Christian Noyer: Does money matter? A European perspective
Speech by Mr Christian Noyer, Governor of the Bank of France, at the 4th ECB Central Banking
Conference "The role of money: money and monetary policy in the twenty-first century", Frankfurt am
Main, 9 November 2006.
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It is a great pleasure and honour for me to take part in this Central Banking Conference.
My communication will be organised as follows: I will first review some stylized facts about money and
inflation that show that money still matters; second, I will relate these stylised facts to the two-pillar
monetary policy strategy of the Eurosystem. I will conclude my presentation by addressing some
interesting challenges we face in implementing our monetary analysis.
Some stylized facts about money and inflation
Let me start with a well known paradox which can be articulated in three propositions: first, price
stability is the objective of all Central Banks; second, as Milton Friedman put it "inflation is always and
everywhere a monetary phenomenon"; and third, nevertheless, in most countries, money has little or
no part in the design or implementation of monetary policy.
There is, of course, one noticeable exception: the euro area. Before getting into more details about our
approach, I would like to mention two reasons why I think money, as such, remains an essential
component for the design and implementation of monetary policy.
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First, money is still of direct relevance to monetary policy in exceptional circumstances:
either strong (or hyper) inflation or deflation. When Paul Volker brought down US inflation
from 13 % to 3 % in three years, he did it by setting a cap on Central Bank money growth.
And symmetrically, when the Japanese authorities had to fight deflation, they resorted to a
"quantitative easing" policy, which basically meant they were targeting a specific amount of
Central Bank money. There has been considerable debate over the theoretical
underpinnings of those policies: namely whether a specific channel of transmission of
monetary policy, independent of interest rates, could be identified. In any case, those
experiments show, in my view, that setting a path for money growth (or its level) can prove
very effective in controlling expectations - or pin down the price level - in an extreme
environment.
•
In more normal circumstances, however, the relationship between money and prices is more
subtle and uncertain. In modern market economies, the demand for money exhibits - at least
in the short and medium run - some chronic instability, if not unpredictability, a point to which
I shall come back later. This has led to the demise of monetary aggregates as targets of
monetary policy, and, in some countries, they have been abandoned as indicators as well.
But we still think, in the euro area, that Friedman is right in the very long run. Our research has
established that low frequency movements in money growth and inflation are closely correlated,
retaining fluctuations with a period of 8 to 10 years. This is because, in our view, money can directly
influence output and inflation in particular due to monetary and financial frictions existing in the
economy and also some stickiness in the price determination process.
Those facts underpin the two pillar approach of the Eurosystem
As you know, the Eurosystem's monetary policy strategy is grounded on two pillars: economic
analysis, on the one hand, and monetary analysis, on the other. A wide set of short-term indicators
(economic analysis) are complemented by the longer-term determinants of inflation (monetary
analysis). This setup is based on a premise and has one important implication.
The premise is that even if money has no systematic and immediate influence on prices, it can provide
valuable and specific information on future inflation, at time horizons stretching beyond those usually
adopted for the construction of central bank inflation projections. Because of the long-term relation
between money growth and inflation, money has leading-indicator properties on future price
developments. One could make the case that this is only an "empirical argument". But, in Central
Banking, empirical realities do matter much. One could also argue that other strategies - such as
targeting the price level or an average level of inflation over the long run - would have the same
stabilizing properties as looking at money growth. I do not disagree in theory. But it is not clear to me
that those strategies would be easier to implement or have the same anchoring effect on inflation
expectations.
The implication is the need to cross-check the information on inflationary pressures and risks to price
stability; this cross-checking implies that we bring together and compare different analytical strategies
and that we use systematically all the information relevant to decision-making.
Of course, monetary policy does not react mechanically to monetary developments, but rather
responds to the information in monetary aggregates that is relevant for maintaining price stability over
the medium term. This is the rationale behind the definition of "a reference value" for monetary
aggregates.
The monetary pillar supports a risk management approach to monetary policy. It allows for an early
assessment and detection of potential imbalances. It sheds light on those risks at a longer time
horizon than the one usually contemplated by monetary policy, but still relevant for the ultimate
objective of price stability.
