Select Committee on European Union Forty-Second Report



32. In this section we examine the monetary policy strategy of the ECB. We analyse the remit that the EC Treaty gives the central bank, and we ask who should define price stability for the euro area. We then appraise the outcome of the ECB's internal review of its monetary policy strategy, focusing on the ECB's definition of price stability and the 'two-pillar structure' of the ECB's monetary policy strategy. Finally, we look at the question of whether the ECB should have an exchange rate target.

Does the EC Treaty give the ECB the right remit?


33. The EC Treaty establishes a clear hierarchy of objectives for the ECB that enforces the primacy of price stability. Article 105(1) states that the "primary objective" of the ECB is "to maintain price stability." The ECB is also "to support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community," which include "a high level of employment" and "sustainable and non-inflationary growth". However, the central bank is only to do so "without prejudice to the objective of price stability." In so far as the Treaty sets out an unambiguous hierarchy of objectives for the ECB, it is very similar to the Bank of England Act 1998, which states (in Section 11):

"In relation to monetary policy, the objectives of the Bank of England shall be—

(a) to maintain price stability, and

(b) subject to that, to support the economic policy of Her Majesty's Government, including its objectives for growth and employment."

34. This type of hierarchical mandate (based around the clause "without prejudice to" or "subject to") differs from the remit given to the Federal Reserve, the central bank of the United States, which is also required to keep prices stable, but also, and at the same time, to seek full employment and moderate long-term interest rates, which are formally seen as having equal importance. The Federal Reserve Act of 1913 (Section 2A) states that the monetary policy objectives of the Board of Governors of the Federal Reserve System and the Federal Open Market Committee are "to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates". President Duisenberg testified to the European Parliament that he preferred the ECB's "unambiguously stated mandate". He said: "it gives more clarity to the people and to the markets as to what we are supposed to do and what we are actually doing."[20]


35. Although the EC Treaty gives the ECB a dual, hierarchical mandate, it was suggested to us that the bank fulfilled this remit by, in effect, reducing it to a single mandate: to provide price stability. The ECB considered that it could best contribute to supporting sustainable non-inflationary growth and a high level of employment in the euro area by fulfilling its primary objective of maintaining price stability. President Duisenberg explained this position:

"By being strictly geared towards maintaining price stability in a credible and lasting manner, monetary policy makes an important contribution to achieving a high level of output and employment, and to sustaining growth. Confidence in lasting price stability removes the inflation risk premium on interest rates, ensuring low real interest rates, which in turn foster investment, growth and employment. Theoretical and empirical evidence clearly confirm that there is no long-term trade off between price stability and economic growth. Trying to use monetary policy to fine-tune economic activity or to gear it above a sustainable level will, in the long run, simply lead to rising inflation - not to faster economic growth."[21]

36. This was also the position of Professor Thygesen (p.24) and of the UK Government:

"Stability helps individuals and businesses to plan for the long term, improving the quality and quantity of investment in the economy and helping to raise productivity and the sustainable rates of growth and employment. Macroeconomic stability is also a prerequisite of successful economic reform, since a framework of stability permits the rapid achievement of the full benefits of structural reform policies."[22]

37. The ECB forcibly denied that monetary policy faced a long-term trade-off between inflation and economic growth. Rather, "maintaining a low and stable rate of inflation" was "the best contribution" that monetary policy could make to economic welfare.[23] Furthermore, the bank pointed out that under the Treaty while it alone had responsibility for delivering its primary objective of price stability, its secondary objectives - a high level of employment and sustainable and non-inflationary growth - were also shared with all the other economic actors of the EU. Miss Silvia Pepino, Vice-President, Economic and Policy Research at JPMorgan, maintained, however, that it is "not appropriate for the ECB to argue that the second part of its mandate is met by simply sticking to the first half of the mandate" (p.86). The bank has received a lot of criticism in the press for not doing enough to promote growth in the euro area. We therefore examined whether, in an ideal world, the ECB's mandate should be changed to give more prominence to employment and growth.


