Lucas Papademos: The science of monetary policy - past advances and
future challenges
Speech by Mr Lucas Papademos, Vice-President of the European Central Bank, at the
conference on "Monetary Policy over 50 years" marking the 50th anniversary of the Deutsche
Bundesbank, Frankfurt am Main, 21 September 2007.
* * *
I. Introduction
The subject of this session requires addressing a number of core issues pertaining to the
effective conduct and successful performance of monetary policy. It is a subject not only of
academic interest but also with important policy implications. The choice of this topic is very
appropriate for a conference organised to mark the 50th anniversary of the Deutsche
Bundesbank, a great institution, which has been very successful and influential in the
conduct of monetary policy aimed at preserving price stability. I am delighted to participate in
this celebration and thank you for the invitation.
So, will monetary policy become more of a science? The way the question has been posed
may implicitly reflect two presumptions, namely that, first, monetary policy does not rely
sufficiently on scientific principles and methods at present, and, second, that there is some
doubt or scepticism on whether monetary policy will acquire more elements of a science in
the future which would be desirable. I would not agree with such implicit presumptions,
although it goes without saying that the conduct of monetary policy will always require
judgement given our imperfect knowledge and the inevitable uncertainty about the
functioning of the economy and the impact of monetary policy actions.
Frederic Mishkin provided us with an excellent and comprehensive review of the progress
made by monetary policy in becoming more of a science over the past fifty years and an
assessment of the limitations to the science of monetary policy. He also highlighted two
recent episodes in the United States that demonstrated how "judgement" was informed by
"science" and resulted in appropriate monetary policy decisions in a changing and uncertain
economic environment; and he discussed some of the gaps in the science of monetary policy
that are likely to be filled in the future. I broadly agree with his review of the advances made
in recent decades towards making monetary policy more of a science. These advances have
allowed monetary policy to be based on a set of "scientific principles and to rely more on
concrete econometric models - of increasing sophistication and policy relevance - when
making decisions on the appropriate monetary policy stance. His review and assessment of
scientific principles and econometric models that can respectively, guide and provide a useful
basis for decision-making, reflect his knowledge and contribution as an academic and his
experience as a central banker. And I fully share the view about the need to continue
pursuing research and analysis that can provide a stronger scientific basis for monetary
policy, while, of course, recognising that monetary policy-making will never be transformed
into a routine process of mechanical application of principles and rules. Nevertheless, there
are several issues I would like to elaborate further pertaining to (i) the role and importance of
the core scientific principles that should guide monetary policy; (ii) the current state and
limitations of the scientific aspects of monetary policy-making; and (iii) the orientation of our
future efforts towards enhancing the science and effectiveness of monetary policy.
II. The science of monetary policy: the role and significance of core principles
In order to assess whether and to which degree monetary policy can be characterised as a
science or has features of a science, it is useful to keep in mind that the two concepts
"science" and "policy" are rather distinct and to explain what precisely we mean when we ask
whether monetary policy will become more of a science. After all, the science of a specific
subject is the systematic and organised body of knowledge on that subject, knowledge which
is founded on objective principles involving the observation of, and experiment with, certain
phenomena. The subject we have in mind is not monetary economics, but monetary policy,
that is a course of action adopted by an authority to achieve certain objectives. All this may
sound a bit too philosophical or abstract, but we need some precision and a systematic
approach to address the issue in a meaningful way. To this end, it is necessary to define
monetary policy in greater detail.
In trying to identify the "systematic knowledge" and "core principles" of monetary policy, and
how these in turn derive from theoretical propositions and are supported by the empirical
evidence, I find it useful to think of monetary policy as comprising three essential
components:
•
the institutional setting
•
the policy framework, which includes the policy objective and the analytical
foundations - theoretical and empirical - linking objectives and instruments
• the communication and the actual conduct of policy.
Monetary policy has become more of a science over the past fifty years because all its main
components are now based on core principles derived from theoretical propositions or
arguments that have been scrutinised and tested, to different degrees, on the basis of the
available empirical evidence, that is by observing reality: the practice and performance of
monetary policy.
