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Background Studies for the ECB's Evaluation of Its Monetary Policy

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Background Studies for the ECB's Evaluation of Its Monetary Policy EUROPEAN CENTRALEUROPEAN BANK Background Studies for the ECB’s Evaluation of its Monetary Policy Strategy Background Studies for the ECB’s Evaluation of its Monetary Policy Strategy of its Monetary Policy Evaluation Background Studies for the ECB’s Background Studies for the ECB’s Evaluation of its Monetary Policy Strategy Editor: Otmar Issing in co-operation with: Ignazio Angeloni Vítor Gaspar Hans-Joachim Klöckers Klaus Masuch Sergio Nicoletti-Altimari Massimo Rostagno Frank Smets Published by: © European Central Bank, November 2003 Address Kaiserstrasse 29 60311 Frankfurt am Main Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main Germany Telephone +49 69 1344 0 Internet http://www.ecb.int Fax +49 69 1344 6000 Telex 411 144 ecb d This publication will also be made available as an e-book to be downloaded from the ECB’s website. The views expressed in this publication do not necessarily reflect those of the European Central Bank. All rights reserved by the authors. Typeset and printed by: De Bussy Ellerman Harms bv ISBN 92-9181-408-3 (print) ISBN 92-9181-409-1 (online) Contents Foreword by Otmar Issing . 5 1. Overview of the background studies for the evaluation of the ECB’s monetary policy strategy . 9 Background studies related to the ECB’s definition of price stability 2. The definition of price stability: choosing a price measure by Gonzalo Camba-Mendez . 31 3. Definition of price stability, range and point inflation targets: The anchoring of long-term inflation expectations by Efrem Castelnuovo, Sergio Nicoletti-Altimari and Diego Rodríguez Palenzuela . 43 4. Relevant economic issues concerning the optimal rate of inflation by Gonzalo Camba-Mendez, Juan Ángel García and Diego Rodríguez Palenzuela . 91 5. Downward nominal wage rigidity and the long-run Phillips curve: Simulation-based evidence for the euro area by Günter Coenen . 127 6. Zero lower bound: Is it a problem in the euro area? by Günter Coenen . 139 7. Inflation targets and the liquidity trap by Matt Klaeffling and Victor Lopez Perez . 157 Background studies related to the two pillars of the ECB’s monetary policy strategy and the role of money 8. The role of money in monetary policy making by Klaus Masuch, Sergio Nicoletti-Altimari, Huw Pill and Massimo Rostagno . 187 9. Why has broad money demand been more stable in the euro area than in other economies? A literature review by Alessandro Calza and Joao Sousa . 229 10. Is the demand for euro area M3 stable? by Annick Bruggeman, Paola Donati and Anders Warne . 245 11. Forecasting real GDP: What role for narrow money? by Claus Brand, Hans-Eggert Reimers and Franz Seitz . 301 Annex A ECB Press Release: The ECB’s monetary policy strategy . 329 Annex B Further references to relevant papers already published by the ECB . 331 List of Contributors . 335 4 5 Foreword This book brings together, in slightly edited form, the technical studies submitted to the Governing Council in May 2003 in the context of its evaluation of the ECB’s monetary policy strategy. The Governing Council first announced its monetary policy strategy in October 1998, three months before the euro was introduced and the single European monetary policy was first implemented. The strategy adopted was a novel one, suited for the special characteristics of the euro area and its central bank. It is therefore not surprising that in the first years of its existence the ECB’s strategy has been the subject of intense scrutiny and debate on the part of scholars, market participants and other observers. The basis for the strategy is the Treaty mandating that the primary objective of the ECB is to maintain price stability. This mandate reflects the broad consensus that, in the long run, both inflation and deflation have negative effects on economic growth and overall welfare. Maintaining price stability is therefore the best contribution that monetary policy can make to economic welfare. In 1998, in order to make the Treaty mandate operational, the Governing Council provided a quantitative definition of price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area as a whole of below 2%. In the context of this definition, the Governing Council emphasised the medium-term orientation of the ECB’s policy. Monetary policy can only have an effect on the price level with long and uncertain lags, and cannot steer price developments with high precision. The medium-term orientation of monetary policy embodies a commitment to avoid overly ambitious attempts to fine-tune inflation outcomes. The medium-term orientation cannot be reduced to a fixed time horizon. Since the time lags of monetary policy are long and variable, they can only be estimated with a high degree of uncertainty. Moreover, the appropriate forward-looking horizon for maintaining price stability depends on the nature of the shocks driving price developments at any given