Jean-Claude Trichet: Key issues for monetary policy - an ECB view
Keynote address by Mr Jean-Claude Trichet, President of the European Central Bank, at the National
Association of Business Economics, Philadelphia, 5 October 2004.
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Mrs President, Ladies and Gentlemen,
It is a great pleasure to share some thoughts on monetary policy issues with members of the National
Association of Business Economics gathered here in Philadelphia for their 46th Annual Meeting.
Only six years ago Europe engaged in a grand enterprise of institutional design that irreversibly tied
together the monetary destiny of eleven, then twelve, nations. The European single currency, the
euro, has in the meantime become a visible token of Europeans' drive towards unification. Historically,
currencies have been rightly regarded as one of the fundamental components of sovereignty. The
Euro is a very powerful symbol of the European identity. I guess the rest of the world sees the euro not
only as Europe's single currency, but also as a symbol of Europeans' strong determination to plan
their future and to realise their dreams.
Taking issue with this historical transition to the European single currency, I intend to focus my
remarks on the challenges presented by the creation of the euro and the execution of monetary policy
in a rapidly changing world: a world in which high-speed structural change - whether spurred by
spontaneous economic forces or institutional evolution - may put tested economic models at risk and
defy policy-makers' searches for well-trusted policy recipes.
Although in my remarks I will take a European perspective, at the end of my considerations I will
attempt to draw a comparison between the monetary policy concept adopted by the European Central
Bank (the ECB) and the one adopted by the US Federal Reserve System.
Central banks and uncertainty
The ECB, like all central banks, is faced with several dimensions of uncertainty. The economy is often
hit by disturbances that are difficult to identify in real time. Even when policy-makers are able to
correctly assess the source and the nature of a disturbance affecting the economy, tracking its
propagation profile and working out its final impact on the key variables of interest is a
highly-demanding task.
Econometric theory has spent decades devising sophisticated tools to isolate different types of shocks
hitting the economy. But inference is often non-robust across various alternative identification
schemes. As a consequence, central bankers are given little guidance by theory in their daily
endeavour to filter out noisy data.
The task of policy-makers is further complicated if they suspect that cyclical movements are
compounded by an ongoing change in the deep structure of the economy. For one thing, structural
changes amplify the identification problem. It becomes more difficult to ascertain whether new
developments are going to be reversed and eventually vanish, or will become ingrained in the
underlying economic mechanism for many years to come. But more importantly, if a structural change
is truly under way, macroeconomic relationships derived from empirical regularities and historical
averages are bound to loose significance. A new set of relationships would need to be estimated and
tested. But serious diagnostics for structural stability rarely give definitive answers, and re-estimation
requires sufficiently extended spans of data that simply do not yet exist.
Structural changes over recent years
The past decade, on both sides of the Atlantic, has not been kind to policymakers' aspirations to a
comfortably stable set of structural relations usable for policy analysis. At the very least, the second
half of the 1990s and the early years of this century have sent us stark reminders that the economic
structure does not hold still for long. Our recent experience in coping with economic changes has
provided more than one stress test of the macroeconomic models that are in use in our institutions.
Let me mention some sources of structural change that are specific to Europe. The setting up of a true
single market out of the various economies member of the European Union is a very ambitious
endeavour, which has no historical precedent and is triggering large scale structural changes in the
European economy.
Fully part of these bold transformations are reforms in the labour and goods markets. These reforms
aim to reduce distortions induced by regulation, strengthening the euro area's competitive position and
its resilience to shocks. This ongoing process to create a single economic entity that would itself be
flexible - thus improving the potential for the economic structure to self-correct - is likely to bring about
notable changes in macroeconomic relationships based on past observations.
One recent additional source of structural change in Europe lies with the enlargement of the European
Union that took place in May 2004. The European Union has witnessed its greatest ever enlargement
with the accession of ten new countries, mainly from eastern and southern Europe. The ten new
Member States will eventually adopt the euro, when the time is right, namely after nominal and real
convergence is performed, affecting in turn the euro area aggregate through a change in trade
patterns, capital and labour flows and a higher level of competition.
