European Monetary System

preparatory work and successful economic convergence, monetary policy is

now jointly determined for a large part of Europe by the Governing Council

of the European Central Bank. The monetary policy is implemented by the

Eurosystem, the name given to the ECB and the 11 central banks of the EU

Member States participating in Monetary Union.

The single currency is quoted on the international financial markets

and is used in non-cash payments. However, the euro will not appear as yet

in tangible form as banknotes and coins. Nonetheless there is no doubt that

this currency, which was only brought into existence on 1 January 1999,

will play an important role both within the euro area and beyond.

There is good reason for this confidence, ladies and gentlemen.

Overall the first few weeks went smoothly for the single currency and the

monetary policy of the Eurosystem. The start did not pass by entirely

without a hitch - which was not to be expected in any case, given the

significance and scale of this project - but there were no major

complications.

Monetary Union is a unique and outstanding achievement. It provides

the great opportunity to achieve the goal of lasting price stability

throughout Europe. Price stability is the best contribution that monetary

policy can make to lasting economic and employment growth in Europe. The

national governments and all those involved in collective wage bargaining

are being called on to remove the structural causes of the excessively high

unemployment. We can only hope that the introduction of the euro will spur

the implementation of structural reforms.

The stability-oriented monetary policy strategy of the Eurosystem

The Treaty establishing the European Community assigns the European

System of Central Banks (ESCB) - and thereby the Eurosystem - the primary

objective of maintaining price stability. The Governing Council will do its

utmost to fulfil this task and to explain its monetary policy so as to be

comprehensible to the general public. For this reason we have developed a

stability-oriented monetary policy which essentially consists of three main

elements.

The Governing Council has published a quantitative definition of its

primary objective, price stability. This gives clear guidance for

expectations in relation to future price developments. Price stability is

defined as an increase in the Harmonised Index of Consumer Prices of the

euro area of less than 2% compared with the previous year. The publication

of this definition provides the public and the European Parliament with a

clear benchmark against which to measure the success of the single monetary

policy, and thereby provides for the transparency and accountability of the

Eurosystem and its policy.

The wording "less than 2%" clearly defines the upper limit for the

measured inflation rate which is compatible with price stability. I do not

think I need emphasise that deflation - or a sustained fall in prices -

would be incompatible with price stability. The latest available data for

the annual rate of inflation according to the Harmonised Index of Consumer

Prices for the euro area as a whole fall within the definition of price

stability. This outcome is clearly the result, above all, of the successful

monetary policy of the national central banks in the years before the start

of Monetary Union.

The ECB has only been responsible for monetary policy for a little

more than one month. It will only be possible to judge the success of its

current policy in one to two years'time. This reflects the fact that the

transmission of monetary policy impulses is subject to relatively long and

variable time lags. The Governing Council has therefore emphasised that

price stability must be maintained in the medium term. This statement

underlines not only the need for a forward-looking approach to monetary

policy, but also takes into consideration the short-term volatility of

prices in response to non-monetary shocks which are beyond the control of

monetary policy.

In order to achieve the goal of price stability, our strategy rests,

in particular, on two "pillars". Before I explain this in more detail, I

should like to emphasise that traditional and previously established

macroeconomic relationships could change as a consequence of the

introduction of the euro. This was one key reason why neither a monetary

targeting nor a direct inflation targeting strategy could be applied. Our

strategy is also more than just a simple combination of these two

approaches. Rather, it is precisely tailored to the needs of the ECB.

The first pillar of the monetary policy strategy is a prominent role

for money. Since inflation is ultimately a monetary phenomenon in the

medium term, the money supply provides a natural "nominal anchor" for a

monetary policy geared to safe-guarding price stability. To emphasise this

prominent role, the Governing Council has published a quantitative

reference value for growth in the money supply. The first reference value

decided upon by the Governing Council for growth in M3 was 4.5% per annum

and was published on 1 December. This value is based on the above-mentioned

definition of price stability and assumes a trend growth in real gross

domestic product of 2-2.5% per annum, as well as a medium-term reduction in

the velocity of circulation of M3 of around 0.5-1% per annum.

We shall not, however, respond mechanistically to deviations from the

reference value for money supply growth, but shall first analyse them

carefully for signals relating to future price developments. Larger or

sustained deviations normally signal risks to price stability.

The second pillar of the monetary policy strategy consists in a

broadly based assessment of the outlook for price developments in the

entire euro area. This assessment will be based on a broad range of

monetary policy indicators. In particular, those variables which could

contain information on future price developments will be analysed in depth.

This analysis should not only provide information on the risks for price

development, but should also help to identify the causes of unexpected

changes in important economic variables.

