Inflation targeting: a view from the ECB

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In the presence of such Knightian uncertainty, in October 1998 the Governing Council of the ECB announced its monetary policy strategy. The designed strategy was a novel one, suited to the special and still partially unknown characteristics of the euro area, and different in a number of respects from other current and past strategies.

Three aspects of the ECB strategy are critical. First, its focus on the price stability objective: Price stability is enshrined in the Treaty on European Union as being the primary objective of the ECB. The ECB Governing Council therefore provided a quantitative definition of price stability as a year-on-year increase of the Harmonized Index of Consumer Prices (HICP) below 2 percent. (15) A second, closely related element, is the medium-term orientation of our policy. Central banks can only affect the price level with "long and uncertain lags"; consequently they cannot be overambitious and try to steer price developments in the short run, nor should they seek to precisely define the horizon of their action. Moreover they need to respond gradually to economic shocks, taking output fluctuations into account. A third element of the strategy relates to the analyses and economic perspectives that ultimately guide policy decisions. The strategy recognizes the need for a comprehensive analysis of economic and financial shocks and dynamics but, at the same time, it attaches a privileged role to indicators based on monetary aggregates. This organization of the information has been labeled the "two-pillar" strategy of the ECB. The ECB's monetary policy strategy was meant to provide a transparent and consistent conceptual framework: structuring the internal analysis of the economic situation and risks to price stability, facilitating the decisionmaking process in the Governing Council, and communicating policy decisions to the public at large.

In almost five years of experience with the ECB monetary policy, the strategy has served all these functions to a high level of satisfaction. The ECB has pursued its mandate of maintaining price stability with vigor and determination, gaining a high level of credibility from the outset. This achievement is all the more remarkable given that the ECB started without a track record and in an uncertain environment. Testifying to this success, inflation expectations, as measured by survey data and by financial market indicators, have remained consistent with our definition of price stability. (16)

In December 2002 the ECB announced the decision to conduct a comprehensive review of its strategy. This decision was sometimes wrongly interpreted by observers as an implicit indication of dissatisfaction with the strategy. In fact, the opposite was true. To ensure the continued satisfactory development of the strategy in a complex and changing environment, it was only natural that, after more than four years of experience, the ECB Governing Council would want to look back and reflect in a systematic way on past experience. The outcome of the strategy review was made public on May 8, 2003, and it aimed primarily at addressing certain misunderstandings that have emerged in our communication with the public. (17)

Regarding the definition of price stability, the Governing Council confirmed the explicit quantitative definition announced back in October 1998. However, in continuing with the past conduct of monetary policy, the Governing Council clarified that in the pursuit of price stability it will aim to maintain inflation rates below but close to 2 percent over the medium term. This clarification emphasizes the need for a sufficient safety margin against the risk of deflation and at the same time is also sufficient to cover the potential presence of a measurement bias in the HICP and the implications of inflation differentials of a structural nature within the euro area.

Regarding the role of money in the strategy framework, the Governing Council confirmed that the strategy's two-pillar framework is an effective tool for organizing the information used to assess the risks to price stability. As discussed in the previous section, the economic literature confirms that integrating the analysis of monetary aggregates with the analysis of conditions on the goods and labor markets in a unified model remains an elusive challenge. Different types of analysis provide information relevant for price developments at different time horizons. What we labeled as economic analysis focuses on the most proximate causes of inflation, such as cost developments and demand-supply imbalances, and primarily contributes to the assessment of short- to medium-term economic dynamics and the risks to price stability at that horizon. Monetary analysis, on the other hand, focuses instead on the ultimate monetary determinants of inflation, and primarily contains information for assessing price trends at medium- to long-term horizons. The Governing Council clarified that the monetary analysis mainly serves as a means of cross-checking, from a medium- to long-term perspective, the short- to medium-term indications coming from the economic analysis.

Let me emphasize the role of the cross-checking All the information coming from different sources, such as short-term conjunctural indicators, quarterly macroeconomic forecasts, the analysis of asset prices and monetary aggregates, have to be compared and properly evaluated to come to an overall assessment of the monetary policy stance. This ensures that, while responding to economic shocks as they manifest themselves, we do not lose sight of the fact that, in the longer term, developments in money need to be consistent with our objective. This helps, in my view, to give a sense of direction and impart a steady course to the conduct of monetary policy.

The Eurosystem staff macroeconomic projections (18) are one important input into the monetary policy decision as a way of organizing a large amount of information and helping to create a consistent picture of possible future developments, but without making them the sole input for the conduct of monetary policy. As discussed in the previous section, forecasts cannot be, per se, a sufficient statistic for policy, nor can they contain all relevant information, not least because the models underlying the forecast are inevitably misspecified to some extent.

There are instances that standard macroeconomic models, which, by definition, are constructed to replicate normal conditions and regularities in the economy, are unable to capture and incorporate. This is particularly the case when large shocks or special circumstances arise, such as episodes of financial instability or asset price bubbles. I am merely recalling the developments over the past two to three years, when we faced exceptional uncertainties and major stock market movements followed by large portfolio adjustment. How those past events can be squared with forecasts of inflation and output, based on models in which financial assets do not play any active role, is still an open issue both for central bankers and academics. In such occasions the need of careful judgment, of a broadening of the horizon for the conduct of policy, and of the consideration of non-standard indicators and different interpretations of the evidence become especially relevant. (19)

Source: Findarticles.com

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