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Tuesday, May 13, 2003

A Lament For the ECB

Paul de Grauwe, Belgian nomination for an up and coming place on the board of the ECB stakes his claim. His point, last weeks ECB announcement of a new monetary policy strategy, far from clarifying things, has only produced confusion. Among other details, it's also nice to note that I'm not the only person who can't fathom the depths of Otmar Issing.

The European Central Bank has a new monetary policy strategy. Or does it? After months of research and deliberations within its governing council, the ECB last week announced a new strategy, only to deny that it constituted a change at all. How are we to make sense of this brain-teaser? The first change is clear enough. The ECB is downgrading the importance of the money supply (M3) in its monetary policy strategy - and rightly so. It did not make sense any more to pretend that the money supply was the most important variable to watch. This signal was so easily distorted by "background noise" that it was rarely a reliable indicator of future inflation. On the contrary, it often gave the wrong signal, as after September 11 2001 when investors fled into short-term assets, thereby massively increasing the money supply. Luckily, ECB policy makers had enough sense to recognise that the build-up of M3 did not signal inflation but its opposite - a risk of deflation. So the Bank did what had to be done: to disregard the money numbers. Since then, the ECB has been forced to do the same all too often. Inevitably it concluded that it was better to stop pretending that the money supply was important while everybody else could see that the measure played almost no role in the setting of interest rates.

The second change is far less clear-cut. The ECB has now defined a new inflation target. Or so it seems. When the ECB started operating in 1998 it defined price stability as a rate of inflation of at most 2 per cent over the medium term. This definition has come under increasing criticism for giving the ECB an incentive to push inflation below 2 per cent, thereby increasing the risk of deflation, especially in those countries where inflation was already significantly lower than the 2 per cent eurozone average. One could have expected the ECB to do last week what common sense dictates: announce a point target of, say, 2 per cent and allow for some leeway above and below that target. Surprisingly, it was not so sensible. In last week's communiqué the ECB first confirmed that the old definition of price stability still held - that inflation should not exceed 2 per cent over the medium term - and then added that "in the pursuit of price stability it will aim to maintain inflation rates close to 2 per cent over the medium term".

How should we interpret these seemingly contradictory statements? The last sentence could mean that the ECB has shifted to a mid-point target of 2 per cent for the rate of inflation. Many analysts have come to that conclusion. However, this interpretation would contradict the ECB's reaffirmation that nothing has changed with its definition of price stability.What an anticlimax. Instead of creating clarity, the ECB has managed to create confusion about its true intentions. There can be no doubt that this is the result of strong disagreements within the governing council - the rate-setting body comprising the 12 national central bank governors plus six permanent ECB members.

The markets demand clarity and transparency. There is now less clarity about the objectives of the ECB than before last week's announcement. So the governing council will have to start again and come up with a new strategy that satisfies the markets' demands.This new strategy should consist of the following elements. First and foremost, the ECB should switch to a more explicit inflation targeting procedure that is now increasingly adopted as best practice in central banking. This consists in defining a point target for inflation with a symmetric range around it. It further requires the central bank to announce its inflation forecast, regular information that helps the market to understand the policy actions of the central bank, thereby promoting transparency.

Second, the ECB's mandate consists not only in maintaining price stability but also in pursuing other objectives - financial stability, stabilisation of the business cycle - as long as these objectives do not interfere with price stability. Up to now the ECB has been mostly silent about this second "pillar" of its mandate. It is time for the Bank to spell out what it intends to do to meet it, or to explain why it continues to ignore it. Immediately after last week's announcement, Otmar Issing, the ECB's chief economist, declared that there was nothing new in the new monetary policy strategy. This is quite unfortunate. The new strategy creates confusion and will maintain the ECB in a defensive position. The only way for the ECB to get out of this uncomfortable position is to come up with a better strategy than the one presented last week.
Source: Financial Times

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