Let me elaborate on the nine principles presented by Mishkin also in relation to the ECB's
monetary policy framework. The first three principles that (i) inflation is fundamentally a
monetary phenomenon, (ii) that price stability has important welfare benefits, including its
contribution to sustained growth and reduced output volatility, and (iii) that there is no
longterm trade-off between unemployment and inflation are widely accepted and clearly underpin
and are reflected in the ECB's mandate and primary policy objective. The first and third
principles are also incorporated in the ECB's analytical framework and they are
overwhelmingly supported by the empirical evidence. These first three principles and the
eighth principle about the importance of central bank commitment to a nominal anchor imply
that price stability (or an inflation target) should be the primary, overriding objective of
monetary policy. This can be considered as a separate or derived principle, which is
integrated into the mandate of the ECB.
The fourth principle concerning the crucial role of expectations in the determination of
inflation dynamics and in the transmission of monetary policy is also universally recognised
and constitutes one of the key advances in the analytical foundations of monetary policy. The
role of inflation expectations as a main channel of the monetary policy transmission
mechanism motivates the focus placed by central banks on the analysis and use of several
indicators of inflation expectations and explains the importance attached in the anchoring of
expectations to price stability also in the ECB's communication policy. This is an area,
however, where more progress is necessary, as I will discuss later on, in order to better
measure, model and favourably influence the inflation expectations of the public at large.
Two other principles, (i) the importance of central bank independence in order to improve the
effectiveness and efficiency of monetary policy and (ii) the need to ensure consistent
implementation of monetary policy over time, are reflected in the institutional set-up of most
central banks, including the ECB. Political authorities, however, occasionally seem to ignore
or forget the significance of central bank independence, which they themselves enshrined in
the EU Treaty, precisely on the basis of past experience and the worldwide evidence which
clearly demonstrate its contribution to effective decision-making that preserves price stability
and helps minimise output volatility. Central bank independence is also crucial for ensuring
that another principle - the commitment to a strong nominal anchor - is credible and thus
effective in ensuring price stability. For the ECB, the unambiguous commitment to price
stability is reflected in the quantification of its policy objective and its communication, but
most importantly in its determination and consistency in pursuing price stability (the nominal
anchor).
So far, I have fully agreed with the role and significance of seven, out of the nine, principles
proposed by Frederic for providing the scientific underpinning of monetary policy. There are
two principles, however, that I do not consider as having been fully and widely accepted and
reflected in the practice of monetary policy: the principle concerning the role and usefulness
of monetary policy rules and the one pertaining to the role of financial frictions in business
cycles. These two principles do not belong, at least not yet, to the core propositions
underlying the science of central banking not because their content is not important but for
other reasons. In the case of the policy rules, the simple reason is that they are not used - by
most central banks - in the actual conduct of monetary policy, although they may be used for
analytical purposes and as benchmarks for comparison of the policies implemented in
practice. There are several reasons why such rules are not used in the practice of monetary
policy. One such reason, which I will highlight later on, is related to the imperfect inflation
available for estimating reliably key variables included in these rules, in real time.
In the case of the role of financial frictions - which I consider to be especially important - I
am somewhat sceptical of its inclusion in the core principles at this stage because we have
not yet reached the state of knowledge to incorporate financial frictions fully in the monetary
policy framework in a generally acceptable manner. This principle is likely to be included in
the core principles in the future, but only after further analysis and empirical support for its
validity and robustness.
There is, however, a notable omission in the list of the key principles to guide the thinking at
central banks and the conduct of monetary policy: the role of money, or more precisely
monetary and credit aggregates, in the monetary policy transmission mechanism and in the
assessment of the medium and long-term risks to price stability as well as to financial
stability. This principle provides one of the foundations in the ECB's analytical framework. I
recognise that in recent years its role and significance has been deemphasised by some
economists and at some central banks, but as I have argued before, the fundamental role of
money in the conduct of monetary policy should not be ignored, but rather emphasised and
further explored. And this should be part of the research agenda that will help us to further
advance the science of monetary policy.
III. Knowledge gaps and challenges in the science of monetary policy
Despite the progress made over the past decades, there are still important knowledge gaps
in our understanding and modelling of the monetary policy transmission mechanism; and
there are also a number of analytical and statistical (measurement) challenges that must be
addressed in order to further advance the science of monetary policy. I had prepared a list of
such gaps and challenges before reading Frederic Mishkin's paper. A comparison with his
list of further likely advances in the science of monetary policy showed a very large overlap
both with regard to the areas for further research and the reasons given to justify the need
for, or likelihood of, further progress. What I would like to do is to highlight a number of the
commonly identified knowledge gaps and analytical issues, define priorities and raise some
additional issues that deserve further analysis.
