The Conduct of Monetary Policy in the Euro Area by bgv12766

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           The Conduct of Monetary Policy in the Euro Area

                                         By PhiliPPe Moutot*


                                              I. Introduction

    It is a great pleasure for me to participate in this conference on monetary policy in
emerging economies and to talk about the characteristics of the monetary policy frame-
work in Europe. You may know that 2008 is a special year for the European Central Bank
(ECB), which celebrated its tenth anniversary on 1 June. Ten years ago an experiment
unprecedented in European history took place: the centralisation of the conduct of mone-
tary policy, which was assigned to an independent central bank, the European Central
Bank, with a clear mandate to maintain price stability. The result of this experiment is an
extraordinary success. Since the very first days of Monetary Union, financial markets and
the general public have manifested full appreciation of the ECB’s firm commitment to
maintain price stability in the euro area over the medium term. Survey-based measures of
both medium and long-term inflation expectations1 have remained constantly at levels in
line with price stability. This vindicates the effectiveness of the ECB’s monetary policy strat-
egy, which includes a quantitative definition of price stability, as a year-on-year increase in
the Harmonised Index of Consumer Prices for the euro area of below 2%. Furthermore,
the stability of medium and long-term inflation expectations reflects the long-term predict-
ability of the ECB’s monetary policy, which encompasses the private sector’s ability to
understand the monetary policy framework of a central bank, including its objectives and
systematic behaviour in reacting to different circumstances and contingencies. In a broad
sense, the long-term predictability of the ECB is a measure of its credibility.2
    The high level of credibility enjoyed by the ECB is part of a broader virtuous circle. Price
stability, in combination with output growth stability, has facilitated the progress made in
the euro area on structural reforms and wage moderation policy, which have led to a sig-
nificant increase in euro area employment over the period 1999-2008.
    In my remarks today, I shall elaborate on the main elements of the ECB’s monetary
policy strategy and illustrate how they are instrumental in ensuring that price stability is
maintained over the medium term. In particular, I shall dwell on the key advantages that the



     * Deputy Director General Economics, European Central Bank. I thank Giovanni Vitale for his contribution to
this speech. All errors, however, remain mine.
     1
       See the ECB’s Survey of Professional Forecasters and Consensus Economics for measures of medium and
long-term inflation expectations respectively.
     2
       See Blattner, T., M. Catenaro, M. Ehrmann, R. Strauch and J. Turunen (2008), “The predictability of mone-
tary policy”, ECB Occasional Paper Series, No 83, March.



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ECB’s monetary policy strategy enjoys as regards its ability to take into account and react
to asset price developments. Given the lack of time, I will not describe the decision-making
process at the ECB, which I think plays a crucial role in ensuring both efficiency and effec-
tiveness in our monetary policy strategy, although some aspects of this topic may be found
in the charts you have received.

              II. The main elements of the ECB’s monetary policy strategy

     The first element of the ECB’s monetary policy strategy is the quantitative definition of
price stability, which is the “magnetic north” of our compass, as the ECB President likes to
put it at the regular press conference that he gives after Governing Council meetings.
     In October 1998 the ECB’s Governing Council defined price stability as a year-on-year
increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below
2%. In May 2003, the Governing Council also clarified that, in the pursuit of price stability,
it aimed to maintain inflation rates below, but close to, 2% over the medium term.
     The combination of a precise definition of price stability and the explicit mention of a
sufficiently long and flexible horizon for monetary policy recognises that monetary policy
cannot control price developments in the short run and that attempts to fine-tune inflation
or economic activity would be destabilising. At the same time the ECB regarded it as im-
portant to provide a numerical benchmark for accountability and a firm anchor for inflation
expectations right from the start.
     While providing a clear quantitative benchmark that contributes to a firm anchoring of
inflation expectations, the ECB’s quantitative definition of price stability allows some room
for flexibility that other monetary policy approaches, such as inflation targeting, may lack.
The ECB’s monetary policy has a clear medium-term orientation, which avoids the mis-
leading impression of an automatic feedback from a numerical target at a particular hori-
zon. This reflects the need to tailor the monetary policy response to the source and nature
of shocks that are hitting the economy, rather than allow that response to be determined
mechanically by a particular numerical value of an inflation forecast at a specific horizon.
     The second element of the ECB’s monetary policy strategy is its approach to organising,
evaluating and cross-checking the information relevant to an assessment of the risks to
price stability. This approach is based on two separate analytical perspectives, referred to
as the two “pillars”: the economic analysis and the monetary analysis. They form the basis
for the Governing Council’s overall assessment of the risks to price stability and its monetary
policy decisions.
     Starting with the economic analysis, its focus is mainly on the assessment of current
economic and financial developments from the perspective of the interplay between sup-
ply and demand in the goods, services and factor markets. To this end, the ECB collects
evidence from survey measures as well as from various cyclical indicators and processes
the data collected using highly diverse statistical and analytical tools.


