MONETARY POLICY A JOURNEY FROM THEORY TO PRACTICE ISBN 978-928990121-5 AN ECB COLLOQUIUM HELD IN HONOUR OF OTMAR ISSING 9 789289901215 EUROPEAN CENTRAL BANKEUROPEAN 16-17 MARCH PRACTICE TO THEORY A JOURNEY FROM POLICY – MONETARY 2006 MONETARY POLICY A JOURNEY FROM THEORY TO PRACTICE AN ECB COLLOQUIUM HELD IN HONOUR OF OTMAR ISSING 16-17 MARCH 2006 © European Central Bank, 2007 Address Kaiserstrasse 29 D-60311 Frankfurt am Main Germany Postel address Postfach 16 03 19 D-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 All rights reserved. Reproduction for educational and non-commercial purposes is permitted provided that the source is acknowledged. ISBN 978-92-899-0121-5 (print) ISBN 978-92-899-0122-2 (online) CONTENTS FOREWORD 5 Jean-Claude Trichet SESSION 1 PRE-COMMITMENT AND GUIDANCE LESSONS FROM THE BUNDESBANK’S HISTORY 8 Manfred J. M. Neumann THE DANGER OF INFLATING EXPECTATIONS OF MACROECONOMIC STABILITY: HEURISTIC SWITCHING IN AN OVERLAPPING GENERATIONS MONETARY MODEL 17 Alex Brazier, Richard Harrison, Mervyn King, Tony Yates MONETARY POLICY AND ASSET PRICES 43 Donald L. Kohn PANEL DISCUSSION:THE ART OF CENTRAL BANKING 52 Stanley Fischer, Arminio Fraga, Lars Heikensten, Hans Tietmeyer, Paul A. Volcker DINNER SPEECHES 73 Jean-Claude Trichet, Martin Wolf, Otmar Issing SESSION 2 STABILITY FIRST: REFLECTIONS INSPIRED BY OTMAR ISSING’S SUCCESS AS THE ECB’S CHIEF ECONOMIST 86 Vítor Gaspar, Anil K. Kashyap PANEL DISCUSSION: ECB MONETARY POLICY: THE FIRST SEVEN YEARS 119 Leszek Balcerowicz, Charles Goodhart, Malcolm Knight William McDonough, Axel A. Weber SESSION 3 THE CONTRIBUTION OF THEORY TO PRACTICE IN MONETARY POLICY: RECENT DEVELOPMENTS 142 Carl E. Walsh PANEL DISCUSSION: CENTRAL BANKING: IS SCIENCE REPLACING ART? 160 Olivier Blanchard, Martin Feldstein, Robert E. Lucas Allan H. Meltzer, Lars E.O. Svensson CONCLUDING REMARKS 186 Otmar Issing PROGRAMME 189 3 FOREWORD On 16-17 March 2006, the European Central Bank organised a colloquium in honour of Otmar Issing, after his eight years in the Executive Board of the European Central Bank (from May 1998 till May 2006). This volume collects the five papers presented at the colloquium, as well as the various contributions to the three panel discussions and the speeches on the occasion of the conference dinner. The truly exceptional list of participants, a global “who-is-who” in central banking and Academia, is a tribute to Otmar Issing’s invaluable contribution to the success of the European Central Bank and its monetary policy strategy. The papers and the panel discussions cover a wide range of monetary policy issues that are close to Otmar’s heart: the role of pre-commitment and the Bundesbank’s experience with monetary targets, the importance of anchoring inflation expectations, the role of asset prices in monetary policy, the focus on price stability and the ECB’s experience with monetary policy in an uncertain and challenging environment. The volume covers both the art and the science of central banking. Also this reflects Otmar Issing’s own journey from being a Professor at the University of Würzburg to becoming the Chief Economist first at the Deutsche Bundesbank and then at the European Central Bank. Otmar Issing has been a constant source of inspiration for the European Central Bank. I am sure this book will equally be a very useful source of inspiration for central bankers and academics over the world. Jean-Claude Trichet President of the European Central Bank 5 SESSION 1 PRE-COMMITMENT AND GUIDANCE LESSONS FROM THE BUNDESBANK’S HISTORY 8 Manfred J. M. Neumann THE DANGER OF INFLATING EXPECTATIONS OF MACROECONOMIC STABILITY: HEURISTIC SWITCHING IN AN OVERLAPPING GENERATIONS MONETARY MODEL 17 Alex Brazier, Richard Harrison, Mervyn King, Tony Yates MONETARY POLICY AND ASSET PRICES 43 Donald L. Kohn PANEL DISCUSSION:THE ART OF CENTRAL BANKING 52 Stanley Fischer, Arminio Fraga, Lars Heikensten, Hans Tietmeyer, Paul A. Volcker DINNER SPEECHES 73 Jean-Claude Trichet, Martin Wolf, Otmar Issing 7 PRE-COMMITMENT AND GUIDANCE LESSONS FROM THE BUNDESBANK’S HISTORY MANFRED J. M. NEUMANN1 1 INTRODUCTION Let me start with a personal note. We have come together today to honour Otmar Issing, an eminent scholar and central banker, who has served as chief economist of the European Central Bank since the Bank’s foundation and who in this capacity has put his stamp on the Bank’s strategy of monetary policy making. He has impressed us with the strength of his convictions as regards the importance of the price stability objective and of the role of money. As you know, Otmar Issing entered the exciting scene of central banking not in 1998 but much earlier, namely in 1990, when he was appointed board member and chief economist of the Deutsche Bundesbank. Should you ever look up the Bundesbank’s Annual