Miguel Fernández Ordóñez: The monetary policy strategy of the
Eurosystem
Speech by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, at the Second
Summit Meeting of Central Banks on Inflation Targeting, Santiago de Chile,
14 November 2007.
* * *
Ladies and gentlemen,
Let me thank Governor Corbo for his kind invitation to speak at this Second Summit Meeting
of Central Banks on Inflation Targeting, hosted by the Central Bank of Chile. It is for me a
privilege and a great pleasure to be here in Santiago and to have the opportunity to address
this distinguished audience.
I would like to begin my intervention today by recalling two important events that took place
in 1999. In that year, the Central Bank of Chile adopted a full-fledged inflation targeting
strategy with a floating exchange rate. This monetary regime has served Chile well, providing
a coherent and transparent framework that is credible in society at large because all the
economic agents clearly understand the policy objectives and the rationale for decisions.
1999 was the same year that the Governing Council of the European Central Bank took up
the responsibility for conducting a single monetary policy for the entire euro area, after a
prolonged period of intensive preparations and successful economic convergence. A few
months earlier, in October 1998, the Governing Council of the newly-created central bank
had dismissed the adoption of either inflation or monetary targeting and had decided instead
to develop its own strategy, which aims at maintaining price stability over the medium-term.
Today I will provide you with an overview of the monetary policy strategy of the Eurosystem. I
will comment on some of the core principles of sound monetary policy that our respective
strategies share and will point out some specific aspects in which they differ. And let me just
note at this point that the Eurosystem's monetary policy strategy - combined with its strong
institutional set-up - has provided the right foundations for an effective and successful
monetary policy in the euro area. I will conclude my remarks with some brief comments on
the challenges ahead which have been brought about by the recent episodes of turbulence in
financial markets.
Needless to say, my remarks today reflect my own views and not necessarily those of the
ECB's Governing Council.
Introduction
In June 2006 - just a few days before I took office as Governor - Banco de España hosted
an International Conference on "Central Banks in the 21st Century", to mark the 150th
anniversary of the adoption of its current name. At the Conference - which discussed the
main challenges facing central banks today - Professor Allan Blinder provided a survey of
relevant questions around monetary policy. His paper "Monetary Policy Today: Sixteen
Questions and About Twelve Answers" followed up on a previous assignment he discharged
in the form of a key-note dinner speech in Frankfurt in 1999, at what was the first research
conference organised by the then brand-new European Central Bank. What I found
noticeable from Professor Blinder's 2006 presentation was that the list of issues had grown
longer rather than shorter since 1999 (from 15 to 16), although he noted that this should not
be misinterpreted as lack of progress. It was the result of dropping four issues from his list -
because, in his view, they were either resolved or had moved out of the radar screen - and
adding five. Most remarkably, among the issues that had been dropped were low and stable
inflation as the central goal of monetary policy, and central bank independence.
I think Professor Blinder was right to remove these issues from his list. There is a broad
agreement among academic economists and policy makers alike that maintaining price
stability is the best contribution that monetary policy can make to support sustainable growth
and job creation. This consensus reflects the fundamental tenet that, as the rational
expectations literature has helped us understand1, there is no trade-off between growth and
inflation at horizons longer than the short run, and that the real effects of monetary policy are
short-lived and uncertain. It is also now conventional wisdom that the public good of price
stability is best safeguarded by delegating monetary policy to independent central banks2,
which are not subject to interference from short-sighted political concerns. These consensual
points - which are laid down in the Maastricht Treaty and, hence, have a constitutional
character in the case of the EU - are a reflection of the painful, central bank led
disinflationary processes that in many countries followed the so-called "Great Inflation" era of
the 1970s and early 1980s3. They are also a sign of a more general dissatisfaction with the
experience during those years of stop-and-go policies, where policy-induced booms proved
later on to be unsustainable and short-lived.
In keeping with the primary objective of price stability, a number of central banks - following
the lead of the Reserve Bank of New Zealand - adopted a strategy of inflation targeting
during the 1990s. The key element is the public announcement of an inflation rate to be
maintained over a more or less defined time horizon. Pioneers of inflation targeting were
joined later on by a number of developing countries (for example Brazil, South Africa and
Thailand) as well as by some East European transitional economies (such as Poland, the
Czech Republic and Hungary). With hindsight, the policies pursued within this framework
have been a success, particularly in those countries which - starting from a relatively high
inflation level - needed to bring inflation expectations back into line with the central bank's
objective. But also other countries (like Norway) with no particular difficulties in terms of
anchoring inflation expectations have moved in this direction, presumably because their
central banks were convinced of the benefits per se of the strategy. At present some twenty
central banks have adopted an inflation targeting framework4, and some observers would
add a few more to that number.
