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The ECB’s Monetary Analysis Revisited

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The European Central Bank at Ten

Abstract

Money plays an important role in the European Central Bank’s (ECB’s) monetary policy strategy. According to the ECB, monetary analysis (formerly known as the “monetary pillar”) helps to guide the policy-making process of the Governing Council by providing information on “medium to long-term trends in inflation, given the close relationship between money and prices over extended horizons” (ECB, 2003a, p. 79). It also serves as a communication device by stressing the ECB commitment to price stability. While a certain proximity to the monetary targeting framework of the German Bundesbank was intentional when the ECB announced its strategy, the ECB later made it clear that monetary analysis is neither its sole nor its most important guide to policy decisions. Today, the prime function of monetary analysis is to serve “as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications coming from economic analysis” (ECB, 2003a, p. 87), which is a broad-based analysis of price developments in the short to medium run based on non-monetary indicators. Still, the continued explicit reliance on money to guide monetary policy is a distinguishing feature of the ECB’s framework compared to that of other central banks.

The views expressed herein are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.

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Notes

  1. 1.

    See Beyer and Reichlin (2008).

  2. 2.

    This exchange was reflected in a speech by Banque de France Governor Christian Noyer (2007), who suggested excluding from the ECB’s money growth figures growth stemming from money holding by private equity or investment funds. ECB Vice-President Lucas Papademos, also in a public appearance, was later reported to refute the idea, however, pointing to the role of the broader aggregate as an inflation indicator (Reuters, 2007). Bloomberg (2007) reported around the same time that ECB President Claude Trichet and German Bundesbank Governor Axel Weber in public supported an important role for money in ECB monetary policy (see also Dow Jones, 2007).

  3. 3.

    According to the ECB (1999, p. 43), in addition to the guiding goal of price stability, the monetary strategy “imposes a clear structure on the policy-making process” and is a “vehicle for communicating with the public”. See also ECB (2004a). In what follows, we focus only on the two latter elements.

  4. 4.

    The notion of monetary analysis as a “cross check” of economic analysis also implies that both approaches apply to the same policy-relevant time horizon (see e.g., Jaeger, 2003).

  5. 5.

    The ECB is constantly working on improving its monetary analysis. For example, Papademos (2006, p. 4) points out that the ECB is carrying out research aimed at “…incorporating a richer financial sector into dynamic stochastic general equilibrium models, in order to study the role of financial variables in the conduct of monetary policy”. He goes on to note that (p. 5) “…the monetary analysis of the ECB has evolved over time and is fairly comprehensive, going beyond the standard assessment based on the quantity theory of money and the stability of money demand”. Beyond the improvements of the macroeconomic part of the monetary analysis, Papademos (2006, p. 6) also emphasis “the usefulness of monitoring and assessing monetary and credit developments…for the safeguarding of financial stability”.

  6. 6.

    More recently, Fatás, Mihov and Rose (2007) showed that empirically any (and not just monetary) nominal target that is systematically achieved by the central bank is associated with low inflation.

  7. 7.

    See also European Central Bank (2003a, p. 79) and Issing, Angeloni, Gaspar, Klöckers, Masuch, Nicoletti-Altimari, Rostagno, and Smets (2003).

  8. 8.

    Unless otherwise stated, all variables in Sects. 3.3.1 and 3.3.2 are defined as (log) deviations from the steady state marked by a “^”.

  9. 9.

    Equilibrium determinacy is discussed, for instance, in Woodford (2003). Also see Sect. 3.3.2. Note that, except for the notation in deviations from the steady state, Eq. 3.3 is similar to a forward-looking Taylor rule with inertia, where the central bank reacts to deviations of inflation from its inflation target (assumed to be identical with the steady state) and the output gap from its steady state (assumed to compatible with the inflation target).

  10. 10.

    Fischer, Lenza, Pill and Reichlin (2008) stress that the ECB’s Quarterly Monetary Assessment is mostly (albeit not exclusively) targeted at medium- to long-term inflation forecasting. See also the background study by Masuch, Nicoletti, Altimari, Rostagno and Pill (2003).

  11. 11.

    As far as the aggregate implications are concerned, the non-separability argument is conceptually close the idea that real monetary balances have a direct demand effect in the tradition of Pigou and Patinkin. Ireland (2001) develops a real balance effect in a cash-in-advance DSGE framework under separable utility. However, the real balance effect has been met with skepticism, owing, in part, to the dominance of non-money holdings in private wealth and the fact that outside money (i.e. currency in circulation) is only a small fraction of monetary aggregates (see Nelson, 2003; Brand, Reimers and Seitz, 2003). The Bundesbank (2005) summarizes the evidence on the real balance model as weak at best for the US, the UK, and the euro area as a whole.

  12. 12.

