Evaluating the strategy five years
European Central Bank Executive Board Member Professor
Otmar Issing addresses the ECB Watchers Conference in Frankfurt
I welcome the opportunity to address this fifth edition
of the ECB Watchers conference. This annual meeting has become a tradition
by now. It is a remarkable tradition: to my knowledge, the ECB is the
only central bank that regularly intervenes in meetings of this kind.
When, four and a half years ago, the ECB started conducting monetary
policy for the euro area, we decided to participate in this initiative
launched by the CFS as we felt the need, as a new central bank, to quickly
establish active channels of debate with the market, academic, and press
communities. We now continue to benefit from these meetings on a regular
basis. I wish to thank Prof. Weber for proposing this formula and for
maintaining his commitment over the years.
This meeting is a special one. In the course of the last year the ECB
has launched, conducted and concluded an evaluation of its monetary
policy strategy. A good deal of the remarks today naturally focus on
such evaluation, its conclusions as announced on 8 May, and the changes
or lack of changes that this review process led to. Accordingly,
my short remarks this morning will be centered on three points:
1. Why has the ECB decided to undertake an evaluation of its strategy;
2. How was this evaluation conducted;
3. What conclusions we reached, and why.
Why an evaluation of the
Many people were surprised by the announcement, last December, that
the ECB would undertake an evaluation of its monetary policy strategy.
Some took it as an implicit indication that we were dissatisfied by
the strategy and prepared to change it. The opposite is true.
When our strategy was announced, on October 1998, the ECB had not yet
assumed its responsibility of conducting monetary policy for the euro
area. The strategy we designed was a novel one, suited for the special
characteristics of the euro area and its central bank, and different
in a number of respects from other current and past strategies. It incorporated
the best judgement and experience of central banks and the key lessons
of economic research, but it lacked one fundamental element: the test
of practical experience. Hence it was only natural that, after a period
of time, the Council would want to go back and reflect on the accumulated
experience in a systematic way. This did not mean that changes were
necessarily needed any more than a new car necessarily needs
repair when it is taken to the garage for its 5,000 miles checkup! It
is true, however, that we undertook our evaluation with an open mind,
ready to introduce changes in case our evaluation had suggested the
need to do so.
There are in my view three areas where a monetary policy strategy plays
a crucial role in a central bank, and this is where our attention focused:
1. The strategy should provide a framework for the internal analysis.
As such, the framework must encompass and organize all relevant information
in an efficient way. It should use the best available research, taking
into account all different sources of uncertainty the central bank faces.
Competing models must be allowed to paint complementary pictures of
the economic outlook and the risks to price stability.
2. The strategy should also provide a framework for the debate within
the decision making body.
From this viewpoint, the strategy must be efficient in terms of allowing
the decision making body to examine and weigh all relevant information,
encompassing any diversity of views that may exist on the transmission
3. Finally, the strategy should provide a framework for external communication.
Here, transparency and effectiveness are linked. Effective communication
facilitates the transmission of monetary policy decisions to the economy.
At the same time, using the same framework for external communication
as for internal analysis should guarantee consistency and improve public
understanding of how monetary policy is conducted, thereby enhancing
transparency and effectiveness at the same time.
How was the evaluation
Accordingly, we went through several steps. The first was to revisit
all the technical issues. All aspects of the strategy were scrutinised,
going through a lively internal debate and resulting in a series of
technical studies now available on our web site. The key role here was
played by the staff of the ECB and of the National Central Banks, the
latter contributing through the Eurosystem Monetary Policy Committee.
Use was made of research accumulated during the recent years, in the
ECB and outside, on a number of issues relevant for the strategy, such
as the transmission of monetary policy, the determinants of prices,
the leading indicator properties of money, credit and other key indicators,
and the like.
The second step was to reflect on how the strategy has contributed to
the debate within the ECB decision making bodies, naturally with a particular
focus on the Council. In the decade leading up to the EMU, a broad consensus
on the principles of sound monetary policy making emerged among the
NCB's now forming the monetary union. Even so, the ECB Governing Council
is a large body, with a wealth of diverse experiences and views. The
strategy must provide a commonly accepted framework within which these
experiences and views all contribute to policy decisions. The strategy
should also ensure that the relevant information is taken into account
fully and orderly. From this point of view, the ultimate test for the
success of the strategy are the extent to which it effectively guides
the debate within the Council and the record of actual policy decisions.
I think it is fair to say that most observers agree that the ECB's record
has been, on the whole, very successful in these four and a half years.