The monetary policy strategy of the Eurosystem
The Eurosystem has not followed the same route. In October 1998, the Governing Council of
the ECB dismissed the adoption of either inflation or monetary targeting and decided instead
to select a strategy of its own, which aims at maintaining price stability over the
mediumterm. The idea was to develop a credible and flexible, tailor-made strategy that would allow
for timely responses to a changing environment, while keeping in clear focus the objective of
price stability. And it was necessary to take account of two key factors of that time: the
regime shift implied by Economic and Monetary Union (EMU) and the heightened uncertainty
that surrounded the introduction of the single currency. Whilst it was important to build on
state-of-the-art economic research and on other central banks' successes (including the best
European monetary tradition), it was also crucial to recognise that the available strategies
had been tried and tested in completely different contexts.
The Eurosystem's monetary policy strategy consists of two main elements. First, the core
feature is a quantitative definition of its Treaty mandate of price stability, to be maintained
over the medium term. Price stability is defined as a year-on-year increase of below 2% in
the Harmonised Index of Consumer Prices (HICP) for the euro area. In May 2003, after a
thorough public evaluation of the strategy, the Governing Council of the ECB confirmed this
definition and clarified that it will aim to maintain inflation rates below but close to 2% over
the medium term. The clarification of May 2003 underlined the need to provide a safety
margin against the risks of deflation as a result of monetary policy becoming ineffective due
to the zero bound constraint on nominal interest rates, should the economy be hit by adverse
shocks.
The second element of the strategy is a comprehensive analysis of the risks to the outlook
for price stability, according to two perspectives: economic analysis and monetary analysis.
These two perspectives offer complementary analytical frameworks to support the Governing
Council's overall assessment of risks to price stability. The economic analysis aims at
identifying those factors that have a bearing on risks at short- to medium-term horizons. It
includes, inter alia, projections of key macroeconomic variables and an analysis of shocks
hitting the euro area economy. In turn, the monetary analysis - which has been broadened
and deepened over time - draws on a wide range of tools, techniques, models and
frameworks, complemented by the use of informed judgment, in order to identify risks at
longer horizons. After the evaluation of the strategy in 2003, the Governing Council of the
ECB explained that the monetary analysis mainly serves as a means of cross-checking the
short to medium-term indications coming from the economic analysis.
When compared to the strategy of inflation targeting, the Eurosystem's Monetary Policy
Strategy shares the essentials: that is, the importance of price stability and the need for
monetary policy to act pre-emptively and make comprehensive use of all available
information. The strong belief that institutional independence must necessarily be
supplemented by high standards of accountability and transparency is also shared by both
camps. This is reflected in the growing weight that central banks, in industrial countries and
beyond, place on the importance of communication. Emphasis on communication has also
been boosted by central bankers becoming increasingly aware that effective communication
facilitates the transmission of monetary policy decisions to the economy, thereby making
their jobs easier.
Nonetheless, the Eurosystem's strategy has some differences when compared with the
inflation targeting strategies. Let me focus my comments in this respect on two particular
issues: the relevant horizon for policy and the role of macroeconomic forecasts in
policymaking and in communication.
The relevant horizon for policy
Inflation targeting is often described as a framework where monetary policy responds to
deviations between a conditional inflation forecast at a specific time horizon, typically of
around two years, and the inflation objective. From a welfare perspective, however, focus on
an ex-ante fixed horizon is problematic for a number of reasons. In particular, economic
theory suggests that the relevant horizon for monetary policy depends in a significant way on
the size and nature of shocks affecting the economy, as well as on the prevailing
circumstances (i.e. the initial state of the economy). Moreover, taken at face value, this
approach neglects the implications of policy for price stability at longer horizons.
In connection with this last point, a number of researchers (and notably research at the BIS5)
have been arguing quite convincingly that that short-term inflation control is not enough to
prevent the emergence of imbalances, which may lead later on to costly episodes of
macroeconomic instability. They point to the "Great Depression" in the 1920s and to Japan's
"lost decade" as cases in point. And they argue that big policy mistakes surrounding those
episodes would have been avoided had the Federal Reserve Board and the Bank of Japan
paid closer attention at the time to credit developments and, more generally, to financial
conditions. These lessons from economic history are even more relevant nowadays, when a
range of innovations in financial markets have enhanced the possibilities for intermediaries to
take and trade risk, thereby challenging the ability of prudential authorities to guard against
excessive risk taking.
