1. The Eurosystems’ monetary policy strategy Maarten Hendrikx Economics & Research Division Monetary Policy Department Operational Monetary Policy Seminar De Nederlandsche Bank April 11, 2006

2. Outline for this presentation 1.The European System of Central Banks 2.Monetary policy strategy of the eurosystem 3.Monetary policy in practice

3. The European System of Central Banks (ESCB) Treaty on European Community and Statute of ESCB ESCB: ECB + NCB’s of EU-member states Eurosystem: ECB + 13 NCB’s of EMU-member states Every first Thursday of the month: monetary meeting of the Governing council: ECB Executive board (6) + Governors of EMU NCB’s (13)

4. Goal of ESCB: price stability (art. 105 EU-treaty) “The primary objective of the ESCB shall be to maintain price stability” “Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community [….]” These include: i) a high level of employment, and ii) sustainable and non-inflationary growth So: growth and employment are secondary to price stability!!

5. Why is price stability the primary objective? Low and stable inflation enhances prosperity and potential economic growth In the long-run: monetary policy will only influence inflation and cannot influence the real economy (growth and employment) In the short-run: a trade-off exists, but too much emphasis on economic growth led to large policy mistakes in the past (stagflation in the 1970s)

6. Political independence of the ESCB (art. 108 EC-treaty) “When exercising the powers and carrying out the tasks […], neither the ECB, nor an NCB, nor any member of their decision making bodies shall seek or take instructions: i) from Community institutions or bodies, ii) from any government of a Member State, or iii) from any other body” Community institutions, bodies and governments respect this principle, and do not seek to influence the decision making bodies of the ECB or NCBs

7. Policy instrument: short term interest rate The instrument ultimately affects the goal: a change in interest rates influences the price level. This is “monetary transmission”. Various transmission channels. Some examples: Through bank lending rates, asset prices, exchange rates, (inflation) expectations,  real economy (consumption/investment/net exports)  price level

8. However: the effect of interest rate instrument is uncertain Monetary transmission is uncertain: long, variable and uncertain time lags after an interest rate change.  monetary policy should be forward looking! Moreover: the economy is uncertain too! Continuously subject to shocks. Inflationary  oil price or euro exchange rate Economic  world trade, share prices “Monetary policy is an art, not a science”? Monetary policy strategy is necessary

9. Eurosystem monetary policy strategy (I): definition of price stability Quantitative definition “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%” ECB: aim at below but close to 2% Pursue over the medium term Definition: enhances credibility and anchors inflation expectations. Adds to transparency and accountability of the ECB.

10. Eurosystem monetary policy strategy (II): two-pillar framework Analyse economic developments, in order to assess risks to price stability. On the basis of two analytical perspectives, or “pillars” Economic pillar: risks to price developments on short to medium term. Mostly real economic indicators and financial developments Monetary pillar: based on medium to long run relation between monetary developments and inflation Cross check

11. Economic pillar All economic developments that are relevant for price stability in the medium term For instance: inflation, economic growth, labour market, exchange rate, etc. etc. Analytical framework: bring these developments together in a macroeconomic model and make projections (BMPE) Projections are important, but not all-encompassing

12. Monetary pillar In the long run, an increase in money supply leads to a higher price level Reference value for the growth of money supply (M3): 4,5% a year. On the basis of inflation (2%), potential growth (2-2½%) and decreasing money velocity (½-1%) Do not apply mechanically, but assess underlying developments (for instance credit growth)

13. Conclusion parts 1 & 2: ESCB has price stability as primary goal ESCB uses the interest rate as an instrument to achieve this goal This is difficult, due to uncertainty in the economy and in monetary transmission Monetary policy strategy: quantitative target for price stability, in combination with analysis in two-pillar strategy Governing council decides every month on interest rates, on the basis of this analysis

14. Part 3: monetary policy in practice How do analysis and discussions on monetary policy go in practice? Short overview of recent developments regarding inflation, business cycle and monetary developments in the euro area Implications for current monetary policy

15. Economic pillar (I): Inflation

16. Economic pillar (II): Inflation

17. Economic pillar (III): exchange rate

18. Economic pillar (IV): GDP-growth

19. Economic pillar (V): business-cycle

20. Economic pillar (VI): Taylor-rule

21. Monetary pillar (I): M3 and credit growth

22. Monetary pillar (II): House prices

23. Interest rate decision