Enlargement has already provided new opportunities for trade and investment. These effects are
visible in a high degree of economic integration between the new and the old Member States. Trade
integration is already visible in the share of these ten countries in the previous 15 Member States'
exports and imports, which stands at around 12-13 % - an increase of some 50% since 1995. Capital
integration has also increased dramatically over recent years, as the share of the new Member States
in the old Member States' total FDI outflows amounts to around 12 %. But both economic theory and
empirical records lead us to believe that more is to come. Lower trade costs and an increase in
competition associated with the enlargement of the European Single Market can have a significantly
positive impact on growth in the European economy as a whole, as recently found by several
economic studies.
It should nonetheless be recognised that Europe and its institutions are not new to having to cope with
rapid change. The introduction of the single currency, the euro, has been a defining experience which
has trained policymakers and the citizens of Europe alike to be careful planners and skilled managers
of uncertain circumstances.
Ambitions were undoubtedly high. The measure of success that Europeans had set themselves was
not easy to match or to even come close to. It was absolutely key to the political feasibility of the whole
project that the new currency was seen to preserve the same attributes of solidity and credibility as the
most credible of all the currencies it was replacing.
The aim of creating a currency that could meet the highest standards was for a long time seen to be at
odds with perceptions and beliefs at the time. World investors and market participants - who determine
hierarchies of credibility and trust, as well as interest rate levels - had been lukewarm and hesitant
vis-à-vis our project for most of the 1990s. Until the end of 1997 they seemed convinced that the future
single currency would display the average - not the best - characteristics of the currencies that it was
designed to replace. Notwithstanding the strict legal requirements set out in the Treaty for joining the
new single currency - which I will come back to in a minute - many observers and investors had
considered it impossible that the new single currency would deliver from day one on its promise to
perform in a similar way to the best-performing constituent national currencies.
Gradually, from the end of 1997, investors, savers and market participants in Europe and throughout
the world changed radically the way they viewed the transition. All along the yield curve - from three
months, the five-year and ten-year benchmarks, to the 30-year segment - the future euro area market
interest rates became aligned with the lowest market rates available denominated in the most credible
currencies.
On 4 January 1999, the first working day after the euro's launch, Europe's financial markets showed
that the transition to the euro had been an ostensible success. The letter and the spirit of the
Maastricht Treaty had been fully vindicated, along with the promise made to Europe's people and its
impact on the financial markets. The euro area's 300 million inhabitants benefited immediately from
the best yield curve, possible financial environment.
The conditions for success
No doubt, a great deal of the success had a solid foundation. On the one hand, national governments
were solemnly committed to respecting a number of clear and transparent convergence criteria before
they could qualify to adopt the euro. These criteria ensured a level of quality in the management of
public finances and - more broadly speaking - a fair pace of economic and monetary convergence
among the economies that were to unify into a single currency area.
On the other hand, the Treaty which had established the European Community had laid down in stone
the fact that monetary policy would be conducted with the aim of maintaining price stability and that
the new central bank would be fully independent. These provisions were designed to ensure the
long-lasting credibility of the euro.
I will now try to expand on these institutional requirements more analytically.
Price stability objective for monetary policy
First, the Treaty establishing the European Union assigned the ECB the primary objective of
maintaining price stability. It was particularly important that this key objective was clear and
unambiguous, since for the national central banks with the most credible currencies and lowest market
interest rates, price stability was enshrined by national law as their own primary objective. In any case,
far from being a novel aspect of the European institutional system, as it is sometimes claimed, price
stability is defined as central banks' primary responsibility in almost all industrialised, emerging and
transition economies, with a particular emphasis being attributed to this notion in all economies that
have adopted "direct inflation targeting". I recognize that the United States has chosen to present its
objective of monetary policy in a different format. But, as I will argue in a while, I do not believe that the
US approach differs fundamentally from the concept we have adopted.
Central bank independence
Second, the Treaty made the ECB fully independent. Economic research has shown that central
bank's independence from other institutions and pressure groups is crucial in ensuring its credibility,
and therefore in creating the conditions for inflation expectations firmly anchored upon the announced
definition of price stability. The importance of independence for sheltering the decision-making body of
a central bank from all forms of interference has proven key in securing the trust of the public and in
anchoring inflation expectations in the long run.
As a counterpart to its independence, and to foster and maintain a broad constituency for stability and
monetary prudence in Europe, the ECB was made accountable to the European people. This
requirement is met in particular through the regular and frequent appearances - at least five per year -
of the ECB's President and members of the Executive Board before the European Parliament.