In recent years, the global economy has experienced the strongest sustained period of
growth since the early 1970s. This impressive expansion has taken place, despite significant
commodity price increases, against the background of relatively subdued global inflation and,
throughout most of this period, a benign outlook within the horizons typically covered by
forecasts. Better monetary policy has in turn been praised for its contribution to this
formidable setting. It has been argued that firmer anchoring of long run inflation expectations
was responsible for the marked decline in inflation persistence and the more favourable
short-term Philips curve trade-off. With inflation expectations well anchored, any given shock
to inflation - coming from aggregate demand, energy prices, or the foreign exchange rate -
would have a smaller effect on expected inflation and hence on trend inflation.
However, this favourable set of circumstances has co-existed until recently with numerous
signs of over-abundant monetary and market liquidity: robust money and credit growth; high
transaction volumes and small bid-ask spreads; low credit spreads and term premia; and
reduced volatility across virtually every asset class. Those vulnerabilities have not gone
unnoticed by central banks, as testified by past analyses in the ECB Financial Stability
Review publication. Although market sentiment had proved extraordinarily resilient to events
which in the past would have triggered sharp corrections (including the shift to less
accommodative monetary policies in the major economies), the analyses identified the risk
that the prolonged period of low rates might have created incentives for excessive risk taking
and that a sudden tightening might leave, using Rajan's words6, "a number of participants
stranded on a limb of illiquidity".
In my view, all of this warns against excessive focus on a fixed, excessively short-term time
horizon for inflation targets. The Eurosystem's monetary policy strategy abstains from
specifying a fixed time horizon for policy. Through its diversified approach, it also accords
due importance to assessing medium- to long-term risks to price stability. It is therefore well
equipped to deal with the perils of short-termism, the temptations of excessive fine-tuning
and the risks of asymmetric responses during upswings and downturns. It also permits
appropriate account to be taken of the endemic pro-cyclical characteristics of the financial
system and of boom-bust cycles in asset prices, and to consider under very specific,
exceptional circumstances a policy of carefully leaning against the wind, despite the
wellknown intrinsic difficulties of identifying misalignments in real time.
The role of forecasts in policy making
Inflation forecasts are at the centre of inflation targeting strategies. Policy discussion and
communication are organised around the forecast process, and decisions are often
explained on the basis of deviations of the inflation forecast from an inflation target at a
specific time horizon. The numbers, including the baseline scenario and risks, are owned by
the policy-setting committee.
The Eurosystem also produces macroeconomic projections. These are based on a
combination of models and experts' technical judgments and are owned by staff, rather than
by the Governing Council. Twice a year, in June and December, projections are produced by
the staff of the Eurosystem under the responsibility of the Monetary Policy Committee, which
is one of the Eurosystem Committees composed of senior staff from the ECB and the
national central banks.
The process leading to these broad exercises involves close interaction between staff of the
ECB and the national central banks to ensure that the euro area projections draw on all
available expertise - both at the country and euro-area levels - and reflect the consensus
view of the staff. There are three main steps: First, initial assumptions underlying the
exercise and covering interest rates, exchange rates, the international environment and fiscal
variables are set, although they are reviewed and can be changed in the course of the
exercise; second, the projection numbers are derived and agreed upon, following a process
of peer review of the individual country projections, consistency checks and integration within
the euro area framework; the third and final step is the preparation of a report for the
Governing Council. In addition to the numbers themselves, the staff also produces a number
of background analyses on relevant issues. In March and September, the projections are
updated by the staff of the ECB. Summary reports of both the Eurosystem's and ECB Staff's
projections exercises are released on the ECB's web-site on the same day that the detailed
projections are presented to the Governing Council. They are also published later on in the
ECB's Monthly Bulletin. Publication is intended to make clear the information set which is
available to the Governing Council when taking its decisions, and not to explain the decisions
themselves.
Due to the forward-looking orientation of the Eurosystem's monetary policy, forecasts
constitute necessarily a very important input into the decision-making process. They are
particularly useful because they are able to summarise a vast amount of information and
analyses within a coherent and internally consistent accounting and economic framework.
However, unlike in the case of inflation targeting strategies, they do not constitute the main
vehicle around which the policy process and communication are organised. The Governing
Council of the ECB bases its policy judgment on these and many other inputs, which include
inter alia competing forecasts from other private and public organisations as well as other
pieces of information that, for a number of reasons, are difficult to integrate within the
framework of the projections.