Finally, we carefully considered the performance of the strategy in
external communication. This is an area where, according to several
observers, including some present here today, the strategy has worked
less well. We have examined the full range of views, including those
coming from the Watchers' meetings and those expressed by market participants,
academics, and the press. Our announcements regarding the strategy on
8th of May, which I am now going to discuss briefly, are aimed primarily
at addressing certain misunderstandings that have emerged in our communication
with the public.
The result of the evaluation
I do not need to discuss here all aspects of our review; the documents
in our website provide a complete account of them. The issues we investigated
included the choice of the specific index used to define price stability,
the preference accorded to headline as opposed to "core" inflation,
how to deal with inflation differentials within the area, the stability
of the euro area money demand function, and many others.
I will limit my remarks to the two most debated aspects: the definition
of price stability and the role of money, or the "two-pillar structure"
of the strategy.
The definition of price
Regarding the definition of price stability, the Governing Council confirmed
the explicit quantitative definition announced already in October 1998,
which is based on an objective and transparent measure, as provided
by the HICP. We remain convinced that this is an important element of
clarity, that contributes positively to both the effectiveness of policy
and to the ECB's accountability.
Moreover, the Council noted that this quantitative definition had been
very successful in anchoring market expectations. The direct and indirect
measures of expected inflation in the euro area have shown a remarkable
stability in the last few years, at a level just below 2%. This is a
very important result, perhaps the most important, for a central bank
whose mandate is to maintain price stability over the medium term. Hence,
the essence of the existing definition of price stability, namely, a
year-on-year increase in the Harmonised Index of Consumer Prices for
the euro area of below 2%,was fully confirmed.
At the same time, the Governing Council clarified that in the pursuit
of price stability it will aim to maintain inflation rates below, but
close to 2% over the medium term. This clarification emphasises the
need for a sufficient safety margin against the risk of deflation.
There are several good reasons for accepting a low rate of inflation.
The major concern is the fact that monetary policy may become less effective,
if interest rate management by the central bank is constrained by a
liquidity trap or a "zero bound" problem. ECB analyses show
that such constraint should not pose a significant threat if inflation
remains sufficiently above zero. The clarification we provided to the
price stability definition offers a safeguard in this sense.
In preventing the emergence of deflationary and inflationary dynamics
alike, a forward-looking orientation of monetary policy is essential.
There is no convincing evidence that relying on rigid rules helps in
this respect. Rather, the medium term orientation of the ECB strategy,
with its explicit reference to all relevant indicators of future price
developments, provides flexibility and forward- looking orientation
while maintaining a firm reference to the medium term price stability
The role of money and the
The Governing Council confirmed that the two-pillar framework of the
strategy is an effective tool to organise the information on different
risks to price stability. Different types of analysis provide information
relevant for price developments at different time horizons. The economic
analysis focusing on the most proximate causes of inflation such
as cost developments and demand-supply imbalances primarily contributes
to assess short to medium-term economic developments and consequently
risks to price stability at that horizon. The monetary analysis
focusing instead on the ultimate monetary determinants of inflation
primarily contains information for assessing price developments
at medium to long-term horizons. The economic literature suggests that
there is no easy way to bring together the monetary analysis with the
economic analysis in a unified framework; or, as we could say more technically,
to integrate money and credit into today's standard macroeconomic models.
In this respect, the monetary analysis mainly serves as a means of cross-checking,
from a medium to long-term perspective, the short to medium-term indications
coming from economic analysis. In particular, to underscore the longer-term
nature of the reference value for monetary growth, which is retained
as a benchmark for the assessment of monetary developments, the Governing
Council decided to discontinue the practice of an annual review.
The ECB's monetary policy strategy will continue to provide a solid
basis to tackle further challenges ahead. I am sure that over time the
merits of our approach will be fully recognized. It is very open and
transparent about the presence of the uncertainty surrounding the functioning
of the economy and the reliability of key economic relationships, which
necessitate a diversified approach. In particular, a prominent role
for money underpins the medium-term orientation of monetary policy and
helps eschew excessive policy activism and overly ambitious attempts
to "fine-tune" economic developments. The two-pillar strategy
also provides a suitable framework to take asset price developments
appropriately into account.
More than four years of experience provide evidence of the success of
the strategy as the basis for monetary policy decisions in the face
of significant uncertainty and sizable adverse shocks. The evidence
shows that the ECB is on the right track. It has earned credibility,
fulfilled the stability mandate given to it by the Treaty and will continue
to do so. This is in the end what counts.
In concluding let me stress, as I always do when discussing these issues,
that our reflection on the strategy is an ongoing process. It did not
start with the recent evaluation and will not end with it. We continuously
re-examine the performance of our strategy while we work with it.
Hence I am sure that your job as Watchers, and occasionally as critics,
is not finished. We continue to look forward to your feedback and need
your constructive critique, not only in the short term - but also over
the medium to long term.