    Note that—assuming a standard household utility function u(.) with u c , u m > 0, u cc , u mm < 0, and u cm > 0—the direct and indirect impact of contemporaneous money on inflation move into opposite directions, with the overall impact being a question of the underlying parameters and, thus, ultimately an empirical matter.

  13. 13.

    A variant of the above model introduces, in addition, non-separability across period—that is, habit persistence in consumption. Andrés, López-Salido and Nelson (2007) show that this adds inertia to output and inflation, and money demand conveys forward-looking information on output similar to what we discuss in Sect. 3.4 around Eq. 3.8.

  14. 14.

    The results of Kremer et al. (2003) are more pronounced in some time samples than others. Also note that their solution technique deviates from Ireland (2004) and Andrés et al. (2006) in that it does not force a non-explosive solution in the Taylor-type rule.

  15. 15.

    See also Brand et al. (2003). Masuch et al. (2003) discuss empirical evidence supporting the view that the money stock serves as a proxy for a spectrum of interest rates. As Nelson (2002) shows, the adjustment-cost approach discussed below can be interpreted as a simple formalization of this idea within a DSGE model.

  16. 16.

    Svensson (2003b, p. 1070), too, calls the idea of money as an indicator variable “the potentially most useful role for money in monetary policy analysis”. See also Smets (2003).

  17. 17.

    Stepping outside the DSGE approach, he looks at a simple economy with a Phillips curve and a standard money demand function. If the productivity increase was fully accommodated by output growth, inflation would remain constant but the money stock would (still) increase.

  18. 18.

    Fischer et al. (2008) also document at some length how the increasing importance of portfolio-related changes for the development of monetary aggregates from the year 2001 onward have reduced the usefulness of mechanical money demand functions for the ECB’s Quarterly Monetary Assessment.

  19. 19.

    Also see Orphanides (2003). The concept of potential output in current New Keynesian DSGE models is not necessarily identical with the long-run trend of output. See, for example, Clarida et al. (1999) and Woodford (2003) for a discussion.

  20. 20.

    Given potential output, the link to inflation would be provided by a dynamic AS-equation such as Eq. 3.1. The fact that monetary policy involves complex transmission processes, including port-folio rebalancing, has also recently been stressed by Goodfriend (2000).

  21. 21.

    Note that a simple cash-in-advance constraint of the form M t−1 /P t−1  > Y t (with P indicating the price level and M the nominal level of the money stock) would, in principle, also create forward-looking behavior of households or investors. The standard assumption is M t /P t  > Y t , which is mimicked by money-in-utility frameworks where the contemporaneous money stock enters the utility function.

  22. 22.

    Habit persistence in consumption would further enrich the dynamics of Eq. 3.8. As Nelson (2002) notes, one interpretation of the equation is that it illustrates the dependence of money demand on long-run asset prices (i.e. interest rates) in the spirit of Meltzer’s (2001) argument discussed earlier. See Coenen et al. (2005) for a related discussion.

  23. 23.

    In general, this will also hold for a policy rule conditioning the interest rate on expected inflation. Assume, for instance, the central bank does not observe the output gap. Based on Eq. 3.5, neither current inflation nor expected inflation will be perfectly correlated with the output gap. Thus money is always likely to add to the central bank’s information set because, just like the output gap itself, it depends on the future time path of interest rates (see also Nelson, 2002).

  24. 24.

    In a broadly related result, Leeper and Roush (2003) find that adding a monetary argument to the interest rates equation improves the fit of empirical impulse responses to monetary shocks for US data (see, e.g., Leeper, Sims and Zah, 1996 and Christiano, Eichenbaum and Evans, 1998 for earlier work). Smets (2003) interprets this as supporting the informational content of money.

  25. 25.

    Also see, for instance, recent contributions from Christiano and Rostagno (2001), Christiano et al. (2005), and Goodfriend and McCallum (2007).

  26. 26.

    The same holds for the reduction in the stringency of reserve requirements. For the US case, Loutskina and Strahan (2008) show empirically how financial innovation, in particular securitization, has reduced the impact of lending conditions set by monetary policy on credit supply.

  27. 27.

    See Bernanke (2007). Making a related point, Van den Heuvel (2007) models bank lending in the presence of capital adequacy regulations but without reserve requirements. The results imply lending will depend, among other things, on banks’ financial structure and interest rates.

  28. 28.

    On the financial accelerator, Greiber and Setzer (2007) and Bundesbank (2005) report that expansionary monetary conditions have positive feedback effects on housing prices, which Greiber and Setzer (2007, p. 2) take to imply that “a stronger case can be made for … the indicator properties of money.” See, however, the discussion above.

  29. 29.

    McCallum (2001), von Hagen (2004), and Masuch et al. (2003), among others, make similar points.