Report for the Year 1990 you will find that Otmar Issing took up that post on October 2 instead of October 1. Now you may wonder what did Otmar do on October 1 – was that day a Sunday or was it one of the too many German holidays? Well, my research tells me that October 1 was a Monday. Apparently, Otmar took a “blauer Montag” or a let’s say a premature Bank holiday. I assume he needed a little time to prepare for the big step from armchair economics of academia to the down-to-earth work of practical men. In contrast to eight years later, Otmar was certainly not expected to design a new policy concept for a new institution. Rather, he was confronted with the Bundesbank’s established tradition of policy making and was expected to continue along the lines that had been paved by Helmut Schlesinger since the mid-1970s. In 1974, the year I met Otmar for the first time at Karl Brunner’s Konstanz Seminar on Monetary Theory and Monetary Policy, the Bundesbank’s governing council decided to start the new strategy of publicly announcing annual monetary targets. Public monetary targeting was used by the Bundesbank for more than two decades to provide guidance with respect to its intended policy course and this way to influence the public’s expectations of inflation. In this brief presentation, I will first recall the background to the introduction of formal targeting. That was the need for a nominal anchoring of monetary policy after the break-down of the Bretton-Woods-System of fixed exchange rates. Next, I will review the Bundesbank’s track record by examining the largest target misses. And, finally, I will discuss why the Bundesbank has been able to preserve its credibility even though missing the target has not been a rare event. 1 Institute for International Economics, University of Bonn, April 2006. 8 2 THE BACKGROUND The background to the adoption of monetary targeting was the systemic need for a reorientation of monetary policy after the final break-down of the Bretton- Woods-System in 1973. The move to flexible exchange rates freed central banks from having to stabilise the exchange rate vis-à-vis the dollar and provided them with the potency of controlling domestic money and credit creation. However, along with this potency goes the burden of responsibility for securing domestic price stability. It is not easy to fulfil this task successfully because in the absence of a binding exchange rate constraint monetary policy is not anchored anymore. Since rational private agents understand that the independent central bankers are free to choose any monetary expansion path, excessive inflation expectations may build up if the authorities are not able to provide credible guidance. To put rhetorical emphasis on the objective of price stability is not enough because rational agents will monitor the policy implementation as closely as possible in order to learn about the underlying objective function. If they get the impression that the structure of that function is not conducive to maintaining price stability, inflation expectations will not settle at the officially desired level but go beyond, and this, in turn, will force rational authorities to validate the excessive expectations by a sufficiently high level of money growth in order to avoid the generation of a recession. The unfortunate equilibrium outcome of this policy game will be a persistently higher inflation than desired as was proven analytically by Barro and Gordon in 1983. In the mid-1970s this analysis was not known, of course. Nevertheless, quite a few central bankers in Germany and, by the way, in Switzerland appeared to understand that the regime change from fixed to floating rates required a new policy strategy in order to be able to check inflation expectations. They concluded that it would be useful, if not necessary, to commit to some type of rule that credibly constrains monetary policy. Though Milton Friedman’s famous k-percent rule was dismissed, as it does not allow for any contingencies, it served as an intellectual guide. In fact, the Bundesbank’s governing council had held a confidential debate about its pros and cons as early as 1970 (Neumann, 1999). Similarly, German academics and the German Council of Economic Experts, in particular, began discussing monetarist analysis and argued in favour of a steadier, rules-based monetary policy oriented to the medium run.2 The historic opportunity to start the new policy regime of monetary targeting came in 1974 when, due to the quadrupling of the oil price and a sharp monetary deceleration, the German economy began cooling down. The Bundesbank desired to switch towards easing without giving labour unions a signal for higher wage demands. Announcing a monetary target appeared to be the solution. 2 See Richter (1999) for a detailed account.