The stability-oriented monetary policy of the European Central Bank

It is a great honour for me to speak today at this Euro Conference in Oslo on behalf of the European Central Bank. The initiative to organise such a conference – outside the euro area – is very welcome. The slogan of the Euro 2002 Information Campaign embarked upon by the ECB and the national central banks of the euro area – “the EURO. OUR money” – seems to imply, at first sight, that the euro is not of great significance for the countries outside the euro area. But the fact that this conference is taking place today is proof of the opposite. Especially European countries with significant trade relations with the euro area should, and are, considering the consequences of the euro for their economies.

In my speech today, I should firstly like to say a few words about the cash changeover, that is, the introduction of euro banknotes and coins, which is now only 62 days away. Secondly, I will describe to you the ECB’s stability-oriented monetary policy, which is one of the cornerstones of a successful European Monetary Union. It should be acknowledged that the ECB’s monetary policy strategy has, at times, been criticised. And as the ECB very much favours an open exchange of views, I will also address some of these critical remarks, in particular those related to the transparency of the ECB and the ECB’s communication policy.

Finally – and I guess you expect me to do so – I will make a few comments about the consequences of the euro for European countries not participating in the euro area.

First things first: let’s start with the cash changeover – the reason why this conference was organised in the first place. The introduction of almost 15 billion banknotes and around 50 billion coins will mark the end of the process leading to full monetary integration in the European Union. This process started roughly ten years ago, when the Heads of State and Government of the European Union signed the Treaty on European Union, also known as the “Maastricht Treaty”.

It should be noted that the euro will not be created on 1 January 2002, as many still believe. The euro has already been in existence since 1 January 1999, when the exchange rates of the countries now participating in the euro area were irrevocably fixed. True, until now, the euro has been the currency of financial and foreign exchange markets, and not the currency of the public at large. But this will change with the introduction of the banknotes and coins.

Although the euro has until now not been very visible to the European citizens, the advantages of a single currency for Europe have become clearer in the past weeks and months. The irrevocable fixing of the exchange rates has shielded the euro area – to some extent – from the weakening of the US economy and external shocks, such as the marked increase in oil prices last year and the terrorist attacks in the United States on 11 September. In the “old days” before Monetary Union, these developments would almost certainly have caused turbulence on European foreign exchange markets, turbulence that would have had a detrimental effect on economic growth.

The introduction of the euro banknotes and coins represents an unprecedented logistical challenge for all parties involved. For this reason, all euro area countries have established elaborate changeover scenarios. But the euro banknotes should not and will not only find their way to the citizens of the euro area. As of 1 December 2001, national central banks of euro area countries may frontload euro banknotes to central banks outside the euro area and to non-euro area credit institutions specialised in the wholesale distribution of banknotes. These frontloaded central banks and credit institutions may, in turn, frontload euro banknotes to other credit institutions. These measures will ensure that the citizens outside the euro area, also here in Norway, may – if required – also acquire euro banknotes from 1 January 2002 onwards.

As I mentioned in my introduction, the ECB and the euro area national central banks have launched a massive information campaign to inform the public about the new currency. In this case as well, efforts are not only targeted at the euro area. The budget for the Euro 2002 Information Campaign amounts to EUR 80 million; 10% of this amount is reserved for communication activities targeted at groups outside the euro area. The main public information leaflet on the introduction of the banknotes and coins has been translated into 23 languages. Communication activities targeted at non-euro area citizens include an advertising campaign in international media, at airports as well as in in-flight magazines and videos. Moreover, the Eurosystem has initiated an international partnership programme, which allows international organisations and companies to co-operate with the Eurosystem in order to inform their customers and staff about the cash changeover. Last but not least, the euro website – at www.euro.ecb.int – plays a crucial role in the communication beyond the border of the euro area. This website is being visited about 12,000 times a day. We are confident that the Euro 2002 Information Campaign will inform the public about the introduction of the euro banknotes and coins, both inside and outside the euro area, as will the public relations campaigns already launched by the euro area national central banks and other (international) organisations.

