European Monetary System

cope with this situation and adapt his attitudes to a composite - EU and

national - institutional architecture, one that lacks the simplicity he was

used to and in which the Eurosystem now represents the most advanced

supranational component. On the other he should be prepared for the further

evolution of that same architecture. Finally, from the citizens that we all

are, it will require a deeper reflection about the multiple "social

contracts" he is part of, and the loyalties they entail.

8. CONCLUSION

I have been fortunate to operate in an environment in which no

conflict has arisen between the central banking profession I have exercised

for more than thirty years and the European conviction that, like many

persons of my generation, I matured in my youth. Since the early '80s I

have also been convinced that monetary union, i.e. a confluence of the two

motives, was desirable and possible. At the same time, the challenges for

the Eurosystem originate precisely from that confluence.

The challenges are not solely economic in their nature, nor can their

features be captured by the functional relationships economists are most

familiar with. Although partly related to economic factors, their features

are in fact tied to the special institutional environment to which the

Eurosystem now belongs. They derive from the tension between the completion

of the union in the monetary field and the incompleteness of the overall

construction. It is a tension because in that environment the notion of the

public interest is no longer as simply and statically defined as it was

when the Nation-State was an all-pervasive reality and the jurisdiction of

the central bank coincided with its jurisdiction. Inevitably, this tension

runs through the institutions of the European Union, the Eurosystem itself,

and even our minds.

A challenge is a call to a difficult task; it entails the two notions

of necessity and difficulty. The problems I have tried to describe are a

challenge not only for practitioners, but also for the academic profession,

because their solutions can hardly be found in a textbook and will only be

invented if the creativity of practitioners will be supplemented with that

of scholars.

***

Monetary policy in EMU

Prof. Otmar Issing

Member of the executive board of the European Central Bank

Washington, D.C.

6 October 1998

1. Introduction

On 1 January 1999, the curtain will ri"+ !-+ 1999\MAYOR99.DOC†[?]р?p-

-#"+ !-+ 1999\INDUSTRIAL MARKETING.DOC?[?]р?x- -#"+ !-se on a world

premiиre. For the first time in history, sovereign states will abandon

their own currencies in favour of a common currency, and transfer their

monetary policy sovereignty to a newly created supranational institution.

This process is all the more unusual from a historical perspective because

the national currencies involved are not being abolished because of their

weakness. On the contrary, proof of a large measure of monetary stability

is demanded as a precondition for participation.

The decision has been taken. The Euro will start on time. It must not

- and it will not - fail. The European System of Central Banks (ESCB) will

devote its best endeavours to making European Monetary Union (EMU) a

success.

The French president recently called this unique project a "great

collective adventure". As a central banker I am generally not in favour of

"adventures" - but who would deny that there are risks and uncertainties in

this enterprise? You should be reassured that at the European Central Bank

(ECB), we have the necessary independence, instruments and tools to deal

with these risks and uncertainties in a successful way. I will discuss some

of these in a moment.

Moreover, when considering the uncertainties implied by the

transition to Stage Three of EMU, we should not forget that Monetary Union

will also reduce, or even eliminate, a number of risks. This has already

been demonstrated, even before the actual introduction of the euro. Recent

turmoil in international financial markets did not cause any significant

disruption to exchange rates among currencies of the designated

participants in Stage Three. This is a clear demonstration of the success

of the EMU process.

Today, I will address the role of monetary policy in EMU.

First, I will make reference to the final goal of monetary policy -

the maintenance of price stability.

Second, I will discuss some important issues relating to the design

and implementation of the monetary policy strategy at the outset of Stage

Three of Monetary Union; and

Finally, I will describe some features of the operational framework

of the ESCB that have recently been finalised.

Let me begin by discussing the over-riding priority we attach to the

maintenance of price stability.

2. The priority of price stability

The Treaty on European Union - the Maastricht Treaty - stipulates

that the "primary objective of the ESCB shall be to maintain price

stability". It was left to the ESCB to provide a quantitative definition of

this primary objective. At the ECB's precursor, the European Monetary

Institute (EMI), it was agreed that, in the interests of transparency and

accountability, the ESCB's chosen operational definition of price stability

should be announced publicly. This announcement would form an important

element of the overall monetary policy strategy. Simply defining price

stability leaves open the question of why price stability is desirable. As

a central banker, the benefits of price stability appear self-evident. Any

single argument in favour of price stability cannot comprehensively

describe the benefits that it brings.

For instance, concerning the United States, Martin Feldstein has

recently shown that, in combination with taxes and social contributions,

even quite modest rates of inflation can cause considerable real economic

losses. Research at the Bundesbank has produced similar results for

Germany.

But elimination of the losses caused by this channel is only one

illustrative example among the many benefits of price stability. The

greatest contribution that the ESCB can make to the euro area's output and

employment performance is to achieve and maintain the stability of prices.

Stable prices are at the core of the 'stability culture' we are trying to

create in Europe, a culture that is the foundation of sustainable and

strong growth in the standard of living for Europe's citizens.