III. 1. The role of money, credit and the financial system
In order to enhance our analysis and assessment of the impact of monetary policy on price
developments, as well as on output fluctuations and asset price dynamics, in a modern
economy with a sophisticated financial sector, priority must be given to the further
development of structural models that incorporate a banking sector, other financial
intermediaries and a richer specification of the structure and functioning of financial markets.
The integration of the financial system, and of the banking sector in particular, in a
state-ofthe-art dynamic stochastic general equilibrium (DSGE) model that is empirically estimated,
would provide a theoretically consistent framework - based on sound microfoundations -
that would allow an analysis of the role of money and credit - of liquidity and financing
conditions - in the transmission of the effects of monetary policy on the economy. Such
models have been or are being developed at the ECB, other central banks and universities,
but there is scope for further extensions and improvements.
Although the task is challenging because of the complexities involved in incorporating a
realistic specification of the financial sector - with financial market frictions (or imperfections)
- into such models, it is important from a policy point of view that we deepen our
understanding of this transmission channel of monetary policy and its implications for price
and output dynamics. Moreover, as Bernanke, Mishkin, Gertler and others have shown, and
as recent experience has vividly demonstrated, information asymmetries and other financial
market imperfections play a crucial role in determining the stability of the financial system
and business cycle fluctuations.
The analysis of the role of money and credit (i) in the transmission of the effects of monetary
policy and (ii) as information variables that can provide useful signals for the assessment of
risks to price stability and financial stability need not be confined to the further development
of DSGE models. These models have great merits but also limitations. They may not be able
to capture (adequately or realistically) important features of markets such as financial
innovations and other structural changes as well as the behaviour of different groups of
agents characterised by fundamental differences in preferences, asymmetric information and
alternative approaches to forming expectations. For example, in recent years, the supply of
credit by banks has been affected by financial innovations - the securitisation of bank assets
and the development of the credit risk transfer market - which resulted in the so-called
"originate and distribute" business model pursued by banks. And we have all witnessed
recently some of the consequences of this bank business model and certain other features of
financial markets. Moreover, capital requirements, the processes of financial integration and
consolidation (both within Europe and more generally on the global level) and the increasing
role of non-bank financial institutions have also been influencing the expansion of credit and
the creation of (monetary) liquidity. Consequently, a better understanding and modelling of
these innovations and processes, as well as of the determinants of asset prices and of the
sectoral demand for money and credit, is necessary in order to improve both our economic
and monetary analysis and our assessment of the likely impact of a change in the monetary
policy stance on financial market conditions and price developments. To this end, various
avenues of analytical work are being pursued at the ECB, and more generally at the
Eurosystem central banks, which draw on a wide range of complementary models and
analytical tools and involve the development of new such models and tools.
The broader aim of this research on the role of money, credit and the financial system in the
monetary transmission mechanism is to enhance the scientific basis - to strengthen the
analytical framework - of our policy deliberations. And I am confident that the outcome of this
research will provide further theoretical and empirical support to two of the core principles
that should guide the conduct of monetary policy: (i) the principle I added on "the role of
money and credit in the monetary policy transmission mechanism and the assessment of
medium to longer term risks to price stability" and (ii) a generalisation of the principle on "the
role of financial frictions for the business cycle" and, I would add, "for financial stability".
Events in recent weeks have amply manifested the importance of financial stability for the
functioning of the economy. What is less manifestly obvious is the precise relationship
between financial stability considerations and monetary policy. Two aspects require, in my
view, further analysis and research. First, our monitoring and assessment of financial stability
so far mainly relies on qualitative evaluations and judgements. Further progress is necessary
towards methods to quantify risks and vulnerabilities identified in the various segments of the
financial sector and to relate them, in a theoretically sound and empirically robust manner, to
our overall assessment of financial stability. Second, and even more challenging, we need to
understand in more detailed and verifiable manner the precise relationship between the
causes and implications of financial instability and monetary policy.
III.2. Expectations
Another priority in our research agenda is to enhance our understanding of the way
expectations are formed by different agents in the economy, and how they can be managed
successfully so as to improve the effectiveness of monetary policy. Inflation expectations
play a crucial role in determining the impact of monetary policy on the economy and in
shaping the dynamic response of prices and output to shocks. Forecasts of future price
developments and policy simulations based on macroeconometric models depend critically
on the modelling of expectations.
