECB remained unchanged. In that
period, however, the ECB made it clear that it was exercising "strong vigilance" and was ready to act
to secure price stability. More recently, since