Jürgen Stark: Contribution to the session on "Implications for the
conduct of monetary policy"
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank,
at the International Symposium on "Globalisation, Inflation and Monetary Policy", organised
by the Bank of France, Paris, 7 March 2008.
* * *
John Taylor has discussed a number of challenges to monetary policy-making in an era of
globalisation. In my remarks, I will focus on the implications of globalisation specifically for
monetary policy-making in the euro area.1
Globalisation may change the environment for monetary policy-making
We all agree that globalisation offers great opportunities. It increases the scope for efficiency
gains through specialisation since it allows economies to make better use of their
comparative advantage in international production. This reduces production costs and
expands the production frontier, generating gains which are passed on to consumers through
lower prices for many goods.
Globalisation thus fosters economic prosperity and raises living standards. At the same time,
the gains from globalisation may not be distributed evenly, as globalisation can affect
2
differently the returns to different factors of production.
To monetary policy-makers, globalisation is important mainly for two reasons:
•
First, the process of globalisation itself can occasionally lead to economic
disruptions, especially if markets lack transparency. Increasingly-globalised and
internationally-integrated financial markets, for example, if not sufficiently
transparent, can at times be conducive to excessive risk-taking and contagion
effects - a theme that rings particularly true in light of the current financial turmoil.
•
Second, and more importantly, increasing global integration induces structural
changes in goods markets and financial markets alike. As a result, foreign shocks
may have a greater impact on domestic inflation, and the transmission of other
impulses to the euro area economy can change. This also applies to the impact of
monetary policy on inflation.
Let me briefly elaborate on how structural changes, which are driven by globalisation, can
affect the process of inflation.
•
There is good reason, for instance, to believe that globalisation increases
competitive pressures, both worldwide and in domestic markets. An increase in
competition may - relative to previous periods - put downward pressure on wages
and prices and thus contain inflation for a period of time.3 A structural intensification
of competition would also induce firms to work harder to increase productivity, and
this would translate into an increase in the growth rate of the natural level of output.4
• Beyond this effect, the increasing use of international production opportunities
based on comparative advantage may lead to a change in the production structure
of our economy, which would in turn alter the relative scarcity of production factors,
and thus the response of their prices and the prices of final goods to economic
shocks.
Thus, globalisation
•
is of importance to monetary policy
•
and it is likely to have a lasting effect on our economy and on the environment for
monetary policy-making.
An initial conclusion therefore is that central banks need to continue to commit resources to
analyse and closely monitor the structural changes and the shocks caused by globalisation,
and need to build an increasing awareness of economic and financial developments outside
their home countries.
Globalisation does not change rules of monetary policy-making
Although globalisation is challenging monetary policy, I fully agree with John Taylor's
assessment that globalisation does not fundamentally alter the rules for monetary
policymaking. Nowadays as ever, over the medium to longer term, inflation is a monetary
phenomenon. This means price stability is for us to achieve.
Let me stress the obvious here, namely that central banks cannot permanently determine the
relative prices of specific goods. In referring to price stability, we mean stability of the
purchasing power (of the domestic legal tender) as measured by the cost of a representative
basket of goods.
While international liquidity conditions may influence market interest rates and thus the
transmission of monetary policy to real activity and inflation, central banks retain the ability to
control short-term interest rates by appropriately influencing the supply of the domestic legal
tender. Short-term rates in turn work their way into the domestic cost of credit and into
longterm interest rates.
Therefore, central banks can ensure price stability in the medium to long-term, even in a
financially-integrated world in which production factors and goods move freely, and even if
the size of the world economy increases relative to that of the domestic economy.5
But, as I said earlier, as a precondition for successful monetary policy central banks need to
properly adapt their analyses to the changing environment. In such an environment, it is
clearly important for stability-orientated monetary policy to analyse developments in external
prices, in international trade flows and in international financial flows.
This said, I agree with John Taylor that developments in exchange rates per se should not be
given any special status but should be taken into account by monetary policy only to the
extent that they have a medium-term influence on price stability. This is because another
fundamental law of monetary economics is alive and well in the globalised economy: flexible
exchange rates are a sine qua non for price stability.