At the same time, the ESCB does not operate in a vacuum. Monetary

policy needs to be supported by an appropriate fiscal policy and necessary

structural reforms implemented at the national level if this 'stability

culture' is to be built on solid and sustainable foundations. The private

sector also has its part to play, notably by exercising wage moderation,

given the high levels of structural unemployment in the euro area. Progress

on all these dimensions is not only desirable, but also absolutely

necessary. Monetary policy alone cannot ensure strong, non-inflationary

growth and improved employment prospects throughout the euro area. However,

only a monetary policy focussed closely on the achievement of price

stability can lay the basis for these conditions.

Of course, that is not to say that the ESCB can, or should, ignore

broader macroeconomic considerations. For instance, the threats posed by

deflation in combination with nominal rigidities to the real economy have

to be taken into account. In order to prevent any misunderstanding, let me

be very clear: my discussion of deflation has to be seen in the context of

the formulation of an optimal definition of price stability for the ESCB

that takes into account deflationary dangers. These dangers certainly

cannot be ruled out and our definition of price stability should reflect

them. However, simply recalling the current rate of inflation in the euro

area - 1.2% - shows that deflation is not an immediate concern for policy-

makers.

While periodic and transitory falls in the price level may be normal,

and should not give rise to major concerns, a prolonged deflation is

clearly inconsistent with any meaningful definition of price stability.

Moreover, since nominal interest rates cannot fall below zero, a prolonged

deflation may render the interest rate policy of the central bank rather

ineffective. What remains is out-right purchases of assets - both foreign

and domestic.

Similarly, the ESCB cannot ignore the implications of nominal

rigidities in wages and prices for the transmission mechanism of monetary

policy. If we were to live long enough under a regime of stable prices, I

would not exclude the possibility that wage and price setting behaviour

would adapt, and nominal rigidities would finally disappear. This would

reduce some of the potential output costs of fighting inflation, and thus

increase the net long-run benefits of price stability. However, for the

time being we may have to live with these rigidities and take their effects

into account when deciding on our monetary policy strategy.

In this respect, the present situation is not easy for the ESCB.

Unemployment in the euro area is currently very high.

However, in contrast to these persistently high levels of

unemployment - which are largely structural in origin - the prospects for

maintaining price stability are currently very encouraging. Inflation

expectations and long-term interest rates in the euro area are at close to

historical lows. Actual area-wide inflation is also very subdued.

The current low 'headline' rate of inflation has been moderated

somewhat by recent falls in oil and commodity prices, themselves stemming,

in part, from the economic and financial crises in Asia and, more recently,

in Russia. However, this effect on inflation has been largely off-set by

the impact of indirect tax rises in a number of participating countries,

which have raised consumer prices for certain goods. All in all, the

changed external environment contributes to an overall outlook of very

subdued inflationary pressures.

In defining price stability, one might ideally refer to a conceptual

measure of 'core' inflation that tries to isolate monetary effects on the

price level - for which the ESCB is properly responsible - from such terms

of trade or indirect tax shocks, over which it has little immediate

control.

In our month-to-month communication with the public, 'core' measures

of inflation may prove useful. But, in its preparatory work for Monetary

Union, the EMI recognised that any sensible definition of price stability

for the euro area would have to be based on a comprehensive and harmonised

price measure. 'Core' measures of inflation typically exclude some items.

They are unlikely to be comprehensive enough to satisfy the requirements of

an index suitable for a sensible public definition. These considerations

point to using the 'headline' measure of the harmonised index of consumer

prices (or HICP) for the euro area in the definition of price stability.

Finally, the ESCB needs to build on the success of its constituent

national central banks (NCBs) in reducing inflation and achieving price

stability during the convergence process in Stage Two of EMU. Given the

current generally benign inflation outlook in the euro area that is the

product of these accomplishments, there is an understandable desire to

'lock-in' the current success in achieving price stability as well as the

apparent credibility of monetary policy, and ensure continuity with

existing central bank practice.

3. The importance of the monetary strategy for a successful start of

European monetary policy

When price stability is defined using the principles just outlined,

how should the ESCB proceed to maintain it? In achieving and maintaining

price stability - the primary objective of the Treaty - the choice of

monetary policy strategy is vital.

Within the ECB, a considerable amount of work on the monetary policy

strategy has already been completed, building to a large extent on the

substantial earlier preparatory work of the EMI. A high degree of consensus

has been reached among the NCBs and within the ECB about the main outlines

of the strategy - I will address some of these areas of agreement in a

moment. The final decision has not yet been made. But you should be

reassured that progress is being made at a good pace. I have no doubt that

we will be in a position to announce the details of the ESCB's monetary

policy strategy in good time, prior to the start of Stage Three.

Being a new institution, the European Central bank must be prepared

to come under intense scrutiny right from the start. In particular, the

international financial markets will monitor its every decision like hawks.