This is of special significance and importance when financial imbalances build up in the economy,
which are fueled by excess money or liquidity growth. Unwinding of those imbalances can be brutal
and discontinuous - the so called non linear reaction - and, as such, very destabilizing. Empirical
evidence suggests that asset booms have typically occurred when money and credit growth were
above their long-term average. Whatever the loss function and ultimate objectives of Central Bankers,
all would agree that monetary policy should not willingly contribute to the formation of such credit and
asset booms.
To make best use of the informational role of money, however, we have to face numerous and
increasing challenges
One major difficulty is to identify in real time the nature of monetary developments and their
implications for future price developments. The challenge of monetary analysis is to see through the
noise in monetary data to recover those underlying trends which are relevant for monetary policy
decisions. Meeting this challenge has not been straightforward in recent years as the euro area
economy was hit by several shocks: financial instability in the aftermath of the stock market collapse in
2000, exceptionally high economic and geopolitical uncertainty between 2001 and 2003, just to name
a few.
First of all, short-run monetary developments are often affected by transitory shocks. We need to
identify and account for such temporary "special factors" or "distortions" that may affect monetary
developments and blur their information content. To some extent it is the aim of the methodology
developed at the ECB which allows for periodic adjustments to measured monetary aggregates in
order to account for portfolio shifts which impact the demand for money without any incidence on
future inflation. This approach has met with great success in the period 2000-2004.
Second, and more permanently, it is necessary to disentangle, in monetary and credit evolutions,
those which reflect structural and permanent changes from those which simply result from moves in
the level of interest rates and the position in the economic cycle. Here, no mechanistic or ad hoc
approach would do the trick. We need to look at the fundamental determinants of money demand.
Ideally, we should have a full and comprehensive model of portfolio allocation and choices which, as
an aside, would produce a determination of the demand for money. We might be a long way from
building such a model.
But we can have some intuitions. We could start from the fact that money is both substitutable and
complementary to financial assets. Because it is substitutable, money demand depends on changes in
relative returns - i.e. the actual and expected moves in interest rates. But money is also a complement
to financial assets, and as such reacts to permanent changes in the supply, availability and
characteristics of those assets. Our economies are becoming more and more "financial" in the sense
that the ratio of financial wealth to GDP is constantly increasing. Since economic agents - especially
financial intermediaries and corporates - need to keep part of their total financial assets in liquid
holdings, there may be a structural increase in the demand for money (everything equal). The euro
and the integration of European capital markets may have accelerated this evolution.
This could help explain the apparent break in the trend of the income velocity of money that took place
in the euro area in 2000/2001. In effect, since 2001, income velocity has been declining by 3.5% a
year, much faster than the rate embedded in the reference value.
According to one possible interpretation, this trend is a reflection of two consecutive shocks: from 2000
to 2004, a temporary "demand" shock, mainly reflecting portfolio shifts; and, since 2004, a "supply"
shock i.e. an increase in liquid assets triggered by the fall in the opportunity cost of holding money in a
context of historically low interest rates.
But the fact that this situation has now lasted since 2001 may suggest another explanation: that the
apparent break in trend velocity that took place at that time is of a structural nature. On-going
econometric research carried out at the Banque de France confirms this intuition. The sharp decrease
in interest rates, of course has played a role. Nevertheless, econometrics seems to show that this only
accounts for a very small part in the break in the trend visible since 2001. So we might be facing a
permanent increase in the demand for money.
Consistent with this hypothesis is the fact that money holdings by corporates and financial institutions
have grown much faster, in recent years, than those of households. Money and credit growth could
then be related to a common cause: financial development and the increasing weight of financial
assets in our economies.
A lot of work, however, remains to be done to fully understand the changes we are facing. This, in my
view, is the beauty of our monetary analysis. It invites us - indeed it forces us - to face the complexity
of our world and the ever changing nature of our environment and our behaviour. This is precisely the
aim of this conference.
I thank you for your attention.