Accountability is not just a vital democratic requirement, it is also crucial in ensuring that the central
bank operates according to the provisions set out by the Treaty. Furthermore, it creates and maintains
a line of trust between the central bank and its public; this trust is also enhanced by a transparent
communication, an issue which I will also come back to. By comparing actual euro area inflation with
the stated objective of price stability, European citizens provide a powerful incentive to policy-makers.
In political democracies, which are also vivid opinion democracies an independent institution is
ultimately responsible vis à vis the public at large.
Fiscal governance
Third, monetary policy is supported by clear rules on fiscal governance. European citizens took a bold
step in creating a single currency in an economic area without a genuine political federation or federal
government. In order to make up for the lack of federal government and budget, the Treaty
establishing the Economic and Monetary Union has introduced rules to prohibit monetary financing of
fiscal deficits and to discourage free-riding among national governments. In addition, a framework was
set up to ensure sound fiscal positions in individual countries. Fiscal rules like those enshrined in the
Maastricht Treaty and in the Stability and Growth Pact are essential in any single currency area as key
for the economic rationale and consistency of the economic and monetary union.
The ECB's monetary policy concept
Although these institutional requirements were necessary to ensure the credibility of Economic and
Monetary Union and of the single currency itself, I contend that they were not sufficient alone. Our
challenge was that the euro had to benefit from the highest levels of credibility and trust available
within the future euro area, since this was vital to European growth and job creation. To meet this
challenge, the ECB designed a specific monetary policy strategy. In November 1998, before the single
currency came into existence on 1 January 1999, the ECB defined the following four fundamental
characteristics of this strategy.
Quantitative definition of price stability
First, the ECB provided a quantitative definition of price stability - a year-on-year increase in the
Harmonised Index of Consumer Prices of below 2% over the medium term. We further clarified that in
the pursuit of price stability the ECB aims at inflation rates below but close to 2%. This provides a
sufficient safety margin against the risk of deflation. These announcements had not only the
advantage of anchoring inflation expectations and enhancing the ECB's transparency and
accountability, but were also instrumental in preserving continuity at the time of transition from the
previous national currencies to the euro: the euro area was given the very same definition of price
stability adopted implicitly or explicitly by the most credible national currencies. A different definition of
price stability would have immediately led to higher inflationary expectations, therefore higher market
interest rates all along the yield curve, and to additional substantial risk premia to protect against
higher uncertainty over future inflation.
Medium-term orientation
Second, the ECB has adopted a medium-term orientation, thereby preserving monetary policy from
short-termism. Constantly faced with economic news, a central bank risks being swamped by the
latest indicator and by its conjectures concerning markets' likely reaction to the latest indicator. This
can gradually steer monetary policy away from its foremost role of providing a firm medium-term
anchor for the economy.
Instrumental in this steady-hand framework is our notion that the appropriate horizon for monetary
policy is the "medium term". In this respect, the time horizon over which price stability has to be
re-established needs to be tailored to the circumstances prevailing in the economy. Sometimes,
notably if there is a suspicion that asset prices are moving up or down substantially, it pays to look
very far ahead, beyond the average lag of monetary transmission. In other cases, the economy may
need to return to price stability within a shorter horizon. In general, the horizon should depend on
whether the shocks are temporary or permanent, whether they emerged on the supply or demand
side, whether they are domestic or external, on their potential for becoming entrenched in pricing
decisions and on their implications for the fragility of the financial system. In all events, the central
bank has to preserve its credibility, thus ensuring that expectations remain consistent with the
declared policy objective.
Comprehensiveness of the analytical framework
Third, the ECB opted for a comprehensive analytical framework. A central bank, in its daily operations,
has to filter an enormous amount of information. It routinely seeks to identify the state of the economy
as new data become available and to evaluate their implications for risks to price stability. As I tried to
argue above, this is a highly demanding exercise, because shocks do not come about with labels and
the economy is potentially always subjected to structural changes. As a consequence, it is clear for all
central banks that no simple rules linking policy to one or two privileged indicators can replace an
accurate examination of economic developments in all their decisions and forecasts.