As I already mentioned, the euro has been in existence since 1 January 1999. The ECB has been in operation since 1 June 1998. But it appears that only now, with the introduction of the euro banknotes, will the European Central Bank have a face, at least in the eyes of the public at large. Hence, the cash changeover should make it easier for the ECB to communicate its main objective, which is the maintenance of price stability. This brings me to the second issue to be addressed by my speech today, the ECB’s monetary policy strategy.

The Treaty explicitly assigns the sole responsibility for the single monetary policy and related tasks to the ECB. The highest decision-making body of the ECB, which is collectively responsible for monetary policy decisions in the euro area, is the Governing Council. The Governing Council consists of the ECB’s President and Vice-President, the other four ECB Executive Board members and the 12 governors of the euro area national central banks. The ECB and these national central banks are referred to collectively as the Eurosystem.

The Treaty also clearly defines the maintenance of price stability in the euro area as the primary objective of the European System of Central Banks (ESCB). Without prejudice to this objective, the ESCB supports the general economic policies in the Community with a view to contributing, inter alia, to a harmonious, balanced and sustainable development of economic activities, a high level of employment, and sustainable and non-inflationary growth.

Rooted in the long-standing experience of the participating national central banks is the conviction that it is with a credible and lasting maintenance of price stability that the welfare of EU citizens can be best enhanced. The experiences of the 1970s and 1980s convinced most people that a central bank is ill-suited to fine tuning economic developments and that the activist use of monetary policy cannot yield lasting increases in real economic activity. However, by focusing on its mandate and avoiding both prolonged periods of inflation and deflation, the central bank provides a stable environment for consumers and firms. This not only reduces allocative distortions, but also creates the appropriate incentives for structural and fiscal polices to effectively promote potential output. To support and safeguard the pursuit of price stability, the Treaty endows the Eurosystem with a high degree of institutional independence and ensures that it has the necessary autonomy from any political interference. The Treaty laid solid foundations for a robust construction. Importantly, overlaps in competence and responsibility for the conduct of the single monetary policy and in the design of fiscal and structural policies have been avoided.
This, however, does not mean that there is no exchange of information between the ECB and the authorities responsible for fiscal and structural policies – quite the contrary.

As already mentioned, the objectives which monetary policy has to pursue are imposed upon the ESCB by the Treaty. The Governing Council has designed its monetary policy strategy in order to meet these objectives in an efficient manner.

The quantitative definition of price stability constitutes the first feature of this strategy. The announcement of a numerical definition is intended to enhance clarity, anchor expectations and offer a yardstick against which the ECB can be held accountable. The Governing Council has defined price stability as “a year-on-year increase in the Harmonised Index of Consumer Prices for the euro area of below 2%”. This definition is very close to the objectives of most participating national central banks before the start of Monetary Union. The headline HICP is the indicator chosen as the preferred measure to quantify the ECB’s primary objective because it is the homogeneous statistic that most closely approximates the “true” basket of private households’ consumption in the euro area. In addition, the definition makes it clear that the ECB’s monetary policy is an indivisible task, with the aim of maintaining price stability in the euro area as a whole, which cannot respond to the specific needs of the individual euro area economies.

Indeed, divergence in inflation between countries is a normal phenomenon in monetary unions, as also evidenced by the US experience. It may be the result of catching-up processes or may be caused by erratic or temporary factors, such as differences in weather conditions. Such inflation differentials are not necessarily a cause for concern. However, inflation differentials could be problematic if they were, for instance, to be the result of excessive wage increases or expansionary fiscal policy.

In these cases, national economic policies would best contribute to avoiding or counteracting such situations which, otherwise, would subsequently require painful adjustments.

Moreover, the ECB always emphasises that price stability has to be maintained over the medium term. This ensures measured policy reactions to the risks to price stability and prevents the introduction of unnecessary volatility to the economy. The medium-term orientation also realistically acknowledges that short-term volatility in prices cannot be controlled by monetary policy – recent examples of this include the oil and food price increases, which have caused inflation in the euro area to temporarily rise above the 2% upper bound – and that monetary policy should therefore only be held responsible for price developments over a longer horizon.