38. Almost all of our witnesses opposed changing the mandate that the EC Treaty gives the ECB. Professor Buiter said that he would "quite strongly" oppose any extension of the ECB's mandate. He declared that the Federal Reserve was lucky that its three-legged mandate had "basically been forgotten in practice"; in reality, he argued, the Federal Reserve basically followed an inflation target (Q 41). Professor Von Hagen, Professor of Economics at the University of Bonn, also considered that that was the case:

"the Fed actually cares most about price stability de facto, and the reason why that can happen despite the legal mandate is that there is a broad agreement, both among monetary policy makers and among members of Congress in the United States today, that monetary policy is not an appropriate tool to promote full employment. It can support full employment but to use monetary policy systematically to reach full employment will always undermine price stability. Thus that is the consensus that makes it possible for the Fed to act very much like the ECB or Bank of England do today although the legal mandate is different" (Q 181).

39. Mr Volcker, who was Chairman of the Board of Governors of the Federal Reserve System from 1979-87, confirmed that in practice the Federal Reserve interpreted its mandate in a narrow, hierarchical way that gave primacy to price stability: "the principal function of the Central Bank has to be concerned about stability." The Federal Reserve interpreted that in a way which did not give it "all that much leeway." It always kept clearly in mind "the primacy of stability." The UK Government also considered that in practice the ECB, the Federal Reserve and the Bank of England all operated in a similar way despite the differences in the wording of their mandates (QQ 144, 214).


40. One of the main reasons why our witnesses were against changing the ECB's remit was that they did not want to see a situation where the central bank was set several objectives that could not possibly be met by using monetary policy alone. Mr David Walton, the Chief European Economist at Goldman Sachs, for example, argued that it was necessary to be careful about how much central banks were asked to do: "At the end of the day, central banks have one instrument, which is interest rates, and really they can only achieve one target" (Q 15). Professor Buiter argued this point forcibly:

"Having an explicitly symmetric inflation target, I think, meets most of the substance of the desire of those who want the central bank to pay more attention to real economic activity. To go beyond that I think creates a danger of illusions being reinforced about what monetary policy can deliver. Monetary policy cannot increase the long-term growth of the economy and has no lasting effect on the equilibrium rate of employment. It has important effects at cyclical frequencies but that is it. The best way to formulate policy is to have a single nominal objective, preferably, in the case of the euro area, a symmetric inflation objective, but definitely not a growth objective on top of that. It is idle talk; it is like making church attendance an objective of monetary policy; there is no way of influencing it significantly in the long-run." (Q 41)

41. Mr Andrew Smith, Chief Economist at KPMG, agreed that the ECB could not be expected to get over "the logical problem, that if you have one instrument, you cannot target two things simultaneously" (Q 15). Dr Schmieding, the Chief European Economist at the Bank of America, contended that it could be "politically dangerous" to change the ECB's mandate:

"It might nourish a popular illusion that indeed the Central Bank can do more than influence the short-term fluctuations of the growth rate but that the Central Bank may be responsible for the longer term trend rate of growth. Coming from this angle, that it might be politically dangerous to nourish such an illusion, I would come out clearly on the side of those saying there should not be an explicit growth objective in the remit of the Central Bank" (Q 69).

42. Professor Von Hagen agreed that "changing the Treaty and actually giving the ECB an explicit mandate for full employment or economic growth could be dangerous because it could undermine the credibility of a very young institution because it would be a very visible action for the European governments to take" (Q 181). The Union of Industrial and Employers' Confederations of Europe (UNICE) reasoned that the current weak activity of the euro area had other causes that monetary policy could not solve (p.91). Professor Draghi and Professor Thygesen agreed that something beyond the monetary policy was needed to restore growth in the euro area (QQ 70, 200).


43. A number of our witnesses suggested that one reason why there was no need to change the ECB's mandate was because the criticisms that the bank ignored its secondary objectives and concentrated on delivering price stability to the exclusion of growth were not well founded. It was unreasonable to say that the ECB was unconcerned with the underlying performance of the economy. In practice, they argued, the central bank did pay some attention to its secondary objectives of growth and employment. Mr Martin Weale, the Director of the National Institute of Economic & Social Research, said that the European Central Bank was "somewhat maligned", explaining that there was a tendency to blame it for the slow growth that the euro area was experiencing.[24] He and many other witnesses pointed out though that, in fact, the bank had been consistently tolerant of inflation in the euro area above its definition of price stability (QQ 1, 4). Professor Buiter bluntly summed up this position: "The fact that inflation has been above target in the euro area for years now is not consistent with the view that monetary policy has been too tight" (Q 44). Professor Goodhart said:

"the ECB has actually in practice run a rather careful and successful tightrope, because almost all the public argument has been that they have been too tight, and growth in the euro zone has been too slow. If you look at what has been achieved on the inflation side, they have allowed the inflation rate continuously to be marginally over their upper limit. Inflation in the euro zone has not been running at or below two per cent, it has running marginally above two per cent. They have actually nicely managed the balance between political pressure for maintaining growth and maintaining expansion in the euro zone, and what they themselves set out to do." (Q 41)

44. Professor Thygesen drew attention to the actions of the ECB in cutting interest rates as providing some evidence that the ECB was not unconcerned with poor growth performance in the euro area. (QQ 62, 65, 70). For example, the ECB cut interest rates in April 1999 by 0.5% and, in explaining this decision, cited "a slowdown in economic activity" indicated by "downward revisions in the growth forecasts" while "the progress in reducing unemployment" had "continued to be very gradual".[25] The ECB acted again to stimulate activity after September 11, 2001, at a time when inflation was running well above the bank's upper limit for price stability. The ECB also cut rates in December 2002 and in March 2003 when inflation was above 2% because it was concerned about the weakness of economic activity. Mr Walton argued that the facts demonstrated that the ECB had become more prepared to cut rates and more tolerant of inflation: when the bank cut interest rates in the euro area down to 2.5% was in April 1999, inflation was at 1%; in June 2003 the bank once again cut rates down to 2.5%, but at this time inflation was above 2%. The bank explained that the latter decision was due to "the subdued pace of economic growth".[26] Mr Walton took this as evidence that the Governing Council was prepared to move more aggressively than when the bank was first established. They now appreciated the fact that they needed to ease monetary conditions when activity was weak.[27] The UK Government said that recent work suggested that monetary policy for the euro area had been "a little bit looser" under the ECB than it would have been under the Bundesbank. The ECB accepted inflation temporarily in excess of its 2% ceiling as unavoidable at times and not necessarily inconsistent with price stability over the medium term. Professor Von Hagen agreed that the ECB was now "showing its readiness to care for promoting real economic growth" when price stability was not a problem. He concluded that "in terms of actual economic policies or monetary policies" there was "virtually no difference today between the three major central banks - the ECB, the Bank of England and the Fed". Mr Weale said that it was right that at first the ECB had focused on controlling inflation: "independent central banks, whose job is to control inflation, need to show that they are taking that job seriously." Mr Volcker agreed that this position was justified. (QQ 1, 5, 12-13, 123, 181, 225)


45. We regard the strength of the ECB's mandate to be its unambiguous nature. The EC Treaty makes it clear that the primary objective of the bank is to achieve price stability. Price stability is desirable because it is conducive to, and a pre-requisite for, long-term stable growth and employment. It is right therefore that price stability is the primary objective of the ECB; we would not seek to change that.

46. Without prejudice to that objective, the ECB must also support growth and employment. For citizens of the EU, economic success must go beyond a narrow definition of price stability; EMU will be judged by its ability to deliver what the EC Treaty terms sustainable and non-inflationary growth and a high level of employment. As the EU's most visible financial institution, how people judge the ECB will inevitably be influenced by the level of growth and employment in the euro area; it is right therefore that the Treaty places these as key but subsidiary elements of the bank's mandate. It should be recognised, however, that there are limits as to what monetary policy alone can achieve.

Who should define price stability for the euro area?

47. Whilst the EC Treaty sets the ECB the primary objective of achieving price stability, it gives the bank no instructions as to how it is to interpret this aspect of its mandate. The Treaty does not give a definition of price stability or establish by whom this concept is to be defined. The ECB is therefore free to define what constitutes price stability. In October 1998, the Governing Council of the ECB announced a quantitative definition of "price stability": it was to aim for a "year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%".[28] The Committee examined the question of whether it was right that the ECB should continue to define price stability for the euro area. The alternative would be for another body outside the central bank to define price stability, while the ECB would continue to control the means by which it would seek to achieve this goal.