By now it is widely accepted that expectations should, by and large, be formed "rationally" in
the sense that they should take into account all relevant available information concerning the
structure and functioning of the economy and the factors and policies - notably monetary
policy - that may affect future price developments. This broad formulation about the nature
and formation of expectations is perfectly reasonable, appropriate and superior to any
mechanical backward-looking specification of expectations formation. In practice, however,
there are crucial issues that must be addressed on how exactly "all available relevant
information concerning the economy's structure and functioning" is obtained and processed
by economic agents. Often the hypothesis of "rational expectations" in incorporated in
theoretical and econometric models by making simplifying and rather unrealistic assumptions
about the available information to agents on the basis of which they can make "optimal
forecasts" about the future. And these assumptions, which essentially relate to the nature
and modalities of the associated learning and information extracting processes and the
homogeneity of agents, play a crucial role in determining the dynamics of the economy and
the magnitude of, and time lags in, the effects of a change in the monetary policy stance on
the price level an output over time.
An important implication of the central role of expectations in the monetary policy
transmission process and of the "rationality" of expectations - in a broad sense - is that the
effectiveness of monetary policy depends on the expectations of the markets and of the
public about future policy actions. And this is the fundamental reason why the adoption and
public announcement of a quantitative definition of price stability (or an operational inflation
objective), the credible commitment of the central bank to this objective, and the effective
communication of its policy decisions aimed at achieving this goal are crucial for the
anchoring of inflation expectations to price stability.
Our own experience and the track record of the ECB since 1999 have been very positive in
this respect: despite the fact that the ECB, as a newly created central bank, did not have a
previous track record of successful policy-making, financial markets immediately understood
the ECB's commitment to price stability as credible and factored it in their expectations. Ever
since 1999, all financial market indicators and private sector forecasts suggest that
expectations of future inflation have remained remarkably well anchored to the ECB's
definition of price stability. For example, expectations derived from the prices of nominal and
indexed-linked bonds provide compelling evidence that long-term inflation expectations are
well anchored in the euro area.
However, while market expectations appear to be "rational" in that they are in line with the
ECB's commitment and demonstrated ability to preserve price stability, the process of
expectation formation among the general public appears to be rather more complex. Survey
evidence suggests that in a number of euro area countries, a portion of the general public
perceives inflation to deviate sometimes significantly from actual inflation or expects inflation
to remain at elevated levels which bear little resemblance to actually recorded inflation or
market expectations of future inflation. More analysis is needed to understand this
discrepancy - and some promising work has already been done at the ECB in this respect.
More generally, research aiming at incorporating empirically plausible theories of
expectations formation into our models is of particular relevance. This will require the
introduction and testing of hypotheses of how economic agents learn about the evolving
structure and functioning of the economy it and may lead to a relaxation of the assumption of
the representative agent which is characteristic of most of our models, including the dynamic
stochastic general equilibrium (DSGE) models, and thus to allow for the heterogeneity of
agents and expectations.
III.3. Some modelling and methodological challenges
This brings me to some key modelling and methodological challenges that deserve more
attention in order to enhance the analytical tools for monetary policy:
•
first, how to develop models that overcome the restrictions that are inherent in the
stylised assumption of the representative agent;
•
second, how to cope with statistical uncertainty and data revisions, and their impact,
in particular, on our estimates of important economic concepts that are relevant for
policy formulation but which are not directly observable, like the potential output
growth and the equilibrium values of the unemployment rate and the real interest
rate; and,
•
third, how to deal with possible non-linearities in economic relationships.
Today's dynamic macroeconomic (DSGE) models, with their sound microfoundations and
ability to ensure internal consistency and invariance of the reduced form parameters to policy
changes, have many merits, as I said. But also limitations, and one of them is that they
model aggregate economic variables by using one "representative" optimising agent whose
choices coincide with the aggregate choices of the underlying group of heterogeneous
individuals. Clearly, this assumption is made for analytical convenience. Yet, the conclusions
drawn from these models may have far-reaching implications. In real economies, agents are
organised into groups and firms, each pursuing their own economic interest. These distinct
individual activities are more or less coordinated and some kind of order emerges - this is
what Adam Smith called the "invisible hand". However, the pursuit of individual optimising
behaviour does not necessarily imply, a priori, optimal outcomes at an aggregate level.
Indeed, many interactions in the economy that require coordination among economic agents
may result in suboptimal aggregate outcomes, even if all agents pursue the same interests.
In addition to coordination failures, models involving representative agents appear
particularly ill-suited to address distributional issues, for example those involving employed
and unemployed workers. Developing richer multiple-agent models is unquestionably difficult
but should nevertheless be part of longer-term research agenda, as the potential benefits for
policy-making are significant.