From the beginning, the ECB felt the need to endow itself with a conceptual framework that could help
it sort through the wealth of conflicting statistics and organise the various pieces into a reliable road
map for internal analysis and communication with the public. This called for the adoption of a
framework that concentrated more on picturing the economy as a large, complex and permanently
evolving system rather than on trying to condense this complexity into simple summary statistics and
models.
As a result, our monthly economic analysis is as comprehensive as possible. It is not constrained by
equations, systems of equations or mechanisms based on a simplified representation of reality. The
ECB's Governing Council reserves the right to include any piece of information, statistic or analysis
that it considers relevant. This desire for comprehensiveness in our economic analysis is common with
that of the US Federal Reserve.
A constituent element of this encompassing framework for processing information - and an ongoing
reminder of the complexity of reality - is our "binocular" perspective over the economy, namely the
cross-checking of the economic analysis with a monetary analysis based on the evolution of the
monetary aggregates. This policy framework, which came to be known as the "two-pillar approach",
allows the notion of a diversified analysis to be conveyed and, in our view, ensures that no information
is lost in the assessment of risks to price stability.
An important rationale behind the two-pillar approach relates to the difference in the time perspectives
relevant for analysing price developments and for forming private inflation expectations. Empirical
analysis has shown that the inflation process can be broadly decomposed into two components. One
is associated with the interplay between demand and cost factors at a high frequency. The other is
connected to more drawn-out and persistent trends. The latter component demonstrates an empirical
association with the trend growth of money on a long-term basis.
The short to medium-term "economic analysis" - with its focus on real activity and financial conditions -
is well-equipped to study shorter-term deviations of inflation from its long-term trend. However, it often
fails to track the mechanisms by which monetary factors are responsible for such trends over
extended horizons. As a consequence, a monetary policy framework exclusively centred on such an
analysis would leave a 'loose end' in the formation of expectations, to the extent that it would offer no
anchor to anticipations of price developments as the horizon lengthens.
Despite the fact that the ECB had a specific arithmetic definition of price stability, it deliberately chose
not to mould its own monetary policy strategy as one of "inflation targeting." To be sure, the concept of
"inflation targeting" is not always a clearly defined concept. However, if it is understood as a framework
that makes macroeconomic forecasts the statistical input feeding the policy-making process, then we
would consider it too narrow a description of what monetary policy should look at.
A central bank needs to maintain appropriate flexibility in the way it responds to shocks, taking
decisions which are robust across a set of different plausible scenarios for the future. In this respect, it
has been increasingly recognised that a central bank that focuses on inflation forecasts at around
two-year horizons would not be able to appropriately take into account the formation of financial
imbalances, as they generally exert effects on price developments at longer horizons. Given the
substantial uncertainty over the sustainability of asset-price developments in particular, it may be
advisable to set interest rates with a time-frame extending well beyond conventional forecast horizons.
However, the mere extension of the time horizon for inflation targeting may still fail to adequately
guard against the detrimental effect that large asset-price swings could exert on price stability. The
Japanese experience of the 1980s shows that it may take many years before asset-price movements
can affect consumer-price inflation to any great extent.
Our monetary analysis, with its focus on money and credit developments, can be valuable in such
situations. As it has been extensively documented in several recent economic studies, asset-price
booms and busts - especially the ones that have led to the worst macroeconomic and financial
imbalances - have generally been accompanied by excessive money and credit growth. Thus, a
monetary policy that ensures that money and credit do not grow unchecked may also help, as a
side-effect, to reduce the likelihood of those abnormally large asset-price swings, with their medium
and long term adverse consequences on price stability.
Transparency
The final principle that we have adhered to since the ECB was established is the importance of open
and transparent communication with investors, savers, market participants and the public at large.
This is a prerequisite for appropriate accountability and enhances the markets' understanding of how
the central bank conducts its monetary policy, thereby enhancing substantially policy effectiveness.
We are transparent in displaying our monetary policy two pillars concept. We are transparent in
publishing our arithmetic definition of price stability.
Communication with the public and the markets has also been facilitated by the fact that our
assessment of the economic situation and the risks to price stability are published regularly and that
monetary policy decisions are explained in a press conference held after each monthly meeting in
which monetary policy is discussed. In this respect we have been bold. In 1999, central banking
communication, with only very few exceptions, involved presenting the bank's diagnosis by publishing
the minutes with a delay of five or six weeks. The ECB was one of the first central banks to give a
real-time detailed analysis and assessment and to organise regular press conferences.