Central banks have to be forward-looking since their actions have an impact on price developments only with a time-lag. Moreover, central banks have to operate in an environment characterised by substantial uncertainty, not only with regard to current and future developments, but also the actual functioning of the economy. This is particularly true in the euro area where the regime shift entailed by the introduction of a single currency may affect economic behaviour and institutional structures. Under these conditions, it is crucial to ensure that policy decisions are robust and all-encompassing. The ECB not only acts with a pre-emptive, forward-looking orientation, but also bases its policy decisions on several models and frameworks.

With the objective of capturing and providing all of the pieces of information on the euro area economy relevant to the assessment of the Governing Council, the ECB designed a two-pillar structure for its strategy. The first pillar assigns a prominent role to money, while the second encompasses the analysis of a wide range of other economic and financial indicators.

In recognition of the fundamentally monetary origins of inflation, the first pillar foresees a prominent role for money, implying that the Governing Council regularly analyses the developments of a broad array of monetary and credit aggregates. In order to signal this prominent role, the Governing Council announced a reference value of 4.5% for the rate of growth of the monetary aggregate M3 that is deemed consistent with the ECB’s definition of price stability. In this respect, it should be understood that there is no mechanistic policy response to deviations of M3 growth from the reference value. The reasons for such deviations have to be assessed carefully. Furthermore, the information from the first pillar of the strategy should also be judged in the light of the analysis under the second pillar.

Under the second pillar of its monetary policy strategy, the ECB regularly monitors a broad set of non-monetary economic and financial variables, such as wages, unit labour costs, fiscal policy statistics and financial market indicators like stock prices and exchange rates. Such an assessment enables a focus on the effect on price developments entailed by cost pressures and the interplay between supply and demand in the goods and labour markets.

Within the framework of the second pillar, the Eurosystem staff also produce macroeconomic projections. In line with the commitment to being a transparent institution, Eurosystem staff projections are published in the ECB’s Monthly Bulletin twice a year. It should be noted that these projections do not represent predictions of the most likely macroeconomic outcomes, because they are based on the assumption of unchanged short-term interest rates and euro exchange rates. This is why they are called “projections” and not “forecasts”. In its decision-making, the Governing Council assesses the staff projections as just one of the inputs into its deliberations, alongside all the other information from the second pillar and the monetary analysis conducted under the first pillar.

Under the uncertainty of the complex and dynamic euro area environment, the distinct, yet mutually reinforcing perspectives of the two pillars and the robust assessment of information which they permit have proved to be the most suitable analytical framework for the Governing Council’s conduct of monetary policy.

Having said all this, it should be acknowledged that the ECB’s monetary policy is sometimes criticised. Some critics focus on the monetary policy strategy itself or on the decisions taken by the Governing Council on the basis of this strategy. Others do not question the monetary policy strategy or decisions, but are not always happy with the way these are communicated. In view of time restrictions and the scope of this conference, I will limit myself today to discussing some of the critical remarks related to the ECB’s transparency and its communication policy. Indeed, some argue that – although the policy pursued since 1 January 1999 has in itself been appropriate – the Governing Council’s decisions are not sufficiently predictable.

Is this criticism justified? Let me first assess the transparency of the ECB, or the perceived lack of it. Without wishing to sound arrogant, the ECB is one of the most transparent central banks in the world. Why is that?

Firstly, every month the President of the ECB describes in detail the monetary policy stance of the ECB at a press conference, almost immediately following the meeting of the Governing Council. No other major central bank in the world has adopted such a practice. The introductory statement prepared for these press conferences very closely follows the deliberations of the Governing Council.

Indeed, the Governing Council discusses at length and then approves the introductory statement.

Hence, in a way, the introductory statement can be perceived as an alternative to minutes of the Governing Council meeting. No major central bank gives that much information about monetary policy decisions so soon after the decisions have been taken.