Some commentators reduced this comprehensive analysis to an inflation

forecast. At the same time, there were demands for the ECB to have to

publish these forecasts in order to satisfy the need for transparency and

accountability. Therefore allow me to make this clear: our strategy

includes a comprehensive analysis of numerous indicators and several

forecasts. To focus on a single official inflation forecast of the

Eurosystem for a specific point in time would in no way accurately reflect

our internal analytical and decision-making process. It would impinge upon

the transparency and clarity of the explanation of our policy. The

publication of an official inflation forecast would also be inappropriate

with regard to the accountability of the ECB, all the more so if this

forecast were based on the assumption of no change in the monetary policy.

The success of the monetary policy of the ECB should primarily be measured

in terms of the maintenance of price stability, not the accuracy of its

conditional forecasts.

The stability-oriented monetary policy strategy of the Eurosystem,

which I have just outlined, constitutes a new and clear strategy. It

emphasises the primacy of the goal of price stability. It takes into

account the inevitable uncertainties concerning economic relationships

inherent in the transition to Monetary Union and the associated systemic

changes and guarantees a high degree of transparency.

Ladies and gentlemen, allow me to comment on certain suggestions on

the orientation of monetary policy which have recently appeared in the

press. Some of these ideas give the impression that monetary policy should

concentrate upon objectives other than price stability, since stable prices

have already been achieved. Inter alia, it has been suggested that the ECB

should react more or less mechanistically to exchange rate developments or

other variables such as, for instance, unit labour costs. Furthermore,

there were calls for monetary policy, by means of reductions in interest

rates, to be used to combat unemployment. Against this background there is

a need to set out clearly the possibilities and limitations of monetary

policy.

Both the reasoning in the Maastricht Treaty and many economic

analyses show that the best contribution the single monetary policy can

make to employment growth is to concentrate on price stability. Without

such a clear approach there is a danger that the public may question the

commitment of the Eurosystem to the goal of maintaining price stability.

Inflation expectations, risk premia and thus long-term rates would rise.

This would increase the cost of the investment which is necessary for a

sustained and lasting rise in the standard of living.

Even under the best possible circumstances, though - i.e. if it

proves to be possible to assure lasting price stability - monetary policy

alone cannot solve the major economic problems of unemployment and future

problems in social security systems.

The Governing Council regards the current high level of unemployment

in the euro area as a matter of great concern. This problem is, however,

predominantly a structural one. It is mainly the result of the rigidities

in the labour and goods markets in the euro area which have arisen partly

through an excessive and disproportionate degree of regulation. Structural

economic reforms, which target the reduction of rigidities, are the

appropriate solution. In those euro area countries in which such reforms

have been implemented unemployment figures have declined markedly. In

addition, I should like to emphasise that moderate wage developments and a

reduction in the burden of tax and social security contributions would

generally help to reduce unemployment. This would be the case even if the

country concerned did not trade heavily with its neighbouring countries.

The positive influence of low taxes and wages on employment clearly has

overall benefits from an international perspective. Such a policy should

not be denounced as "wage dumping".

Turning to the role of exchange rates between the euro and other

important currencies outside the EU, in particular the US dollar, the

Eurosystem has, in formulating its monetary policy strategy, made an

unambiguous choice. This strategy clearly rules out explicit or implicit

objectives or target zones for the euro exchange rate. The pursuit of an

exchange rate objective could easily jeopardise the maintenance of the

objective of price stability and could thereby also be detrimental to real

economic development. Target zones for exchange rates could, for example,

lead to the ECB having to raise interest rates in a recession, despite

increasing downward pressure on prices. I am sure you will agree that such

a mechanistic response to a change in the euro exchange rate would not be

optimal. Furthermore, it is important to remember that we are living in a

world with high capital mobility. Exchange rate agreements, which might

have been possible to implement until recently, are no longer feasible.

The lack of an exchange rate target does not mean that the ECB is

totally indifferent to or takes no account of the euro exchange rate. On

the contrary, the exchange rate will be observed and analysed as a

potentially important monetary policy indicator in the context of the

broadly based assessment of the outlook for price developments. A stability-

oriented monetary and fiscal policy, as stipulated by the Maastricht Treaty

and the Stability and Growth Pact, is an essential pre-condition for a

stable euro exchange rate. Of course, there is no guarantee of lasting

exchange rate stability, not even in a fixed exchange rate regime. Exchange

rate fluctuations are often caused by structural or fiscal policy,

asymmetric real shocks or conjunctural differences. Monetary policy would

clearly be overburdened if it had to prevent such movements in the exchange

rate.

We cannot and shall not gear our monetary policy towards a single

variable, whether a money supply aggregate, an index, the exchange rate or

an inflation forecast for a particular point in time. Nor can we be

involved in any ex ante co-ordination which would entail an obligation to

react to particular commitments or plans. The ECB will always carefully

analyse all relevant indicators. In this context, it is particularly

important that the economic causes of potential risks to price stability in

the euro area are understood as fully as possible. Appropriate monetary

policy decisions also depend upon the causes of unexpected changes in

important economic variables. The Governing Council must, for example, take

a view on whether changes in important indicators are of a temporary or

permanent nature, and whether a demand or supply shock is involved. In our

deliberations we also attempt to take into account how the financial

markets, consumers and firms are expected to react to monetary policy

decisions. I believe few would contest that such a complex analysis cannot

meaningfully be reduced to a more or less mechanistic reaction to a few

variables or a single official forecast.