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    In this context, the ECB/Eurosystem staff macroeconomic projections play a crucial
role in structuring and synthesising a large amount of economic data, even if they should
not be considered as an all-encompassing tool for the conduct of monetary policy. It is
important to bear in mind that the projections are produced under staff responsibility as
an input into the deliberations of the Governing Council. Twice a year they are structured
as a broad exercise involving not only the ECB but also all the national central banks in the
Eurosystem, while the remaining two exercises are produced by ECB staff. The projections
are now published four times a year.
    Let me share here with you one conviction that I developed over the years I spent
participating in and for a long time chairing the projections exercises. I am of the opinion
that the encompassing nature of the ECB’s strategy and the ongoing quest to broaden and
deepen our knowledge make it possible for a “federal” institution such as the ECB to work
effectively and efficiently. In particular, the complex interaction of policy and technical
committees, involving also the national central banks of the euro area, has never suffered
from a dogmatic approach that could have led to frictions and inefficiencies. Quite the
contrary, the open character of the projections exercises is crucial to blending the neces-
sary technical sophistication and the involvement of all euro area national central banks
into the policy process and has been supported by the appropriate collaboration of policy
and technical committees.
    Turning to the monetary analysis, this serves as a means of cross-checking, from a
medium to a long-term perspective, the short to medium-term indications coming from the
economic analysis. Since the beginning of its existence the ECB has assigned a specific
role to money in recognition of the close link between monetary growth and inflation in the
medium to long run. Information from money and credit may help to identify risks to price
stability at time horizons beyond those usually covered by conventional macroeconomic
projections; it might also be helpful in assessing business cycle developments.
    In this vein, maintaining a distinct monetary pillar allows the information on monetary
developments to be appropriately weighted in the decision-making process and avoids the
risk that this process is dominated by shorter-term considerations. In particular, the mone-
tary analysis involves a detailed analysis of money, its components and counterparts with
a view to identifying the underlying trend and the relevant signal for price developments
at longer horizons. Hence, the monetary pillar fulfils the need to put monetary policy into
a medium-term perspective, simultaneously implying that there is no mechanical link be-
tween short-term monetary developments and monetary policy decisions.
    The experience with monetary analysis in the first ten years of the ECB is that, on the
whole, it helps us to extract useful information about the risks to price stability. This in-
formation has always proven relevant and, at times, has made a decisive contribution to
monetary policy decisions, for example when the ECB decided to increase interest rates
at the end of 2005. The successful experience with monetary analysis suggests that there
is further scope to exploit the potential information content of monetary developments.


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Monetary and credit aggregates may help policy-makers to assess the developments in the
various yields -some of which are not even observable- that would eventually impact on
aggregate demand.3 Also, monetary aggregates can provide information about the shocks
hitting the economy when such shocks are correlated with monetary developments. For
example, the analysis of global capital flows and their effect on domestic aggregates can
help us to understand how international investors’ portfolio shifts can affect domestic li-
quidity conditions and, eventually, threaten the maintenance of price stability. In the case
of the euro area, some recent analysis4 suggests that global portfolio shifts and the related
asset price changes could explain the evolution of domestic liquidity and help to estimate
money demand in the euro area.
    Finally, the monitoring and the analysis of monetary and credit developments help
central banks to explicitly take into consideration the risks of financial instability and their
possible effects on price stability over various horizons. In recent years, extensive work
has been undertaken at the Bank for International Settlements, the ECB and elsewhere
which demonstrates that excessive monetary and credit growth can provide useful early
signals concerning the potential emergence of asset price bubbles. Furthermore, this line
of research shows that a combination of excessive liquidity growth and asset price boom
episodes is likely to lead to painful recessions. Thus, monetary analysis can help the ECB
to identify, in a timely manner, distortions and imbalances in the financial system which
could eventually threaten price stability over the medium to long term. In fact, by clearly
communicating on all aspects of monetary analysis, including those connected to financial
stability, the ECB may influence market expectations in the direction of self correction.

                    III. Asset prices and the ECB’s monetary policy strategy

    I shall now elaborate on how the encompassing nature of the ECB’s monetary policy
strategy makes it well-suited to face extreme situations, namely those arising in the event
of financial instability and credit crunches triggered by a sudden gyration in asset prices.
Central banks usually incorporate into their assessments the evolution of asset prices and
its likely impact on price stability. However, such an assessment becomes more com-
plicated if asset prices develop unsustainable dynamics whose future behaviour is very
difficult to gauge. In such circumstances, the central bank needs to explore a number of
“low probability, high risk” scenarios in order to figure out the possible consequences of
an abrupt and sudden gyration of asset prices. Typically, these are situations where buoy-



      3
       See Nelson, E., (2003), “The future of monetary aggregates in monetary policy analysis”, Journal of Mone-
tary Economics, Vol. 50, pp. 1029-1059.
     4
       De Santis, R., C. A. Favero and B. Roffia (2008), “Euro area money demand and international portfolio al-
location”, presented at the ECB workshop on “The external dimension of monetary analysis”, Frankfurt am Main,
12-13 December 2007.