Secondly, in between the fortnightly meetings of the Governing Council, the ECB publishes its Monthly Bulletin. In conjunction with the introductory statement, the editorial of the Monthly Bulletin provides an up-to-date assessment of the monetary policy stance.

Thirdly, the President of the ECB is invited to address recent monetary and economic developments at his quarterly testimonies before the Economic and Monetary Affairs Committee of the European Parliament. These testimonies also give the public a good overview of the ECB’s current views on economic and monetary developments, as well as of the ECB’s monetary policy stance. In addition, the Vice-President presents the ECB’s Annual Report to the same Committee, after which it is presented by the President to the European Parliament in a plenary session.

Finally, members of the Governing Council deliver many speeches and give many interviews to international and national media.

Again, there is no other major central bank where the members of the decision-making bodies are so active in the public arena.

Indeed, some claim that members of the Governing Council are sometimes too active, thereby adding to confusion about the ECB’s monetary policy stance. I should like to make two remarks in this respect. Firstly, given the unique decentralised set-up of the Eurosystem, national central bank governors play an important role in conveying the messages of the Eurosystem to the audiences in their respective countries. Indeed, the message is better understood – and hence more effective – if it is communicated in the respective language and is put in a national context. Secondly, market players and media should not try to wring out every last drop of meaning from the many speeches and interviews of members of the Governing Council. The “market pundits” sometimes resemble the soothsayers in the Roman Empire, opening up the bodies of dead birds and other animals and trying to predict future events from their bowels. Speeches of Governing Council members often seek to explain the ECB’s monetary policy and monetary policy strategy to the public. Their main purpose is not to signal changes in the monetary policy stance. As I already mentioned, key in assessing the ECB’s monetary policy stance are the President’s introductory statement and the Monthly Bulletin’s editorial. If it is decided to use other means of communication to convey a change in the ECB’s monetary policy stance, the message will be so clear that nobody can miss it. Moreover, under normal circumstances, it will most likely be the President of the ECB who will convey these messages.

To conclude, one can hardly accuse the ECB of not being sufficiently transparent. Moreover, if the markets and the media take the two-pillar strategy as their point of reference in assessing the monetary policy stance, monetary policy decisions should – in general – not come as a surprise. Indeed, recent empirical evidence has shown that markets appear to be quite able to predict monetary policy actions. According to research by ECB staff, in the period under review – i.e. from 1 January 1999 to spring 2001 – financial markets were able to predict monetary policy decisions rather well. There were only two exceptions to this general rule, namely the decision to cut rates in early 1999 and the decision to cut rates on 10 May this year.

Ladies and gentlemen, I should now like to come to the “dessert” of my speech today: the consequences of the euro for countries outside the euro area, a topic which cannot be omitted from today’s conference. Of course, I refer in particular to countries like Norway [Iceland], which are not a member of the European Union, but are part of the “European family” and have close trade links with the European Union and the euro area. The euro is, however, also very relevant for other countries, in particular the so-called accession countries in southern, central and eastern Europe.

Firstly, it is important to note that there is no universal recipe or formula that can be applied by the countries concerned. Every country will have to make its own assessment of the consequences of the euro and decide upon appropriate action, if deemed necessary.

Secondly, to the extent that the euro is beneficial for economic growth in the euro area and Economic and Monetary Union provides a framework for stable, macroeconomic developments, the euro will – overall – also be beneficial to the euro area’s main trading partners. Indeed, higher economic growth in the euro area will foster trade, not only within the euro area, but also with countries outside the euro area.

The introduction of the euro might lead some countries to decide to adopt some form of exchange rate target and to use the euro as an anchor currency. In principle, there might be two complementary reasons for doing so. Some countries might decide to pursue such a policy because the euro area is a major trading partner. In this case, exchange rate stability vis-à-vis the euro is regarded as desirable to foster trade and commerce. Other countries might want to use the euro as an anchor currency to basically import the euro area’s stability-oriented policies and environment. This is particularly relevant for some of the accession countries. At the moment, the euro already plays some role as an anchor currency in 56 countries, which together represent 4% of world GDP.