  30. 30.

    As Woodford (2003) shows, the determinacy conditions may involve both lower- and upper-bounds for the reaction to state variables if the Taylor-type rule is forward-looking and the κ ≥ 0.

  31. 31.

    See also Christiano and Rostagno (2001), Benhabib, Schmitt-Grohe and Uribe (2001a), and Carlstrom and Fuerst (2002). As Christiano et al. (2008) explain, balance-sheet effects along the lines previously discussed could also be part of the supply-side impact of interest rates.

  32. 32.

    Galí et al. (2004, p.31) stress that rules that bind the central bank’s nominal policy rate to endogenous variables, including real variables, can be interpreted as a commitment to as money supply target—albeit one that excludes money: “A commitment to a money-supply target implies a commitment to raise nominal interest rates at a certain rate in response to increases in the general level of prices above that characteristic for the optimal equilibrium, and similarly to raise interest rates in response to increases in real activity; otherwise, the central bank would be accommodating the increased money demand that would result from increases in either prices or real activity”.

  33. 33.

    Similar conclusions seem to hold for the related debate on multiple global equilibria. As, for instance, Benhabib et al. (2001a, b) demonstrate, local determinacy may go hand-in-hand with global indeterminacy—for instance, in the case of a self-fulfilling deflationary trap where the nominal interest rate drops to its zero lower bound. However, Woodford (2003) argues that some plausible learning processes can ensure that the forces anchoring the locally stable equilibrium also anchor the global equilibrium if shocks to expectations are not too large. Moreover, the problem of globally indeterminate equilibria is not confined to Taylor-type rules and can also occur under monetary strategies based on money targeting.

  34. 34.

    See, among others, Hallman, Porter and Small (1991), Tödter and Reimers (1997), Neumann (1997), Orphanides and Porter (2000), and Masuch, Pill and Willeke (2001).

  35. 35.

    Unless otherwise stated, all variables in Sect. 3.3 are defined as (log) levels.

  36. 36.

    Equation 3.9 nests a number of P* approaches. Hallman et al. (1991), for instance, assume α = 1, which seems to be in line with Reynard’s (2007) empirical observation that the price gap influences inflation with considerable lags and some persistence.

  37. 37.

    As discussed, the other channel works through the demand (or Euler) equation (Eq. 3.6), and both interact in the general equilibrium. In addition, the parameters in Eq. 3.5 are structural in nature.

  38. 38.

    See Benati (2005), Gerlach and Svensson (2003), Jaeger (2003), Neumann and Greiber (2004), Christiano and Fitzgerald (2003), Backhus and Kehoe (1992), or Lucas (1980) for other (also mostly empirical) work in the same direction.

  39. 39.

    The difference to the P* model is less pronounced in Gerlach and Svensson’s (2003) specification of the two-pillar Phillips curve which is based on the real money gap instead of long-run excess money growth.

  40. 40.

    See Bordes and Clerc (2007) for a similar discussion of the underpinnings of Eq. 3.13. Interestingly, according to Gerlach (2004), the ECB (2001b) in an early description of its policy framework explicitly allowed for the possibility of a direct impact of money on inflation expectations—a statement that was removed from later editions of the book (ECB, 2004a, b).

  41. 41.

    Compare Nelson (2007) and Beck and Wieland (2007b), who discuss the two-pillar Phillips curve but ultimately reject it as a-theoretical. Ireland (2004), too, states that a thorough analysis of the role of real balances in the macro economy may require more than adding money to the Phillips curve.

  42. 42.

    Yet another strand of research, as e.g. in Stavrev (2006) and Hofmann (2008), combines a variety of approaches for inflation forecasting. While perhaps helpful as a forecasting tool, this approach provides little guidance for the question at hand.

  43. 43.

    All models are initially estimated over the same training period, 1993Q1–1999Q4, and their inflation forecasting performance is assessed for the period 2000Q1–2007Q2. See Berger and Stavrev (2008).

  44. 44.

    The adjustment cost results are particularly interesting because Berger and Stavrev (2008) condition the central bank’s interest rate function on model-consistent expected inflation. The improvement in forecasting accuracy from incorporating monetary factors in the interest rate rule suggests that money supplies additional information. As discussed in Sect. 3.3.2, one reason could be that because of informational frictions the central bank does not fully observe the state of the economy reflected, in part, in monetary developments.

  45. 45.

    Money affects inflation mainly through improving the empirical specification of the aggregate demand and aggregate supply equations, while the effects from the fact that monetary policy reacts to money balances in the generalized models (see Sect. 3.3.2) is small.

  46. 46.

    One possible explanation for the relatively weak performance of the money-enhanced partial equilibrium may be their particular sensitivity to money demand instability. Fischer et al. (2008) also note that, from the perspective of forecasting practitioners, simple bivariate models foregoing an explicit money demand specification are dominating other approaches.