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ant asset prices trigger excessive debt built up by investors in order to leverage their long
positions in the appreciating assets. Hence, asset price growth also feeds itself, because
the appreciating value of the assets increases the value of the investors’ balance sheets
and the value of the collateral they can put upfront to continue borrowing and pushing
asset prices further up. These general features characterise both the stock market crash
in 2000 and, I think, the more recent house price correction in the United States. As both
these episodes show, the serious challenges to monetary policy arise from the possibility
that the bursting of the bubble will lead to a sharp deterioration in borrowers’ net worth and
the possibility of a generalised tightening in credit conditions as financial intermediaries
react to such stretched balance sheets. Furthermore, the resulting credit crunch is likely
to at least temporarily impair the transmission mechanism of monetary policy. Owing to
well-documented real and financial linkages among the world’s economic regions, the
consequences of the bursting of a bubble in a given country are more and more likely to
also have pervasive effects on financial conditions abroad.
    In such circumstances, monetary policy cannot ignore the risk of financial instability. It
also cannot content itself with calling for fiscal and prudential regulation. If a credit crunch
is imminent, a line of response can and should be organised by central banks. Hence an
efficient monetary policy strategy must be able to constantly incorporate asset price devel-
opments into policy deliberations with a view, to the maximum extent possible, to detecting
in advance potential bubbles and the likely consequences that their bursting can have on
the broader economic and financial system. An efficient monetary policy strategy must
be able to organise an effective and credible reaction to credit crisis episodes in order to
limit the damage caused by financial instability, while at the same time maintaining price
stability. In my view, the two-pillar strategy of the ECB is better suited to cope with the chal-
lenges arising from asset prices developments than pure “rule-based” strategies such as
inflation targeting.
    On the first aspect, namely the detection of asset price bubbles and their likely impact
on the risks to price stability, rule-based strategies such as inflation targeting typically ex-
clude asset price developments from their assessment because of the inherent difficulty of
incorporating financial markets into inflation forecasting models over a fixed horizon.
    Unlike rule-based strategies, the ECB’s monetary policy strategy, and in particular its
two-pillar framework, is well-suited to incorporate asset price dynamics into policy delibera-
tions. In the context of the ECB’s strategy asset prices are not treated as a target, but rather
as a leading indicator of future economic activity because of their impact on wealth, the
cost of capital and the balance sheet positions of various euro area sectors. Ultimately, the
role of these factors, evaluated in the broader context of the economic analysis, contrib-
utes to providing the Governing Council with a complete picture of the likely developments
in economic activity and price developments. Moreover, the medium-term orientation of
the ECB’s monetary policy accommodates the need to evaluate the impact of economic
shocks -including those driving asset prices- over horizons whose length is sufficient to


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trace out all the implications of lower-frequency asset price dynamics. In the monetary
analysis, which plays an important role in shaping the medium to long-term outlook for
price developments, the assessment of money and credit makes it possible to follow the
interactions between price formation in asset markets and credit and liquidity creation in
the financial sector. Moreover, because monetary analysis deals with the balance sheets of
financial institutions, it provides a link to the assessment of financial frictions which may
arise and is naturally combined with the development of low probability, high risk scenarios
in the context of dynamic stochastic general equilibrium (DSGE) models with financial fric-
tions, thereby also helping to cross-check short-term forecasts.
    The two-pillar strategy therefore allows the ECB to better assess the consequences of
possible asset market overvaluations and eventually organise a prudent line of response.
Constructed measures of “excess liquidity” -defined in terms of the quantity of money
that would result from standard money demand models- and “excess credit” formation,
in combination with more standard measures of asset price overvaluation, could help to
detect early signals of a possible asset price bubble even in the absence of increasing
pressures on headline consumer inflation. To be sure, my argument is that the monitoring
of monetary and credit aggregates could facilitate what I admit is an extremely challenging
task, namely the early detection of an asset price bubble, thus providing the opportunity for
central banks to prudently “lean against the wind”. To lean against the wind, a central bank
confronted with an inflating asset market adopts a somewhat tighter policy stance than
that it would adopt if asset market conditions were more “normal”. The aim of such an ap-
proach is not to “prick the bubble”, which could create undesirable financial instability and
possibly higher nominal and real volatility, but rather to take some steam out of the bubble
process. In practice, the policy of leaning against asset price movements may be advis-
able on a case-by-case basis and only under certain conditions, which tend, admittedly, to
happen only very rarely. First, the central bank should estimate with a high probability that
asset prices are driven by non-fundamental forces. Second, it should be sufficiently clear
that the unsustainable dynamics in asset prices are likely to continue in the near future.
Third, the bubble should be sensitive to modest interest rate increases. And fourth, the
expected cost of a sudden collapse in asset prices should be significant. Finally, “leaning
against the wind” features the desirable characteristic of symmetry, whereby the central
bank is not seen as acting only when asset prices take a downturn and thus inducing a
more correct ex-ante assessment of risks in the decision-making process of investors in
financial and real assets. By its own nature, a “leaning against the wind” policy that pru-
dently responds to a suspected asset price misalignment does not lend itself to the form of
a simple rule, which is eventually expanded by including an asset price index. In connec-
tion with this, there is the second aspect I have mentioned before, namely the ability of the
ECB’s monetary policy strategy to support and provide a sound rationale for central bank
intervention in the event of financial crisis. A broad and encompassing strategy such as
the ECB’s two-pillar strategy allows the policy-maker to disentangle the mechanics of the


