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. This strategy comprises three elements: First and foremost it contains a clear commitment to the primary goal of the ECB, which is to safeguard price stability. Price stability was defined as an annual increase in the price level of below two percent over the medium term.
The other two elements, which soon became famous under the headline of “two pillars”, serve as a means to assess the risks to the goal of price stability . The monetary analysis pillar comprises all information coming from various monetary and credit aggregates and serves to figure out the risks to price stability over the medium- to long-run . The economic analysis pillar is based on a wide set of domestic and international economic indicators from the real and financial sectors (wages, import prices, interest and exchange rates etc.). It provides a basis for the assessment of short- to medium-term price developments.
This two pillar approach constitutes a framework for cross-checking indications from the shorter-term economic analysis with those from the longer-term monetary analysis in order to obtain a robust view about the risks to price stability.
In the standard model of the neo-keynesian approach, which has become more and more “state-of-the-art”, the usefulness of money to monetary policy analysis is challenged; there is no need for monetary cross-checking, monetary analysis has no value-added and is superfluous. I am not convinced by these arguments. Customary inflation forecasts and economic analysis alone are not a sufficient basis for monetary policy decisions. While such decisions must not ignore longer-term developments, the time horizon for inflation forecasts is usually only one to two years, beyond it gets highly uncertain.
Moreover, while monetary policy has always to be conducted under uncertainty, the ECB was confronted with a situation of extreme uncertainty. There was uncertainty concerning the state of the economy. The data situation around the start was very unsatisfactory. Unobservable indicators like the output gap, which plays e.g. a central role 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 area at that time were especially doubtful with data coming from different international institutions varying widely, and being revised substantially at later stages. Nor was it clear which models provide the most reasonable account of the functioning of the economy, especially in a case where 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 which did not rely on a solid framework could have been misguided. This posed a risk of substantial policy errors, which would have constituted a deadly blow on reputation, the most important capital of any central bank. Thus the ECB needed to rely on the few robust results theory and experience can provide. The long-run connection between money and price developments is among the most robust economic relationships. “Inflation is always and everywhere a monetary phenomenon”. This statement 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. But 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 also shown that there is hardly any major asset price inflation episode which was not accompanied if not preceded by strong growth of money and/or credit.
The question is not whether or not to include monetary analysis in the monetary policy strategy, but how to reconcile the results from the monetary and the economic analyses to achieve a comprehensive and consistent assessment of the risks to price stability. In the strategy of the ECB this is the role of crosschecking.
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 which followed the neglect of money during the fifties and sixties of the last century. After all, is it not premature – if not plainly arrogant- to claim that all this 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 monetary policy is confronted with. But, it has recognised the need to include monetary analysis – in a very broad sense – into its policy considerations. And the strategy was flexible enough to integrate the broadening and deepening of both the monetary and economic analysis.
The two pillar strategy responds to the fact that we (still) lack a model which encompasses both dimensions, the economic or real and the 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 which has served it well and allowed it to establish a remarkable track record.