First ECB Central Banking Conference November 2000, Frankfurt, Germany Monetary Analysis: Tools and Applications Editors: Hans-Joachim Klöckers Caroline Willeke Lex Hoogduin Julian Morgan Bernhard Winkler Published by: © European Central Bank, August 2001 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 Copies of the individual articles can also be downloaded from the ECB’s website. The views expressed in this publication are those of the authors and not necessarily those of the ECB. No responsibility for them should be attributed to the ECB or to any of the other institutions with which the authors are affiliated. All rights reserved by the authors. Editors: Hans-Joachim Klöckers Caroline Willeke Typeset and printed by: Druckhaus Thomas Müntzer GmbH ISBN 92-9181-148-3 Table of Contents Foreword “The importance of monetary analysis” O. Issing (European Central Bank) . 5 Preface H.-J. Klo¨ ckers (European Central Bank) . 9 Summary “Monetary analysis: tools and applications” H. Pill (European Central Bank) . 11 “Uncertainty and multiple perspectives” J. Selody (Bank of Canada) . 31 “The role of M3 in the policy analysis of the Swiss National Bank” T. Jordan, M. Peytrignet and Georg Rich (Swiss National Bank) . 47 “Money and credit in an inflation-targeting regime: The Bank of England’s Quarterly Monetary Assessment” A. Hauser (Bank of England) . 63 “Money and inflation: the role of information regarding the determinants of M2 behaviour” A. Orphanides and R. D. Porter (Board of Governors of the Federal Reserve System) . 77 “The impact of financial anxieties on money demand in Japan” T. Kimura (Bank of Japan) . 97 “Framework and tools of monetary analysis” K. Masuch, H. Pill and C. Willeke (European Central Bank) . 117 “Monetary analysis in the Bank of Italy prior to EMU: The role of real and monetary variables in the models of the Italian economy” F. Altissimo, E. Gaiotti and A. Locarno (Banca d’Italia) . 145 “The role of the analysis of the consolidated balance sheet of the bankingsector in the context of the Bundesbank’s monetary targeting strategy prior to Stage Three” J. Reischle (Deutsche Bundesbank) . 165 4 Table of Contents “The integration of analysis of extended monetary and credit aggregates in the experience of the Banque de France” F. Drumetz and I. Odonnat (Banque de France) . 187 “Flow of funds analysis in the experience of the Banco de Espan˜a” J.Pen˜ alosa and T. Sastre (Banco de Espan˜a) ................................. 209 List of Participants ........................................................ 223 Foreword The importance of monetary analysis Otmar Issing Member of the Executive Board of the European Central Bank These days, few economists would disagree with the statement that inflation is a mone- tary phenomenon in the long run. Indeed, this statement is one of the central tenets of economic theory. The long-run relationship between money and prices has been con- firmed by an impressive number of empirical studies, both across countries and across time. Moreover, the ability to implement monetary policy ultimately hinges on a central bank’s monopoly control over the creation of base money. Given the fundamental money-prices relationship and their monopoly power over the legal tender, the mone- tary authorities have a natural interest in monetary developments. At a more practical level, monetary data are collected in a timely manner and are more accurate than many other economic indicators. All these factors explain why money plays a prominent role in monetary policy-making and thus why the monetary analysis undertaken at central banks is both necessary and important. The monetary policy strategy of the ECB recognises the monetary nature of inflation by assigning a prominent role to money in the formulation of monetary policy decisions aimed at the maintenance of price stability. This prominence is signalled by the an- nouncement of a quantitative reference value for the growth rate of the broad mone- tary aggregate M3. In December 1998 the Governing Council of the ECB has set this reference value at 4 Ý% and this value was subsequently confirmed in 1999 and 2000. A detailed analysis of monetary developments with the aim of extracting the informa- tion relevant for monetary policy decisions represents the first “pillar” of the ECB’s monetary policy strategy. Among other things, this analysis includes an investigation of the deviation of M3 growth from the reference value. Monetary analysis begins with the very definition of a key monetary aggregate. While it is easy to speak about the “M” which appears in economics textbooks, it is much harder in practice to give a meaningful definition of a monetary aggregate. There is now a consensus that broad aggregates, such as euro area M3, tend to perform better as monetary policy indicators than do narrower measures of money, since they interna- lise the portfolio shifts pervasive in a world of financial