48. In relation to central banks, commentators distinguish between 'goal independence' and 'operational independence' (which is sometimes called 'instrument independence'). If a central bank has goal independence, it is free to change its objectives. If a central bank has operational independence, it is free to change the level of its designated policy instrument (that is, interest rates), which are the means by which a central bank operates to achieve its goals. Both the Bank of England and the ECB have operational independence. The Bank of England, however, is not goal independent. The objective the Monetary Policy Committee (MPC) is asked to meet is set by the Chancellor of the Exchequer. The Chancellor defines price stability and specifies the rate of inflation that the MPC is to target, so there is no goal independence. The ECB in contrast has a high degree of goal independence: it is in command of the definition of what is meant by price stability and the time horizon over which it should achieve this objective.[29] It is not completely goal independent, however, because it does not set the ultimate objectives of policy, which are enshrined in the EC Treaty. Nonetheless, critics of the ECB say that because the bank can define price stability it can decide the parameters within which it operates and so in effect is free to set its own targets. They argue that the definition of price stability is a political target (see, for example, Q 9); hence, it should be decided by a political body.


49. Some witnesses argued that decisions on the target level of inflation, and on the balance to be struck between price stability and other objectives, should be made by a political body rather than the ECB. Professor Goodhart argued that giving the right to define price stability to a political body could help to address the so-called 'democratic deficit' in the EU. Dr Schmieding agreed that it would ultimately be preferable for the legitimacy of EMU for a political body to define price stability. Such a change would reduce the independence of the ECB and ensure that the goals of the ECB and the governments in Europe were more closely aligned. Mr Bootle claimed that continuing to allow the ECB its high degree of goal independence was "potentially very dangerous", as its aims might be out of step with those of the citizens. Some body outside the central bank should define price stability; otherwise there was a risk that "a substantial part of the eurozone" could go into deflation (QQ 42, 47, 66, 96-99).

50. When considering which political body should define price stability, Professor Buiter cautioned against following the UK model:

"The British system puts the power to change the target in the hands of one man or one woman, the Chancellor and, in principle, he could change it every day before and after lunch. That has not happened, but the framework carries that risk. I would want a system that has greater safeguards than the current British one, which only has self-control as the safeguard to refrain the body politick from changing the target arbitrarily and too frequently."

51. To overcome this "shortcoming", which was also of concern to Dr Schmieding, Professor Buiter proposed giving the power to the Eurogroup, the group of finance ministers of participating Member States[30] (QQ 47, 58, 66). Miss Pepino suggested that Ecofin would be the most appropriate body (p.87). The ECB normally jealously protects its independence, but when the European Parliament asked President Duisenberg if it might not be more appropriate to allow a political body to define price stability, he replied rather curiously:

"I am almost inclined to say: if the political authorities want to define it, let them do it. Let me leave it at that."[31]


52. A number of witnesses warned that it could be potentially dangerous for governments to set the ECB's inflation target. Greater political influence might increase the danger that the ECB would be forced to aim at an inappropriately high level of inflation or would be unduly swayed by the situation in one Member State.[32] Professor Draghi agreed with the criticisms of the current set up and argued that, ideally, there was a case for changing the EC Treaty. But, he cautioned, it was important to consider what the practical alternatives could be:

"Let us imagine for instance that the new euroland inflation rate were to be fixed by the Eurogroup. There you have 12 finance ministers, each one strongly convinced that their own country's interests are to become the European interests; each one, because of his national interest, is less keen to give in to other countries' views. A European inflation rate set by a body made up of 12 finance ministers seems to be, to me at least, a fairly complex, possibly cumbersome process. If the inflation rate were to be set by other bodies like the Commission, it would be even less accountable than the ECB, because the Commission is made up of non-elected officials. Even though I share this criticism [of the current set up], especially when we compare this framework with other countries' monetary policy frameworks, both the objective difficulties of amending the Treaty and the practical difficulties of having a process working to produce a reasonable outcome make me think that it is hard to change the present framework into something which is more accountable." (Q 194)

53. Professor Giavazzi, Professor of Economics at Bocconi University, Milan, was against asking the Council to define price stability; he was worried about the difficulty of finding agreement between 15 or 25 finance ministers and the political bargaining that that might involve. Mr Volcker argued very strongly against giving the power to define price stability to politicians, because he was extremely concerned that they might not agree on the most appropriate definition. Professor Goodhart on the other hand disputed the assertion that politicians would choose to set an inappropriate and excessive target for inflation (QQ 47, 88, 139-40).