Does a globalised world call for more international monetary coordination?
With a growing set of prices and asset valuations being determined internationally,
information on international developments is crucial for monetary policy-making. In this light,
the financial turmoil in particular has shown the value that growing financial globalisation
places on a timely and open international exchange of information among central banks and
regulators.
Central banks should therefore cooperate by exchanging information and by designing a
solid international financial architecture.
Beyond that, however, the scope for monetary policy-makers to coordinate is limited. This is
the case as each central bank has just one policy instrument, and this instrument can only
achieve a single domestic objective, price stability. As a consequence, each central bank is
well advised to react to foreign developments only if these become relevant for domestic
price stability. I therefore fully agree with John Taylor's conclusion that central banks should
not mechanically follow other central banks' policy decisions.
Not least as a result of this consensus, I question the strong conclusions that John Taylor
draws from some of his empirical analysis.
In brief, John Taylor finds that a simple monetary policy rule, also widely referred to as the
"Taylor rule", when applied to the euro area, has residuals that correlate positively with the
US federal funds rate. He interprets this finding as implying a leader-follower structure in the
sense that US monetary policy induces the ECB to deviate from its objective of price stability
out of concern for the exchange rate.
This is not the case. Indeed, a more reasonable explanation for John Taylor's findings is the
following:
Central banks which are concerned with domestic price stability seek to offset potentially
destabilising shocks. In a globalised world, though, different central banks naturally respond
in part to similar global factors. And, as we know, a number of these factors are not well
captured by a mechanical policy rule of the type which John Taylor takes as a benchmark for
good monetary policy-making. Adequate policy reactions to global factors, and to the risks
that they pose for domestic price stability, will thus show up - within the context of a simple
rule - in the residual term.
Some observers, John Taylor included, interpret this residual as a measure of the monetary
stance. It may indeed, in some cases, be possible to interpret the residual in this way.
However, often the residual is a measure of the lack of explanatory power of the simple
policy rule itself.
Now, to the extent that economies are structurally different and are hit by shocks with
different timings,
• global factors affect these economies with different lags.
•
As a result, the measures of inflation and the output gap used in John Taylor's policy
rule are also affected with different lags.
•
In such a context, monetary policy has to react in a pre-emptive manner to current
and future likely developments to ensure domestic price stability over the medium to
longer term.
•
However, such a behaviour might generate a spurious correlation between the
residuals of a simple Taylor type policy rule for the euro area and interest rates in
other economies.
I suspect that this is what lies behind John Taylor's result concerning the deviations from a
euro area "policy rule" and the US federal funds rate.
Having inside knowledge, I can in fact rule out that John Taylor's results constitute any sign
of a leader-follower structure or any sign of a focus on the side of the ECB on the dollar-euro
exchange rate, or in fact on any exchange rate, as a target of policy. Neither is the case. I
agree with John Taylor, however, that any development in that direction would be deeply
worrying.
Only a clear assignment of responsibilities ensures clarity about the central bank's objective,
which is at the heart of successful monetary policy. Yet international complementarities exist
in monetary policymaking, to the extent that an international architecture which has each
central bank keeping its own house in order is also conducive to an environment of global
monetary stability.
Such architecture provides the best basis for a friendly and open exchange of views and
information at an international level. Today there is frequent interaction as, for example, the
BIS provides a much-appreciated forum for discussion among central bankers. In addition,
there are further occasions for fruitful exchanges - this very symposium being one of them.
The role of the monetary policy strategy in an increasingly globalised world
I have argued that the best international monetary architecture is one in which each central
bank focuses on achieving domestic price stability. In practice, even more is needed to
guarantee a successful monetary policy. A clear mandate for price stability and a
welldefined monetary policy strategy based on this mandate are essential for coping successfully
with the analytical and practical challenges which lie ahead. Fortunately, both conditions are
in place in the euro area.
A clear mandate for price stability
• ensures that a central bank is fully accountable for achieving price stability. The
commitment to price stability which such a mandate generates is, in turn, conducive
to anchoring private sector expectations in a lasting way. This anchoring is
particularly important if globalisation causes sequences of one-sided shocks to
inflation.