By way of example, information (i.e. data, indicators, analyses, etc.) that becomes available
after the cut-off date for the projections cannot, by definition, be incorporated in the exercise.
At a more fundamental level, we should acknowledge that even the state-of-the-art
macroeconometric models of the kind used nowadays by leading central banks are, as yet, unable
to fully incorporate a richer description of the economy's financial structure. Wealth effects,
swings in asset prices, credit and liquidity constraints and other financial frictions are not
sufficiently taken into account. That results in an over-simplified view about the channels
through which monetary policy can affect economic activity and inflation. It also affects the
ability of such models to identify, and hence estimate with any degree of precision, the
potentially significant role of financial variables and financial intermediation in the monetary
transmission process.
Academic research is progressing on this front and, hopefully, at some point in time,
workable and operational models will be developed that allow for more realistic settings
where the complex interactions between the real and financial sectors of the economy are
acknowledged in full and where financial variables (notably money and credit) play an active
role in the monetary transmission mechanism. When this has been achieved, it will be
possible to turn the two pillars of our analysis into a larger, single pillar as Vice President
Lucas Papademos7 has put it. Or, if you prefer another metaphor, we could join the two
pillars with an arch, thus forming a solid bridge to support our monetary policy decisions.
But policy is an ongoing activity. Policy-makers cannot afford the luxury of waiting for
research advances to happen. Empirical evidence supporting these advances is itself
frequently uncertain and provisional, open to revisions. Constantly confronted with the
burdens of judgment, we are very much like sailors in Neurath's boat. And, in this respect, I
believe that the Eurosystem's monetary policy strategy has been particularly useful in helping
us navigate through the deep waters of pervasive uncertainty and to make decisions in real
time. In my view, the Eurosystem's concept has clear strengths. It permits a diversified
approach to the assessment of economic developments and the outlook for price stability. It
encourages cross-checking between different forms of analysis. It is a pragmatic and robust
approach intended to help avoid major policy errors.
The monetary policy strategy of the Eurosystem in retrospect
The ECB Governing Council had three main objectives in mind when it decided to announce
a new monetary policy strategy for stage three of EMU in October 1998. First, the strategy
should facilitate transparency and accountability, helping the public to understand and
assess monetary policy decisions. Second, it also should promote credibility and confidence
among euro area citizens that the Eurosystem would keep a clear focus on its constitutional
assignment of maintaining price stability. And third, the monetary policy strategy was
important for internal decision-making. It should constitute a conceptual framework for
structuring information and provide guidance and consistent decision criteria to
policymakers, who are constantly confronted with alternative paradigms, limited information and
difficult views about the current state and prospects of the economy.
Next year will be the 10th anniversary of the creation of the ECB and the announcement of
the monetary policy strategy of the Eurosystem. In retrospect, the monetary policy strategy -
together with a strong institutional set-up- has provided the right foundations for an effective
and successful monetary policy in the euro area. The Governing Council of the ECB has
demonstrated that it is well-equipped to take prompt and swift action in order to secure price
stability over the medium-term. At the same time, it has retained the appropriate degree of
flexibility to respond to shocks and to take into account the unique uncertainties facing the
euro area. The average annual increase in the HICP since the launch of the euro has been
very close to 2%, despite the sizeable adverse price shocks during this period. Moreover,
long-term inflation expectations have been stable and well anchored at levels broadly
consistent with the definition of price stability, as shown by the evidence coming from
surveys or from indicators derived from index-linked bonds. The 318 million citizens of the
euro area believe that price stability is here to stay. This is a considerable achievement that
could not be taken for granted a few years ago. And the Governing Council of the ECB can
claim credit for it.
Concluding remarks
But monetary policy is constantly confronted with new challenges and, certainly,
developments since this summer (winter in this hemisphere, of course) indicate that we are
not currently short of such challenges. At the beginning of July, the ECB Governing Council
pointed out the risk of a potential abrupt shift in market sentiment. This risk materialised in
August, although through somewhat unexpected channels. Growing default rates in the US
market for subprime mortgages resulted in a loss of confidence in the valuation of structured
credit instruments and the disruption of the asset-backed commercial paper (ABCP) market.
As a consequence, conduits and structured investment vehicles (SIVs), which were
borrowing in this market to finance their holdings of asset-backed securities, started facing
difficulties to refinance themselves. Tensions spread to the interbank markets of most OECD
countries, as banks began hoarding liquidity to meet their liquidity support commitments with
conduits and to put the underlying assets on their balance sheets. Moreover, banks curtailed
interbank lending because of uncertainty surrounding the potential exposures of their
counterparties.