juncture. The most distinctive feature of the strategy has become known as the two-pillar framework for the analysis of the risks to price stability. One pillar attaches a prominent role to money, reflecting the fundamental tenet that over the longer term both inflation and deflation are monetary phenomena. Within the monetary pillar a reference value for the growth of a broad monetary aggregate was announced in October 1998. In parallel with the analysis of monetary growth the ECB has used as a second pillar a broadly based assessment of other indicators relevant for the outlook for price stability in the euro area, drawing on a wide range of economic and financial variables. Regular staff projection exercises are used to systematically combine much of the information analysed under this pillar. The two-pillar framework makes explicit the complexity and uncertainty confronting monetary policy-makers and facilitates the cross-checking of information and complementary analytical perspectives. In the nearly five years of experience with the ECB’s monetary policy the strategy has served its functions well. It has provided from the outset a robust basis for internal decision-making and a consistent framework for external communication, thereby fostering accountability to the general public. Indeed, all evidence shows that the ECB has firmly established its credibility vis-à-vis the public. Since 1999, medium and long- term inflation expectations – as measured by survey data or financial market indicators – have remained consistent with the ECB’s definition of price stability. This is all the more 6 Issing remarkable given that the ECB started without a track record of its own and that it has experienced a number of sizeable adverse price shocks. As a result of these shocks, HICP inflation was above (and sometimes significantly above) 2% for quite some time. But, as the shocks gradually unwound, so inflation has returned towards levels compatible with price stability. Medium and long-term inflation expectations remained well anchored throughout this period. In December 2002 the Governing Council announced its decision to undertake a comprehensive evaluation of the strategy. After four years of conducting monetary policy for a new currency in a new economic entity, the euro area, it was only natural to take stock of experience and reassure ourselves that we were on the right track. From the beginning of the evaluation exercise, it was clear that one of the key issues would be communication, an area where the institutional and multilingual context of the euro area poses particular challenges. We considered a wide range of views, including those expressed by market participants, academics and the press. Indeed, one of the main purposes of our announcement on 8 May 2003 was to address certain misunderstandings that had emerged in our communication with the public. Moreover, in the preparation of the strategy evaluation by the Governing Council, the main relevant technical issues were revisited, resulting in a series of new studies and surveys that were published on 8 May and that are now brought together in this volume. Staff of both the ECB and the NCBs took part in the technical exercise and preparatory discussions. The issues investigated included the choice of the specific index and format used to define price stability; the preference accorded to headline as opposed to core inflation; the question of how to deal with inflation differentials within the euro area; the indicator properties of monetary aggregates, the stability of the euro area money demand function, and many others. Taking the results in the background studies as a basis for its reflections on the strategy, on 8 May 2003 the ECB Governing Council announced the results of the strategy review. These focused on two main aspects: the definition of price stability and the two-pillar structure of the strategy. Regarding the definition of price stability, the Governing Council confirmed the quantitative definition already announced in October 1998, based on an objective and transparent measure, the HICP, which provides a clear benchmark for accountability. The Governing Council noted that this quantitative definition was a successful contribution to anchoring medium and long-term inflation expectations. At the same time, the Governing Council clarified that, in the pursuit of price stability, it aims to maintain inflation rates below, but close to, 2% over the medium term. There are a number of well-grounded arguments for tolerating a low rate of inflation, and not aiming at zero inflation. The major concern is the need for a safety margin against potential risks of deflation. In a context of strong deflationary pressures, monetary policy may become less effective if central bank interest rate management is constrained by a liquidity trap or a “zero bound” problem. ECB analyses (reflected by some of the studies in this volume) show that such constraints should not pose a significant threat if inflation remains sufficiently above zero.
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