innovation and rapid change. In particular, econometric evidence suggests that euro area M3 both has a stable relation- ship with the price level in the long run and possesses leading indicator properties for inflation over the medium term. As such, this aggregate has the properties required to define the reference value and thus to signal the prominent role of money in the ECB’s monetary policy. To a large extent, monetary analysis represents the analytical work necessary to de- termine from the available monetary data the underlying relationship between money 6 Otmar Issing and the price level. Monetary developments may be subject to a host of special influ- ences and distortions which render the relationship between money and prices complex in the short run. Extracting the stable long-run relationship – say between euro area M3 and the euro area price level – from shorter-term developments in M3 is, in es- sence, the filtering of signals from noise. This analysis is demanding, since it requires both a strong command of economic theory and a detailed knowledge of the institu- tional environment. In particular, monetary analysis should always encompass a close monitoring of financial innovation as this may affect the fundamental relationship be- tween money and prices. To implement this more detailed assessment, monetary analysis undertaken at the ECB is not limited solely to the analysis of M3. The main components and counterparts of M3 in the balance sheet of the Monetary Financial Institutions sector are also closely monitored. In particular, the developments of credit to the private sector and of the most liquid components of M3, included in the narrow monetary aggregate M1, are followed with particular attention. This broader analysis is necessary to put develop- ments into perspective, to obtain a better understanding of M3 developments and, more generally, to develop a broader insight into monetary conditions and their impli- cations for monetary policy decisions aimed at maintaining price stability. Monetary analysis can provide many kinds of information. Used as an indicator, monetary developments may signal risks to future price stability. Furthermore, mone- tary analysis may also be useful to monitor (and possibly offset) macroeconomic risks which are not directly related to price stability stricto sensu, but which may nevertheless have important consequences. For instance, historical experience has shown that booms and busts in capital markets, often associated with phenomena of excessive enthusiasm or excessive pessimism about the future, have typically been accompanied by large swings in monetary and credit aggregates. A broader analysis of the flow of funds may also provide important inputs. In fact, by providing an insight into the composition of the balance sheet of the main actors in the economy (households, firms and intermediaries), a flow of funds analysis can help to assess the likely impact of interest rate changes on spending decisions, allowing a deeper understanding of the monetary policy transmission and therefore a proper cali- bration of monetary policy instruments. So far, the unavailability of the necessary data has prevented the ECB from carrying out a fully-fledged flow of funds analysis for the euro area as a whole, but the situation should improve substantially in this regard in not too distant a future. At the ECB, detailed monetary analysis and the announcement of a reference value for M3 growth are closely interwoven, since the reference value constitutes per se a commitment to analyse monetary data carefully. It shows that monetary growth – the ultimate source of inflation in the long run – is taken seriously in the policy-making process. Given that the link between money and prices has a long-run nature, it also signals that monetary policy has an appropriate medium-term orientation. This, in turn, contributes to shaping agents’ expectations in a manner which enhances the credibility of the central bank. The experience of the first two years of Stage Three of Economic and Monetary Union (EMU) has shown that monetary developments in the euro area – and in parti- cular the deviation of M3 growth from the reference value of 4 Ý% – have provided consistent and reliable guidance for monetary policy. Interest rate decisions by the ECB The importance of monetary analysis 7 Governing Council have been supported by remarkably consistent information from the first pillar of the ECB’s monetary policy strategy. At the same time, some caution needs to be exercised since M3 developments have presumably been influenced on occasion by special factors and distortions. For example, the exceptionally strong rise in M3 growth in January 1999 may have been due, in part, to the special environment at the start of Stage Three of EMU (e.g. the change in the reserve requirement regime associated with the introduction of the Eurosystem’s operational framework).