Solutions adopted range from very strict – or even full – links to the euro (for instance, the use of the euro as legal tender, or other forms of “euroisation”) to looser forms of anchoring (such as peg arrangements). The Eurosystem neither pursues the internationalisation of the euro as an independent policy goal, nor does it foster or hinder the process. In other words, if countries outside the euro area want to adopt an exchange rate target featuring the euro, they are free to do so, provided that such an arrangement does not impose any obligations on the Eurosystem. Such obligations, for instance the requirement to intervene in the foreign exchange markets, might be incompatible with the ECB’s primary objective to maintain price stability. Indeed, at the moment the only multilateral exchange rate arrangement, in which the Eurosystem is involved, is ERM II, the successor to the former European Exchange Rate Mechanism. ERM II membership is a precondition for full euro area membership. At the moment, Denmark is the only “out” Member State participating in it.

Of course, there is a trade-off between adopting the euro as an anchor currency and the degree of policy flexibility. Countries that in one way or another adopt an exchange rate target have less leeway for economic adjustment via the exchange rate channel. This might be of particular relevance if the countries concerned are still catching up with the euro area, or if the business cycle of the countries concerned is not yet in sync with that of the euro area.

A rather extreme form of adjusting to the introduction of the euro is euroisation, which implies the adoption of the euro as legal tender by a country outside the euro area. Some accession countries are currently considering this option. Although euroisation has its merits, accession countries in particular should not regard it as an alternative to the exchange rate criterion in the Maastricht Treaty, which has to be complied with if a Member State wants to join the euro area. Indeed, the Treaty requires that Member States observe the normal fluctuation margins provided for by ERM II for at least two years, without devaluing against the euro. Firstly, in this respect, there should be “equal treatment” of the countries that have already introduced the euro and Member States which would like to join the euro area. The convergence process leading to the adoption of the euro, which is laid down in the Treaty, has been successful for the current euro area countries. Hence, why should new Member States not benefit from the same convergence process? Secondly, the observance of exchange rate stability is an important litmus test for the degree of convergence. It is not only a broad criterion measuring the degree of convergence on a number of counts, but it also reflects the credibility of financial markets in the convergence process, as well as the durability of the convergence achieved. The importance of the latter is explicitly acknowledged in the Treaty. Thirdly, membership of ERM II is potentially less costly for the country concerned than full euroisation.

Countries which have not adopted the euro and have not yet fully converged with the euro area might, at a certain point, still need to be able to allow their exchange rate to depreciate or appreciate.

The fluctuation margins of ERM II, set at 15% around the central parity rate agreed upon in the context of ERM II, allow a substantial deprecation or appreciation of the exchange rate. Moreover, if necessary, it can also be decided to change the central parity and to devalue or revalue the exchange rate. The latter option would still be less costly in terms of lost confidence and credibility than abandoning the policy of euroisation and reintroducing the national currency. Hence, membership of ERM II provides more flexibility for the country concerned than euroisation.

Ladies and gentlemen, I should now like to come to the conclusion of my speech today. The introduction of the euro – now almost two years ago – and the forthcoming cash changeover constitute two of the most important steps in the history of European integration. The framework in place to govern the second largest currency bloc in the world is robust and sound. The stability-oriented monetary policy strategy of the ECB is one of the key elements of this framework. It guarantees – as I have tried to explain today – the purchasing power of the euro.

The euro area is not an island. Although the introduction of the euro has made the European economies less vulnerable to external shocks, global developments still matter for the development of the euro area.

This is obviously also true for the countries outside the euro area. The euro area is too big to be overlooked or ignored.

Those countries outside the euro area having traditionally close ties with the countries that have adopted the euro are rightly considering the consequences for themselves of the introduction the euro. The conference today is proof of this. Whatever the consequences, it is important to realise that there is no tailor-made framework that countries outside the euro area can adopt. This said, I am convinced that Norway will make the right choices.