THE CENTRAL BANK THAT HAS MISSED THE POINT
Published in the Financial Times, May, 2003
The new policy strategy of the ECB The ECB has a new monetary policy strategy. It was announced last week after months of research and deliberations within the Governing Council of the ECB. What is this new strategy and should we be happy about it?
First the ECB is downgrading the importance of the money stock (M3) in its monetary policy strategy, and rightly so. It just did not make sense anymore to pretend that the money stock is the most important variable to watch. This variable is so much polluted by noise that it rarely gave the right warning signal of future inflation. On the contrary it often gave the wrong signal like when, after September 11, investors fled into short-term assets, thereby massively increasing the money stock (M3). Luckily the ECB policy makers had enough common sense to recognize that the build-up of M3 was not signalling inflation, but its opposite, a risk of deflation. And the ECB did what had to be done: disregard the money numbers.
Since then, the ECB has been forced to do the same all too often. And inevitably it came to the conclusion that it is better to stop pretending that the money stock is very important while everybody can see that in actual fact the money stock plays almost no role in the policies of the ECB. Thus, this part of the new strategy is certainly a step forward.
What about the second part? The ECB has now defined a new inflation target. Or so it seems. When the ECB started its operation in 1998 it defined price stability to be a rate of inflation of at most 2% over the medium term. This definition came under increasing criticism mainly because it gave the ECB an incentive to push the rate of inflation below 2% thereby increasing the risk of deflation, especially in those countries were inflation was already significantly lower than 2%. One could have expected that last week the ECB would have done what common sense dictates, i.e. announcing a point target of, say, 2% and allowing for some leeway above and below that target. Surprisingly, it did not follow this common sense strategy. In its communiqué of last Thursday the Governing Council of the ECB first confirmed that the old definition of price stability still holds, i.e. that inflation should not exceed 2% over the medium term, and then added that “in the pursuit of price stability it will aim to maintain inflation rates close to 2% over the medium term”.
How to interpret these seemingly contradictory statements? The last sentence could mean that the ECB has shifted to a midpoint target of 2% for the rate of inflation. Quite a lot of analysts came to that conclusion. This interpretation, however, is in contradiction with the ECB’s reaffirmation that nothing has changed with its definition of price stability, which is that inflation should not exceed 2%.
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 markets demand clarity and transparency. There is now less clarity about the objectives of the ECB than before the announcement of the new strategy. The result of all this is that the Governing Council will have to do its work all over again, and come up with a new strategy that satisfies the markets’ desire for clarity.
This new strategy will have to consist of the following elements. First and foremost, the ECB will have to switch to a more explicit inflation targeting procedure that is now increasingly used as the 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. This announcement 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) if these objectives do not interfere with price stability. Up to now the ECB has been mostly silent about this second part of its mandate. It is time for the ECB to clarify this second “pillar” of its mandate.
Immediately after the announcement of the new policy strategy, the chief economist of the Bank, Otmar Issing, came out warning that there is nothing new in the new monetary policy strategy. This is quite unfortunate. A change in strategy is needed. What we now have is unsatisfactory. The new strategy creates confusion and will maintain the ECB in a defensive position. It can only get out of this by coming up with a better strategy than the one presented last week.