We live - and have to make decisions - in a world of pervasive uncertainty. However, while
the academic profession has made tremendous progress in analysing risk in well-defined
stochastic economies, the "Knightian" uncertainty that confronts central bankers is of an
altogether different dimension. Among the various forms of uncertainty that central bankers
face, the uncertainty about how the policy instrument affects inflation and economic activity -
the monetary transmission mechanism - and the uncertainty about the (statistical)
measurement of the current state of the economy - the data - appear to weigh particularly
heavily. Central bankers need to have a good understanding of the timing and the ultimate
effects of changes in the monetary policy instruments on inflation and economic activity. For
this purpose, monetary policy-making requires more than just the qualitative information that
theory provides. They must have quantitative information about magnitudes and lags, even if
that information is imperfect. At the same time, caution and circumspection in the face of
such model and data uncertainty is clearly warranted. Model uncertainty suggests that further
analysis of the robustness of the effects of monetary policy actions across a variety of
models would be valuable.
Recent research has shown that central banks should moderate the responsiveness of their
policy decisions to real activity when underlying data are known to be subject to
measurement error. After all, a strong policy response to mismeasured data will induce
unnecessary fluctuations in the economy. In view of this, the weight given to the individual
information variables should depend on how precisely those variables are measured. This is
especially applicable to variables that are not directly observable, but which are relevant for
policy formulation, such as the potential output growth and the equilibrium values of the real
unemployment rate and the real interest rate. It would therefore be not advisable for central
banks to heavily rely in their policy decisions - and in the respective communication - on
models or policy rules that place an inordinate weight on such unobservable parameters,
which are difficult to measure in real time, and subject to considerable uncertainty of the
underlying data.
My final remark on model and methodological challenges concerns the fact that most
macroeconomic models today are solved and estimated in linear form, essentially relying on
the linear stochastic difference approach used in macroeconomics since the 1950s. Again,
this feature has merits and limitations: linear modelling techniques are powerful and easy to
handle and can be scaled to larger and more complete models. But there are a number of
essential policy questions that simply cannot be addressed within linear frameworks.
One prominent question relates to the emergence of time-varying risk premia that are
apparently influencing the behaviour of the long-end of the yield curve. Research carried out
at the ECB has shown that such time-variation appears to be important for understanding the
behaviour of long yields and that these premia are systematically related to economic
fundamentals. Modelling them, however, requires nonlinear economic frameworks. Similarly,
we might possibly need nonlinear techniques to answer the question how policy should deal
with really large shocks. Linear models may give sufficiently accurate answers for dealing
with small to medium-sized shocks, but if economic relationships are essentially non-linear,
then such models may make considerable prediction errors in a situation where large shocks
carry the economy far away from a state characterised by "average behaviour". For all these
reasons, it seems important from a policy perspective to develop and employ non-linear
modelling and estimation techniques.
IV. Concluding remarks
To sum up, over the past decades, tremendous progress has been made towards making
monetary policy more of a science. Undoubtedly, this has contributed to enhancing the
effectiveness of monetary policy. At the same time, there is still room - and indeed a need -
to further advance the scientific elements of monetary policy-making by addressing a number
of conceptual, methodological and empirical challenges. Some of these challenges are a
consequence of the nature of the economic system and the uncertainty surrounding its
evolution over time. The economic environment is continuously changing and at fast pace as
a result of the actions of economic agents. Technological advances, financial innovations,
the process of globalisation, even changing preferences, are influencing the structure and
functioning of markets and the monetary policy transmission mechanism. Monetary
policymakers have to take decisions against the background of the evolving economic environment
and then face a host of uncertainties. This makes our task challenging - but admittedly also
more exciting. Moreover, these observations have two important implications for monetary
policy. First, the ability to combine "science and art" in a well-structured, balanced, prudent
and effective way will always remain a key feature of the successful performance of
monetary policy. Second, in an environment of continuous change and considerable
uncertainty, it is essential that central banks provide an anchor of stability and certainty:
through their commitment to and delivery of price stability. This conclusion is directly linked to
the purpose of this conference, to celebrate the Bundesbank's 50-year-long unwavering
dedication to its task of "safeguarding the currency" ("die Wähung zu sichern") as it is stated
in the Bundesbank Act. I am confident that 50 years from now, on the occasion of the 100th
anniversary of the Bundesbank, a conference can be again be organised to celebrate this
great achievement: "Stable money for Germany and Europe".
Thank you very much for your attention.