54. Mr Klaus Regling, Director General of the Directorate-General for Economic & Financial Affairs at the European Commission, put the decision to allow the ECB to define price stability in its historical context and argued that this institutional balance should not be changed:

"As price stability had been decided to be the primary goal of the Economic and Monetary Union, it was reasonable to look closely to those central banks that had performed well. These central banks had never worked with a specific inflation target imposed on them from the outside world […] In order to make use of the better parts of the European monetary heritage it was decided to keep the tradition of letting the central bank determine its operational value. The experience of the euro area in the first years confirms the advantages of such a set-up" (p.90).

55. UNICE was adamant that the ECB's independence, which it described as a "key pillar" of EMU, "must be preserved and the ECB must continue to set the operational definition of price stability". Mr Volcker agreed that if the ECB were to be "a truly independent Central Bank," it ought to be the one to determine the "technical matter" of defining price stability. Mr Lorenzo Codogno, Managing Director, Co-Head of European Economics at the Bank of America, agreed that the ECB was "best equipped" and "most qualified" to define price stability, especially if its ability were compared "to European governments, the EU Parliament, the EU Commission or the EU Council." The fact that the ECB set its inflation objective and at the same time was judged against this benchmark was "not an aberration": there was "no doubt" that the ECB could be held accountable for this self-imposed target. Professor Thygesen agreed that it was "natural" to let the bank define price stability itself, and, as the public and political debate had consistently demonstrated, the bank was held to account for its definition (pp.25, 91; QQ 20, 132).


56. The ECB enjoys a high degree of independence. The question arises whether greater political involvement could and should be introduced to the process by which price stability is defined for the euro area without seriously prejudicing that independence. Giving the right to define price stability for the euro area to a political body could arguably help to address perceptions that the process currently lacks sufficient political accountability. We believe, however, that for the time being the ECB should continue to define price stability for the euro area. If at some later date a political body outside the ECB were to define price stability for the euro area, that body could perhaps best be the Heads of State or Government of those Member States that have adopted the euro, acting on a recommendation from the Eurogroup.

The ECB's Internal Review of its Monetary Policy Strategy

57. In December 2002, President Duisenberg announced that in the course of the first half of 2003 the Governing Council of the ECB would undertake a thorough evaluation of the ECB's monetary policy strategy, which was originally announced in October 1998.[33] The ECB announced the outcome of its review in a press seminar on 8 May 2003.[34] We do not discuss here all elements of the ECB's review. Instead, we focus on the two most-debated aspects: the ECB's definition of price stability and the 'two-pillar structure' of the ECB's monetary policy strategy.

The ECB's definition of price stability

58. Having reviewed its definition of price stability, the ECB announced that:

"the Governing Council confirmed that it defines price stability as announced in 1998, namely as a year-on-year increase in the HICP for the euro area of below 2%. At the same time, it clarified that in the pursuit of price stability it aims to maintain inflation rates at levels close to 2% over the medium term."

59. The bank announced that this clarification aimed to underline "the ECB's general commitment to provide a sufficient safety margin to guard against potential risks of deflation." The safety margin also addressed "the issue of the possible presence of a [positive] measurement bias in the HICP and the implications of inflation differentials within the euro area."[35]


60. Definitions of price stability or targets for inflation that are 'asymmetrical' - such as that of the ECB, which originally said it aimed for inflation of below 2% - were criticised for having a perceived deflationary bias. As HM Treasury put it, "policy makers could have an incentive to drive inflation as low as possible to ensure they meet their target comfortably".[36] The fact that inflation in the euro area has averaged above 2% since the beginning of 2000 demonstrates to us that in practice the ECB has ignored this temptation. The Financial Secretary agreed, saying that the ECB had shown itself to be "sensitive to risks of deflation" (QQ 217, 222, 225).

61. Announcing the outcome of its monetary policy strategy review, the ECB stressed that it had always been vigilant in preventing deflationary and inflationary dynamics alike from emerging in the euro area. The bank argued that the use of the word "increase" in its original announcement of its strategy in 1998 excluded deflation from its definition of price stability.[37] The bank would never want to expose the euro area to the risk of deflation. By adding that it would not only try to achieve inflation "below 2%" but also "close to 2%", the bank aimed to clarify this aspect of its policy by making it clear that the bank considered it to be desirable to maintain a small safety margin against deflationary spirals in the form of a positive rate of inflation. President Duisenberg said that this 'clarification' of the ECB's definition of price stability was given "specifically to do away with this eternal debate about our being less vigilant in fighting deflation than inflation. This means we have a significant and adequate margin above 0% such that we need not be concerned with deflation at all."[38] Professor Issing was insistent, however, that the clarification of the bank's definition of price stability did not represent any change of policy:

"this 'close to 2%' is not a change, it is a clarification of what we have done so far, what we have achieved - namely inflation expectations remaining in a narrow range of between roughly 1.7% and 1.9% - and what we intend to do in our forward-looking monetary policy."[39]

62. During the first half of 2003, the President of the ECB frequently stressed that the bank watched, and was prepared to act against, deflationary as well as inflationary developments. Countering accusations of a deflationary bias to the ECB's monetary policy, the President told the European Parliament, for example, that the bank was committed to acting to avoid "both inflation and deflation."[40]


63. One reason why the ECB wanted to clarify that its definition of price stability provided a sufficient safety margin to guard against potential risks of deflation was that there was a measurement bias in the HICP. This bias might cause the HICP as published to overstate systematically the true rate of inflation in the euro area. Research had shown that not enough was known "to estimate with any degree of precision the magnitude of measurement biases in European consumer price indices."[41] Furthermore, the measurement bias possibly varied over time. The bank concluded, however, that the bias was "likely to be small and to further decline in the future."[42]


64. Another reason why the ECB announced a safety margin to guard against deflation was to address "the implications of inflation differentials within the euro area". Since 1999 there had been some divergence in inflation rates between Member States, which had made the ECB's job in setting interest rates for the euro area more difficult. Witnesses stressed to us that it was natural that different regions or countries in the euro area - a large currency area with a market of more than 300 million people - would experience different rates of inflation. Critics of the bank feared, however, that if the euro area as a whole experienced a low level of inflation, then, as a consequence of these inflation differentials, some countries might be pushed into an extended and costly period of deflation. The bank's clarification of its strategy seemed, in part, to have been an attempt to counter such a fear.

65. The bank emphasized that in setting a single monetary policy for the euro area, it could not address inflation differentials between countries. They were a normal feature of any currency area: in a single country, monetary policy could not reduce inflation differentials across regions or cities.[43] Professor Goodhart confirmed this: "there are asymmetries within any European country; so that the monetary policy which is suitable for the tradeable goods sector in the UK, (before sterling started to decline) is not necessarily the monetary policy best adapted to the housing sector. You can get asymmetries within a country as well as between countries". Such differentials should correct themselves almost automatically over time (and new ones would appear); they were, in the bank's terms, "an integral part of the adjustment mechanism resulting from demand and supply shocks in the economies". Dr Schmieding explained that those countries with a level of inflation below the average for the euro area, such as Germany, would, over time, benefit from the competitive advantage that that difference brought, thus rectifying the situation. In the meantime, however, the ECB's clarification of its definition of price stability could be seen as an attempt to show that it would aim to achieve over the medium term an inflation rate for the euro area as a whole that was high enough to prevent regions with lower inflation rates from facing significant costs of deflation. The ECB itself stressed that "a period of falling prices in a country within a monetary union should be mainly seen as an adjustment of relative prices within the currency union" and so the concern for the conduct of its monetary policy would continue to be avoiding situations where there were risks of deflation in the euro area as a whole.[44] Professor Thygesen and the Federation of German Industries (BDI) both mentioned the potential problem of inflation differentials in the euro area. If the definition of price stability was too low that "could lead to a deflationary trend in EMU states with below-average price increases"; both witnesses concluded, however, that this was not the case for the euro area and that the ECB's definition provided "an adequate safety margin against deflationary risks" (pp. 24, 85; QQ 37, 68).

Should the ECB's definition of price stability be changed to a symmetrical inflation target?