Facing this environment in the run-up to Monetary Union, the ESCB must

ensure that everything possible is done to make the launch of Stage Three

as tension-free as is possible. Choosing and announcing an appropriate

monetary strategy is crucial.

The monetary policy strategy is, in the first place, important for

the internal decision-making process of the ESCB - how the Governing

Council will decide on the appropriate monetary policy stance, given the

economic environment. Above all, the ESCB strategy must lead to good - that

is to say, timely and forward-looking - monetary policy decisions.

But the strategy is also of the utmost significance in communicating

with audiences outside the ESCB. It should stabilise inflation

expectations. The more the strategy helps to promote credibility and

confidence in the ESCB's monetary policy at the outset of EMU, the more

effective that policy will be - and the easier the ESCB's task of

maintaining price stability will become.

In deciding upon the appropriate monetary policy strategy, the

following aspects must be seen as essential requirements. The strategy

must:

* reinforce the ESCB's commitment to price stability, the

primary and over-riding task stipulated by the Treaty;

* it must clearly signal the anti-inflationary objectives of

the ESCB, and serve as a consistent benchmark for the

monetary policy stance; and,

* it must be transparent and explained clearly to the general

public - only then can the strategy serve as a basis for the

ESCB's accountability to the public at large.

The realisation that achievement of an optimal, non-inflationary

macroeconomic outcome may founder on the private sector's distrust has been

central to the monetary policy debate of the nineteen-eighties and

'nineties. The search for answers to the questions raised by this debate

has spawned an enormous economic literature. The keywords "time

inconsistency" and "credibility" draw forth an almost unmanageable flood of

publications that have appeared in the wake of the pioneering contributions

of Kydland / Prescott and Barro / Gordon.

The need to establish a credible and consistent monetary strategy in

the face of the well-known time inconsistency problem faced by policy

makers - the dilemma highlighted by this economic literature - is

especially important for the ESCB at the outset of Monetary Union. As a

brand new institution, the ESCB will have no track record of its own.

Building its reputation, and the associated credibility of monetary

policy, is vital. But the process of doing so is complicated by the

relatively high level of uncertainty surrounding the transition to Monetary

Union itself. The transition to Stage Three is a unique event, and will

create unique opportunities for many - but it will also create some unique

problems for monetary policy makers. At the ECB, we are addressing these

problems and are confident that the risks can be managed successfully. Many

of the difficulties we face will be overcome through our own efforts over

the coming months.

Among these problems are the difficulties involved in creating a

comprehensive and accurate database of euro area-wide statistics. Running a

single monetary policy for the euro area requires timely, reliable and

accurate euro area data. In some cases, the euro area statistics simply did

not exist until quite recently. In others, the statistics are based on new

concepts, and the properties of the data series are not yet well known. The

long runs of high quality back-data required for empirical economic

analysis may be unavailable. Those that do exist are likely to have been

constructed using some degree of estimation and judgement, possibly

rendering the econometric results produced with them questionable.

Furthermore, the regime shift associated with the adoption of the

single monetary policy may change the way expectations are formed in the

euro area, and thereby alter forward-looking economic behaviour. Monetary

policy's effects on consumption, investment, and wage bargaining - and

therefore the whole transmission mechanism of monetary policy to

developments in the price level - would be among the important economic

relationships to be affected in this way.

This may be no bad thing. Indeed, using the regime shift implied by

the transition to Stage Three to change both public and private sector

behaviour in favourable directions may be one of the largest gains that the

euro area can extract from Monetary Union. Nevertheless, these changes are

likely to complicate the implementation of certain important elements of a

monetary strategy, at least in the short term, as past relationships

between macroeconomic variables may break down. What is good for the euro

area economy as a whole may create some practical problems for the ESCB.

One example of this so-called 'Lucas critique' phenomenon is the

impact of current, very low rates of inflation on private behaviour. For

many countries participating in Monetary Union, there is simply no - or

only very recent - experience of how the private sector will behave in an

environment of sustained and credible low inflation. Instability in past

relationships may result, should behaviour change in this new, low

inflation environment. I have already argued that these structural changes

will benefit Europe's citizens - price stability will allow markets to work

more efficiently, thereby raising growth, and improving employment

prospects. But these changes may also complicate the ESCB's assessment of

economic and financial conditions.

These uncertainties - arising directly from the transition to Stage

Three itself - are both compounded by, and inter-related with, the broader

economic context in which Monetary Union will be established. The

increasing internationalisation of the global economy, and the current

rapid pace of technological change, have affected all sectors of the

economy, and the banking and financial systems in particular. For example,

at present there are many, inter-related innovations in the payments

system, such as:

* the introduction of TARGET (directly related to EMU itself);

* greater technological sophistication of payments mechanisms,

as use of computers and information technology becomes more

widespread and advanced;

* the additional incentive for cash-less payments that may

arise from the fact that for some time to come -

approximately three years - the new euro-denominated notes

and coin will not come into circulation. In particular,

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