STRASBOURG, France — In October 1998, just before the start of the European Monetary Union, the Governing Council of the European Central Bank (ECB) adopted a stability-oriented monetary policy strategy comprising three elements. The first was a commitment to the primary goal of the ECB — safeguarding price stability. Price stability was defined as an annual increase in the price level of no more than 2 percent over the medium term.
The other two elements served as a means of assessing risks to price stability and soon became famous under the headline of “two pillars”:
(1) Analysis of information from various monetary and credit aggregates for figuring out risks to price stability over the medium to long run.
(2) Analysis of a wide set of domestic and international economic indicators from real-time financial sectors (wages, import prices, interest and exchange rates, etc.) for assessing short- to medium-term price developments.
In the standard model of the neo-Keynesian approach, which increasingly has become “state of the art,” the usefulness of money to monetary policy analysis is challenged. There is no need for monetary cross-checking, as monetary analysis does not add value and is superfluous. I am not convinced.
Customary inflation forecasts and economic analysis alone are not a sufficient basis for monetary policy decisions. The time horizon for inflation forecasts is usually only one to two years; beyond that it gets highly uncertain.
Moreover, while monetary policy must always be conducted with uncertainty, the ECB was confronted with a situation of extreme uncertainty. There was uncertainty concerning the state of the economy, since the data situation was very unsatisfactory.
Unobservable indicators such as the output gap, which plays a central role, for example, in neo-Keynesian recommendations for monetary policy, are generally known to be very difficult to estimate in real time. Estimates for the output gap of the euro-zone at the time were especially doubtful, as data from different international institutions varied widely and was revised substantially later on.
Nor was it clear which models provide the most reasonable account of the functioning of the economy, especially when more or less heterogeneous countries were to form a monetary union. This was compounded by strategic uncertainty related to how markets, investors and consumers would react to the replacement of national currencies with the euro.
In this highly uncertain environment, monetary policy decisions that did not rely on a solid framework posed a risk of substantial policy errors that could have dealt a deadly blow to the central bank’s reputation. Thus the ECB needed to rely on the few robust results that theory and experience provide. The long-term connection between money supply and prices is among the more robust relationships.
The statement that “Inflation is always and everywhere a monetary phenomenon,” by the late Nobel laureate Milton Friedman, has never lost its validity. And who would deny that monetary policy has to do with money? Certainly, monetary analysis is no easy task, though this is true for all relevant economic explanations.
No question, the neo-Keynesian approach is useful for a central bank’s policy analysis. Including monetary analysis in a monetary policy strategy is vital to the central bank’s decision-making process. It would be strange to suggest that any central bank could ignore the information from money.
Many studies have shown that most major asset price-inflation episodes have been accompanied, if not preceded, by strong growth of money and/or credit. The question is not whether to include monetary analysis in monetary policy strategy, but how to reconcile the results from monetary and economic analyses to a comprehensive and consistent assessment of the risks to price stability. According to ECB strategy, this is the role of cross-checking.
It is not surprising that, in a world of low inflation, central banks as well as academics have lost interest in “money.” One can only hope that the world does not have to go through the same process of pathological learning via high inflation that followed the neglect of money during the 1950s and ’60s.
After all, is it not premature — if not plainly arrogant — to claim that all the evidence collected over many centuries and across numerous countries has lost any meaning for the present and the future? Can models without an explicit, well-developed financial sector be expected to explain an economic world in which financial markets play an ever-increasing role? How could central banks, which depend on these financial markets to serve as the transmission mechanism of monetary policy, possibly rely on such models?
The ECB has never claimed that its strategy is the ultimate solution to the challenges that confront monetary policy. But it has recognized the need to include monetary analysis — in a very broad sense — into its policy considerations.
The two-pillar strategy responds to the fact that we still lack a model that encompasses both dimensions — economic and monetary — in a consistent and robust manner. As long as such a “one-pillar-approach” is unavailable, there is no convincing reason why the ECB should change a strategy that has allowed it to establish a remarkable track record.
By subscribing, you can help us get the story right.