66. The Bank of England is an example of a central bank that operates with a 'symmetrical' inflation target. The bank's primary monetary policy objective is to deliver price stability, which is defined by the Government's inflation target. The target specifies that the bank is to aim for underlying inflation (measured by the 12-month increase in the Retail Price Index excluding mortgage interest rates) of 2.5%. This target is symmetrical because inflation would be allowed to move away from the target by 1% in either direction, which means that "deviations below the target are treated in the same way as deviations above the target".[45]

67. Many of our witnesses argued that, in contrast to clearly-framed monetary policy objectives such as that of the Bank of England, the ECB's definition of price stability did not provide the clearest guide for inflationary expectations. They criticised the bank's definition for being imprecise and asymmetric. These criticisms were not alleviated by the bank's 'clarification' of its definition; witnesses still complained that the bank specified the upper limit for price developments but did not define a lower limit;[46] as Mr Bootle said, there was "an awful lot of confusion" following the revision. Some people thought that there had been a change; others thought that there had not been (Q 86). As Professor Goodhart said:

"there is a fair way to go to get real clarity and transparency. I do not know what the central point for the target is. I do not know whether there is a lower bound. I do not know, if there are bounds, whether they are symmetric." (Q 45)

68. Our witnesses said that it was essential to know what margin of fluctuation around the target figure the central bank would tolerate. "We need to know this margin to be able to understand and anticipate the central bank's actions."[47] Our witnesses therefore argued that the ECB's price stability objective should be more precise and ideally should be changed to a symmetrical inflation target. Almost all of our witnesses made a point of explicitly calling for such a change. A symmetrical inflation target would be entirely transparent as to what level of inflation the bank was aiming for and what range of inflation it would tolerate; as such, it would help the ECB to communicate its monetary policy objective in a clear and unambiguous way and should anchor more effectively inflation expectations. The increased transparency of objective would mean that the bank's monetary policy decisions should become more predictable, which would help to smooth interest rates fluctuation by leading markets to anticipate and prepare for the decisions. A symmetrical inflation target would also provide a clearer benchmark against which the bank could be held to account (QQ 1, 4-5, 41, 49, 69, 71-72, 86, 88, 96).


69. In regarding an undershooting of the target as being as important as an overshooting, the Government said that its symmetrical approach clearly and explicitly guarded against deflation as well as inflation. The Government also stressed that its target was aimed at ensuring that monetary policy not only delivered price stability but also supported growth and employment, because monetary policy would be "neither unnecessarily loose nor unnecessarily tight."[48] Dr Schmieding agreed that in an explicit symmetrical inflation objective, there was "an implicit assumption on the need or the objective for the Central Bank to try to keep the real economy close to its natural rate", which would ensure that the central bank maintained a satisfactory growth rate for the euro area. As Professor Buiter put it, having an explicitly symmetric inflation target would meet "most of the substance of the desire of those who want the central bank to pay more attention to real economic activity." (QQ 41, 69; p.87)


70. The UK Government, Professor Buiter and Professor Goodhart all suggested that the outcome of the ECB's review of its monetary policy strategy meant that the ECB was gradually moving towards a symmetrical inflation target (albeit one which dare not speak its name). Professor Thygesen said that completing the move would not make much difference to the way in which the ECB conducted its monetary policy. President Duisenberg even complained that the matter was "almost a question of semantics."[49] Indeed, as we have seen above (paragraphs 43-44), many of our witnesses already judged that the ECB did keep one eye on the growth rate of the economy and expected the bank to be vigilant in fighting deflation. Dr Schmieding shared the view that "it would not have made any difference to the actual decisions by the ECB" if the bank had had a symmetrical inflation target. Nonetheless, he considered that such a change would be "preferable on grounds of rhetoric - preferable in terms of making it easier to communicate with the public." (QQ 35, 71-72, 223-24)

71. For example, in its review of its monetary policy, the ECB confirmed that it viewed 2% as the upper limit for inflation. Yet the bank had in practice consistently allowed inflation of above 2%. This discrepancy lent some support to the view that the bank's definition of price stability was more symmetrical than it seemed. If this were the case, the ECB should go further in 'clarifying' or redefining its definition of price stability, in order to, as Mr Walton put it, "realign its words with its actual actions" (Q 1). The view of Professor Wyplosz, who criticised the ECB for being "unnecessarily cryptic", summarised the disappointment of our witnesses: "No central bank with a price stability objective can operate without some inflation target. The new posture hurts both the bank's transparency and its ability to anchor expectations, a key requirement for policy effectiveness."[50]


72. The ECB, however, remained hostile to the idea of an explicit inflation target. President Duisenberg said:

"I protest against the word 'target'. We do not have a target, as you know, and […] we won't have a target."[51]

73. This refusal to consider the notion of the ECB adopting an explicit inflation target was reinforced by the ECB's Chief Economist, Professor Issing, when he announced the outcome of the bank's review of its monetary policy strategy. He was asked whether the clarification of the bank's definition of price stability meant that the ECB had adopted an inflation target; he replied curtly:

"Certainly not. We have confirmed our two-pillar approach. This is totally different from what is normally seen as inflation targeting."[52]

Quite clearly the ECB has rejected inflation targeting. Yet, as we will argue below, adopting an inflation target need not automatically imply the abandonment of the bank's two pillars or the adoption of an inflation-targeting strategy.