Since the summer, the global economy and the euro area have entered a period of increased
financial market volatility, significant re-appraisal of risks and market nervousness. The
Governing Council of the ECB is paying great attention to these market developments and, in
particular, has acted swiftly to provide the liquidity that was needed to permit an orderly
functioning of the money market, to reduce the volatility of very short-term interest rates
around the minimum bid rate of the main refinancing operations, and to contain the risk that
tensions in these markets would propagate through the banking system. The Eurosystem will
continue to play its part to consolidate a smooth return to a normal functioning of markets.
The Governing Council is also monitoring very closely the macroeconomic effects that the
recent episodes of financial unrest may have on the prospects for the euro area economy.
Sound fundamentals and the expected robust global growth should support a relatively
favourable medium-term outlook for economic activity. However, disruptions in financial
markets have increased the uncertainty surrounding this outlook, which poses particular
challenges for monetary policy. As a result, the Governing Council has indicated that it will
need some time to fully grasp the consequences for its policy stance.
From today's perspective, the modal scenario going forward is one of financial conditions
normalising over a period of time, which could be protracted, although some low-probability,
more challenging scenarios cannot be totally ruled out at the moment. Under this central
scenario, the effects of financial market turbulence on borrowing costs would most likely be
contained. In line with that, the consensus view that seems to be emerging among
international organisations and private analysts is that, whilst some slowdown of growth may
be expected, the overall effects would most likely remain moderate, with the euro area
economy continuing to expand at rates close to potential going forward. Nonetheless,
downside risks to growth have increased.
Other things being equal, a less dynamic growth picture could mitigate the risks to price
stability. But, unfortunately, as often happens when we need other things to be equal, they
are not. We are currently facing renewed inflation pressures, which come essentially from the
dramatic increase of oil and food prices. The concern is that all this could lead to
secondround effects in a context in which euro area labour markets have become tighter. It is true
that in the recent past we have experienced various episodes of substantial increases in oil
prices without negative consequences on underlying inflation. But pure extrapolation from
this recent past may not be appropriate due to the possible existence of threshold effects.
The persistence of the current inflation shock also entails the serious risk that inflation
expectations could become unhinged and that, as a result, our credibility as central bankers
could be significantly damaged. It cannot be forgotten that there is a two-way relationship
between credibility and effectiveness of monetary policy. Effectiveness depends on the
credibility of central banks. But, no less importantly, the credibility of central banks depends
critically on the effectiveness of the monetary policy that they have applied.
The conduct of monetary policy has also been complicated over the recent period by sharp
and abrupt moves in exchange rates, which might signal that the long-awaited correction of
global imbalances is not proceeding in as orderly a fashion as we would have hoped. Against
this background, the Governing Council is monitoring exchange rate markets closely. And, in
this respect, the President of the ECB has repeatedly indicated that excess volatility and
disorderly movements of exchange rates are undesirable for economic growth.
In summary, monetary policy is operating in an environment of heightened uncertainty. This
is the result of the materialisation of some risks that we have been pointing out for a long
time. First, the potential consequences of the turmoil in financial markets, which go beyond a
sound reappraisal of risks and a less dynamic economic outlook. Second, renewed inflation
pressures associated with the explosion of oil and commodity prices. And third, sharp and
abrupt changes in exchange rates of late.
Academic economists like to put labels on economic periods. And I have referred to some of
these labels earlier in my speech: the "Great Depression" of the 1920s, the "Great Inflation"
era of the 1970s and early 1980s, and the "Great Moderation" we have witnessed since then.
It is my hope that the increased uncertainty we are facing is conjunctural and does not
become structural, and that we are not entering an era which, later on, academic economists
could label as the "Great Uncertainty". I believe that central banks are both willing and able to
prevent this from happening.
Therefore, at this juncture it is particularly important that the Eurosystem remains focused on
its fundamental mandate of maintaining price stability over the medium term. The Governing
Council of the ECB has indicated in this respect that it is fully committed to acting in a firm
and timely manner to ensure that any risks to price stability over the medium term do not
materialise and that medium to longer-term inflation expectations in the euro area remain
solidly anchored at levels consistent with price stability. Such anchoring is a prerequisite for
monetary policy to make an ongoing contribution towards supporting sustained economic
growth, well-functioning markets and job creation in the euro area. This is true now more
than ever, when we are confronted with a panorama which is more uncertain than that which
we have faced during recent years.
Thank you for your attention.