Our commitment to transparency has been effective in making the ECB highly predictable in its
decisions and actions. As a matter of fact the combination of the display of our monetary policy
concept and of our definition of price stability together with a candid real time explanation of our
successive diagnostic makes us at the highest level of predictability according to research.
The comparison of two central banks
Let me finally explain how I see our European monetary policy concept in comparison with the US
Federal Reserve monetary policy concept. I will not dwell on what is from time to time presented as
the major difference, namely the legal objective assigned to the central bank. The US legislator
mentions the objectives of price stability, growth and job creation. My understanding is that the
Congress does not mean that the central bank can choose between two contradictory objectives,
namely price stability and growth! Rather I understand it is assuming that these objectives are not
contradictory but complementary - price stability being a necessary condition for sustainable growth
and job creation: the central bank is called upon to deliver price stability and to be credible in the
medium and long term delivery of price stability, thereby contributing to maximizing sustainable
growth. By the way empirical studies have convincingly established that a central bank enjoying a
large degree of credibility can deliver price stability efficiently thereby maximising long term
sustainable growth and minimizing output volatility. This is what the Federal Reserve stresses when it
says frequently that price stability is a condition for a sustainable high level of growth. This is for the
same reason that an overwhelming majority of central banks in the world have price stability as their
primary objective, whether they have adopted a monetary policy concept close to the ECB or whether
they have adopted an "inflation targeting" concept.
As you see, my understanding is that, conceptually, we are much closer than is sometimes underlined.
On top of that I see two major similarities:
First, both the ECB and the Fed place strong emphasis on the transparency of the decision-making
process, on the transparency of the analysis made by the responsible decision-making body, on
explaining in real time the economic assessment to the public and market participants, and on
accountability vis-à-vis the respective parliaments. And I am called upon the European Parliament
exactly as frequently as the President of the Federal Reserve Board is invited on the Hill.
Second, and it is perhaps a decisive common feature of our monetary policy concepts, both the ECB
and the Fed try to be as comprehensive as possible in their analyses. Neither the Fed nor the ECB
base their decisions on the mechanical result of a system of equations or a simple policy rule. We both
believe that we need all pertinent information, modelling and forecasts, as well as judgements
enlightened by the collegial wisdom and experience of the decision-making body.
To be complete, I also see two differences, which may explain why, despite our strong similarities,
observers sometimes argue that the ECB and the Fed have adopted different monetary policy
concepts.
First, we have made public our precise quantitative definition of price stability whereas the Fed has not
done it so far. Given its long track record, the Fed may be in a different position than other central
banks. It is not for me to judge. Let me only point out the reasons for the ECB's position. Providing a
definition of price stability fosters transparency: everybody knows precisely what we are aiming at.
This is beneficial for meaningful accountability: the public can judge whether or to what extent we are
achieving our goals in comparison with the yardstick we have set ourselves. This is also beneficial for
medium and long-term credibility: inflationary expectations can find an anchor more easily.
The second difference with the Federal Reserve as I touched upon previously, is the explicit
cross-checking, from a medium to long-term perspective, of our economic analysis with a detailed
monetary analysis. We see three advantages to this approach. First, it reflects that inflation is
ultimately a monetary phenomenon, a notion very widely acknowledged by central bankers and
academics. Second, by preventing abnormal abundance or the drying-up of liquidity, it may, at least to
some extent, prevent abnormal boom-bust episodes in asset prices. Third, and perhaps most
importantly, it helps better anchor medium to long-term inflationary expectations, which is of vital
importance for all central banks and all the more important for the ECB which could not rely on a long
track record.
Having said that, I understand that trends in money demand have not been as stable in the United
States as they have been in the euro area. This may partly explain the differences in our approaches.
All in all, it seems to me that our similarities are more important than our differences. Above all, there
is no simple escape for a central bank from a rigorous analysis of the shocks hitting the economy and
the underlying changes affecting the economic structure. Similarly to the Fed, we believe that the
central bank needs realism and pragmatism in its assessment of the rapidly changing financial and
economic environment. Policy decisions must ultimately be based on a judgement and must be clearly
explained to the public in a transparent manner. Since its beginning the ECB has striven to score
highly on each of these points and will continue to do so in the face of the challenges that lay ahead.
Thank you very much for your attention.