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crisis process and to identify the possible scenarios and the eventual transmission chan-
nels from the epicentre of the crisis to the rest of the economy. The value added of such an
approach to monetary policy-making is particularly high at times of financial turmoil, which
always come with new characteristics because of financial innovation and more general
changes in the microstructure of financial markets.
    One case in point is the recent turmoil in global financial markets. Spurred by financial
innovation that has made it possible to divide up the risk entailed in certain assets, namely
mortgage loans, the major international financial institutions have developed a new busi-
ness model, the “originate-and-distribute” model. It consists in transforming the original
mortgages, which are relatively risky and illiquid assets, into new, less risky and more
liquid assets that can be traded outside of the balance sheet. The benefit for the financial
institutions involved in these transactions is that the original risky mortgages have disap-
peared from their balance sheets, thus encouraging leverage and creating further liquidity
- potentially through mortgage lending. These developments have had a significant impact
on the transmission mechanism of monetary policy in the last few years. For example, in
the United States, but also in the euro area, in a context of rising interest rates financial
institutions did not feel as much constrained in their loan supply as they were in the past,
owing to their ability to expand their balance sheet. The tightening of monetary policy did
not increase medium and long-term interest rates as would have been expected on the
basis of historical regularities. The eruption of the global financial crisis in August 2007
brought about a sudden and painful turnaround in global liquidity conditions. It suddenly
became clear that the “originate-and-distribute” model was built upon the false belief that
mortgage lending, especially in the United States, would continue to grow in line with the
equally false expectations of a relentless upswing in house prices. Once investors realised
that US house prices had embarked on a sustained downward trend that was hitting the
demand for new mortgage loans and increasing the delinquency rates on existing mort-
gages -especially on sub-prime mortgages- the “virtuous” cycle broke down: the market for
mortgage-backed derivatives shut down and many investors found themselves with illiquid
paper. However, the shock-waves to the mortgage market did not stop and spread beyond
its boundaries. The credit derivative markets, which in good times may have contributed
to the allocation of risk and provided insurance against credit risk, dried up, because
investors were no longer able to evaluate the financial situation of their counterparties.
But even more worryingly for central banks, money markets came very close to an abrupt
standstill and tensions in these crucial markets remained significant until just before this
summer. Of course, all major central banks were prompt in their response and organised
extraordinary liquidity injections to help the system to recover. However, the ECB was
the only institution which did not have to substantially change its liquidity management
framework owing to its large number counterparties and its wide range of acceptable col-
lateral. In particular the ECB, from its very first extraordinary liquidity operation, managed
to explain and communicate to the markets and the general public that such measures


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were intended to have a short-term duration and specifically targeted at smoothing liquidity
frictions in the financial system. Such measures should not be confused with a change in
the monetary policy stance, which depends only on the assessment of the risks to price
stability that could emerge from the economic and monetary analysis. In these circum-
stances our monetary analysis was particularly helpful in showing that the credit crunch,
which seemed strong in the United States, was, despite the tightening of financing condi-
tions, not apparent yet in the euro area. This allowed the ECB to confirm the existence of
upside risks to price stability, which led to the recent 25 basis point increase in its official
rate. Overall -and I conclude- the organisation of the ECB’s strategy around the two pillars
permitted successful analysis and communication to the public that the actions taken as
a necessary response to a liquidity shortage were of a different nature and should not be
confused with the conduct of its monetary policy, which has a single aim: maintaining price
stability over the medium term.




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