• prevents central bank policy from going astray. While John Taylor expresses
concerns that central banks may be increasingly tempted to stabilise exchange rates
at the expense of price stability, a clear mandate for price stability guarantees that a
central bank will not fall into this trap. Instead price stability-orientated central banks
do not assign any special role to exchange rates, important as they are as
information variables in the economic analysis.
Building on a clear mandate, a successful strategy
•
supports accountability.
•
ensures a transparent and systematic response to risks to price stability
• guides an effective communication policy,
•
and enhances the predictability of monetary policy over the medium to longer term.
In this context, any measure of price stability used by central banks must adequately reflect
the evolution of the purchasing power of money. Price stability is therefore best defined in
terms of the cost of a representative, i.e. broad, basket of goods. An example which provides
a clear and assessable yardstick of price stability is the basket underlying the euro area
Harmonised Index of Consumer Prices.
This encompassing definition of the underlying basket contrasts with partial, or so-called
"core" measures of inflation. While these measures can be useful for assessing risks to price
stability, they - if put front and centre - risk providing a distorted view of underlying price
developments which would jeopardise the anchoring of inflation expectations. This would be
particularly detrimental in situations in which globalisation might induce sustained
movements of prices of certain categories of goods.
A broad, transparent and widely accepted yardstick instead creates the necessary clarity to
ensure a firm anchoring of inflation expectations. It is this clarity which allows a central bank
to adopt a medium-term orientation within which policy-makers can appropriately discount
short-term price volatility and transitory movements in inflation.
As mentioned, globalisation is likely to change the structure of the euro area economy both
with regard to goods markets and financial markets. A strategy which monitors structural
changes both from a goods market angle and from a financial or monetary point of view is
therefore well-suited to cope with the challenges brought about by globalisation. The
complementary perspectives of the economic analysis and the monetary analysis, which
underlie the ECB's "two-pillar strategy", are conducive to appropriately adapting our policies
to the changing environment. At the same time, the two-pillar strategy keeps minds focused
on the fundamental laws of monetary economics.
In particular, having an explicit monetary pillar guarantees that the ECB always has
considerable expertise in the analysis of monetary and credit developments and in the
analysis of their impact on price stability. The close link between monetary developments
and evolving imbalances in asset and credit markets implies that monetary analysis enables
central banks to detect such imbalances at an early stage and to respond to the implied risks
to price and financial stability in a timely and forward-looking manner. This has, in the past,
proved an invaluable asset for the ECB, notably in times of global financial turbulence.
Just as the two-pillar strategy structures the discussion within the ECB, it also provides the
basis for communicating our understanding of the economy to the outside world. By adhering
to transparency, the ECB has achieved a high level of predictability for its monetary policy
decisions. Our strategy therefore improves our policy effectiveness.
Let me conclude.
1. Especially in an environment of ongoing globalisation, monetary policy must aim to
robustly anchor inflation expectations. This requires a permanent alertness to risks
to price stability on the side of the central bank, as shocks to inflation must not
translate into second-round effects in price-setting and wage-setting.
2. That being said, an efficient adjustment of the economy to macroeconomic shocks
can be best facilitated by monetary policy-makers if they keep a firm focus on their
domestic price stability objective. In particular, there will be no external stability
without domestic price stability.
3. Domestic price stability is a precondition for global monetary stability. Globalisation
therefore does not expand the need for international monetary co-operation beyond
an open exchange of views and information. The best international architecture is
one in which each central bank has a clear mandate to focus on domestic price
stability.
4. Greater microeconomic flexibility would not only allow our economy to take better
advantage of the opportunities provided by globalisation, but would also facilitate
macroeconomic adjustment in the wake of shocks and improve the resilience of the
economy. Globalisation therefore intensifies the need for more flexibility in product
and labour markets.
5. I have argued that a monetary policy strategy which carefully monitors
developments in domestic, as well as international, financial and goods markets is
well-equipped to cope with challenges that globalisation brings for monetary policy.
Such a strategy is in place in the euro area. At the same time, price stability is the
best contribution monetary policy can make to enable the euro area economy to
take the full advantage of the opportunities offered by globalisation.