  47. 47.

    For instance, Bruggeman, Donato and Warne (2003) find long-run euro area money demand consistently related to real GDP. Dreger and Wolters (2006) also argue that standard money demand functions are well capable of explaining the recent surge in euro area liquidity provided that the short-run homogeneity restriction on money and prices is dropped. See, among others, the surveys by Calza and Sousa (2003), Golinelli and Pastorello (2002), and Ericsson (1998).

  48. 48.

    See, for example, the discussion in Friedman and Kuttner (1996) and Kahn and Benolkin (2007).

  49. 49.

    The demand for cash also depends on the size of an economy’s informal sector and its use abroad.

  50. 50.

    For instance, according to Friedman and Kuttner (1996), the Federal Reserve targeted money mainly during 1975–1982, in the sense that it varied either the federal funds rate or non-borrowed reserves (whichever, was the policy instrument at the time) in response to observed fluctuations or either M1 or M2 that departed from the corresponding stated targets.

  51. 51.

    Some argue that money remains important for central banks to control the overnight interbank interest rate, but Woodford (2003) maintains that the achievement of the central bank’s interest target does not require any quantity adjustments through open-market operations in response to deviations of the market rate from the target rate.

  52. 52.

    According to ECB staff, augmenting money demand equations after they have proven unstable over time should be seen as providing ex post support for the judgmental adjustment of M3 rather than a plausible alternative framework for making that judgmental assessment in real time (Fischer et al., 2008).

  53. 53.

    See, the ECB’s Monetary Bulletins from October 2004 and July 2007.

  54. 54.

    See, for example, ECB Monthly Bulletins May 2003, October 2004, and January 2005.

  55. 55.

    Berger and Harjes (2009) find a potential link between global liquidity, primarily determined by US liquidity, and euro area inflation.

  56. 56.

    See ECB (2004b), p.49.

  57. 57.

    See Faruqee (2005) for a more formal treatment of the question of structural breaks in euro area velocity.

  58. 58.

    Securitization may broadly be defined as the process of converting a pool of designated financial assets into tradable securities backed by cash flows of the assets and their underlying collateral (see European Securitization Forum, 1999; ECB, 2008).

  59. 59.

    It is important to reiterate that money does not affect prices directly according the bank lending channel but through its impact on demand and output (see Bernanke and Gertler, 1995).

  60. 60.

    ECB (2008, p. 91) and Altunbas et al. (2007). Gross euro area securitization issuance of about euro 300 billion amounts to roughly 2 percentage points but not all of this was passed on by banks via “true sales”, or sold on to the market at all.

  61. 61.

    See, among others, Kydland and Prescott (1977) and Fudenberg and Maskin (1986) for important contributions to the literature on reputation and the so-called inflation bias. Clarida et al. (1999), and Woodford (2003) discuss the related problem of a stabilization bias.

  62. 62.

    It is interesting to note that the Bundesbank was in a similar situation at the onset of the European Monetary System (EMS) in 1979, when several of members of its council were initially directly in favor of abandoning monetary targeting strategy. However, as von Hagen (1999) writes, later on they acknowledged the importance of “the high reputation the strategy had gained the Bank abroad” and supported the strategy, recognizing that its abandoning “the time when the new EMS was beginning to operate would create the impression that the Bundesbank was giving up on its efforts to maintain price stability and would fuel inflation expectations”.

  63. 63.

    See Issing (2006, p. 2) and Jaeger (2003). A certain overplaying of the importance of monetary targeting in actual decision-making was also part of the Bundesbank’s monetary strategy (see, for instance, Posen, 2000).

  64. 64.

    Their basic setup is a regression of the change in the Euribor rate on the post-meeting policy rate surprise (i.e., the difference between the actual post-meeting policy rate and the expected rate) and a communication indicator based on Berger et al. (2010).

  65. 65.

    In a related result, Bulíř, Čihák and Šmídková (2008) report that there are indications that information on the ECB’s policy inclination based on the “monetary pillar” is frequently out of sync with other signals send by the ECB, including the staff’s inflation forecast, press releases, or monthly bulletins.

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  1. European Department, International Monetary Fund, 700 19th Street NW, Washington, DC, 20431, USA

    Helge Berger, Thomas Harjes & Emil Stavrev

  2. Free University, Berlin, Germany

    Helge Berger

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    Jakob Haan

  2. , European Department, International Monetary Fund, 19th Street NW 700, Washington, DC, 20431, USA

    Helge Berger

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Berger, H., Harjes, T., Stavrev, E. (2010). The ECB’s Monetary Analysis Revisited. In: Haan, J., Berger, H. (eds) The European Central Bank at Ten. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-14237-6_3

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