In addition, concern was often expressed that the Eurosystem would

not act transparently enough. In this context, it was said that a

transparent monetary policy also necessitated the publication of the

minutes of the meetings of the Governing Council and disclosure of the

voting behaviour of the individual members of the Council.

For sound reasons the Governing Council decided not to adopt this

approach. The publication of individual positions could easily lead to

national influence being exerted over the individual Council members. The

members of the Governing Council must not, however, be seen as national

representatives. They decide together on the monetary policy for the euro

area as a whole. The Governing Council has committed itself to go beyond

the reporting and explanatory requirements laid down in the Treaty, which

are among the most comprehensive requirements by international standards.

On the basis of our strategy, after every first meeting in the month

I deliver to the press a detailed explanation of our assessment of the

overall economic situation and, in particular, the outlook for price

stability. The content of this so-called "introductory statement" is very

close to what other central banks refer to as minutes. In this way, the

public receives comprehensive information immediately following the

meetings of the Governing Council. In addition, each month we shall publish

a detailed report on the economic situation and monetary policy throughout

the euro area in our Bulletin. Such rapid information on the results of the

meetings of the Governing Council and the current economic analysis of the

ECB without doubt demonstrates a high degree of openness and transparency.

The most recent monetary policy decisions and operations

Co-operation between the European central banks was always very

close. In the last few months of 1998 the countries participating in the

third stage of Monetary Union co-operated more and more closely. The co-

ordinated reduction in leading rates at the beginning of December 1998

clearly showed that the currency union had begun de facto before the start

of Stage Three. This co-ordinated measure contributed substantially - as we

now know - to the stabilisation of market expectations.

For more than five weeks the ECB has been conducting monetary policy

operations, mainly in the form of reverse open market operations. The main

operation will be carried out at a weekly frequency with a maturity of two

weeks. So far, five such operations have been conducted successfully, at a

fixed interest rate of 3%.

Besides the reverse transactions which constitute the main instrument

for liquidity control and targeting interest rates, the Eurosystem offers

two "standing" facilities: the marginal lending facility and the deposit

facility. These can be accessed by credit institutions via the national

central banks. The marginal lending facility is primarily a safety valve

for short-term liquidity shortages in the banking system and thereby limits

upward movements in money market rates. To some extent, its counterpart is

the short-term deposit facility, which is used to absorb short-term

liquidity surpluses. This forms the lower limit for money market rates. For

the start of Monetary Union the interest rate on the deposit facility was

set at 2% and the rate on the marginal lending facility was set at 4.5%.

As a transitional measure, the Governing Council decided to establish

a narrow corridor of 2.75-3.25% between the rates on the marginal lending

facility and the deposit facility from 4 to 21 January 1999. The intention

was to facilitate the necessary adjustment to the new institutional

environment brought about by the transition to Stage Three. As already

announced, on 21 January 1999 it was decided to return to the rates on the

two "standing" facilities that were set for the start of the single

monetary policy. Since 22 January 1999, therefore, the rate on the deposit

facility has been 2% and the rate on the marginal lending facility has been

4.5%.

A critical factor in this decision was the behaviour of the money

market for the euro area as a whole since the beginning of the year. The

Governing Council established that over time there had been a marked

reduction in the difficulties experienced by some market participants with

the introduction of the integrated money market and, in particular, with

cross-border liquidity flows. All in all, the integration of the money

market in the euro area reached a satisfactory stage only three weeks after

its implementation. In analysing the money market it should be noted that,

inter alia, there can be a marked difference between ECB interest rates and

short-term market rates. On the one hand, market rates may include credit

risk premia, and on the other, expectations may lead to differences between

the two rates.

At its meeting last Thursday the Governing Council confirmed its

earlier assessment of the outlook for price stability. Therefore it was

decided to leave the conditions for the next main refinancing operations,

on 10 and 17 February 1999, unchanged. They will be carried out as volume

tenders at a fixed rate of 3%, the same conditions as the last such

monetary policy operations.

In addition, in recent weeks the first longer-term open market

operations were also conducted, in the form of reverse transactions. These

were carried out on 14 January 1999 in three parallel tender procedures

with maturities of one, two and three months. The fixed rate tender

procedure was used. By contrast with the regular main refinancing

operations, the Eurosystem does not use these longer-term operations to

send signals to the market and therefore usually acts as a price-taker. The

ECB thus gives advance indication of the planned allocation. The interest

rates which arise from these monetary policy operations should therefore be

seen as indicators of prevailing market conditions.

Regular assessment of the monetary, financial and economic situation

To conclude, I should like briefly to report on the Governing

Council’s current assessment of the monetary, financial and economic

situation. On the basis of these assessments the Governing Council decided

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