74. One of the main reasons why the bank refused publicly to countenance adopting a symmetrical inflation target was that it believed that such a target would cause the public to focus too narrowly on whether inflation was just inside or outside the range. President Duisenberg explained that monetary policy was a much more complex process:

"We specifically did not define a range, although we considered it, because we want to avoid being seen as targeting inflation towards a precisely defined range. We recognise that monetary policy in the short-term cannot fine-tune the inflation performance of the euro area economy as a whole to an extent which would make a precise quantitative definition of a range sensible or viable."[53]

75. President Duisenberg said that trying to reduce the complexity of monetary policy to a single inflation target would be a mistake:

"Experience suggests that it can be very misleading to summarise the assessment of medium-term inflationary pressures in one single figure, even when a measure of statistical error is attached to it. Unfortunately, monetary policy is not so simple and the repeated significant forecast errors by all major institutions over the last few years provide evidence of this."[54]

76. The ECB's incoming president, Mr Trichet, also wanted the ECB to avoid implying that it took a limiting, mechanistic and over-simplistic approach to monetary policy:

"the main disadvantage of applying direct inflation targeting to a vast and complex economy is the mechanical aspect of monetary policy instrumentation. A system of equations and the calculation of a law of probability are supposed to indicate the appropriate conduct to be adopted by Monetary Policy Councils […] the extraordinary complexity of reality cannot be reduced to an equation or a system of equations."[55]

77. A second major reason why the ECB did not want to change its definition of price stability to a symmetrical inflation target was that the bank was concerned that announcing any change to its definition of price stability would be perceived in the public as such a shift of policy that it would risk the bank's hard-won credibility. President Duisenberg explained that, during its review of the ECB's monetary policy strategy, the Governing Council had not always immediately agreed on everything, particularly on whether to change the definition of price stability:

"There were those who pleaded for an even tighter interpretation. There were others who pleaded for a looser interpretation. In the end we all agreed that we would have a big credibility problem and would even create our own credibility problem if we were to change the definition. And so we quickly reached consensus that there was no need, and that it would even be dangerous, to change the definition."[56]

78. A final reason why the ECB rejected any change to its definition of price stability was that it considered it unnecessary. As we have seen, one of the major arguments in favour of a clear and symmetrical inflation target is that it should anchor more effectively inflation expectations. The ECB announced, however, that "its performance in maintaining low volatility of long-term inflation expectations in the euro area [was] comparable to that of the best-performing countries."[57] The ECB, the Commission and the UK Government all highlighted the fact that "longer-term inflation expectations" for the euro area had been "firmly anchored at levels in line with the definition of price stability since January 1999, remaining in a range between 1.7% and 1.9%." (Q 225; p.88) The ECB did acknowledge, however, that "some aspects" of its monetary policy strategy had "proved difficult to communicate effectively."[58]


79. We welcome the fact that at the start of its operations the ECB announced a quantitative numerical value for its objective of price stability. Such a decision was essential for transparency and accountability. The ECB's initial definition of price stability as being a "year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%" did not make it clear that there was a lower limit. This led to some confusion and left the ECB open to criticisms that it was not sufficiently vigilant about the risks of deflation.

80. In the light of the ECB's announcement on 8 May 2003 of the results of the Governing Council's review of its monetary policy, the bank's definition of price stability is clearer than it was before and not so open to criticisms of asymmetry. Nonetheless, comparisons with the symmetrical inflation targets of some other central banks remain unfavourable, and the ECB's definition of price stability could still be clearer.

81. The ultimate test for the success of a central bank's monetary policy strategy is its record of actual policy decisions. As we say above (paragraph 25), this has generally been good so far. Where the strategy has not performed so well is in communicating the bank's decisions.

82. The ECB's definition of price stability has recently been reaffirmed and clarified. We hope that Mr Trichet, the bank's incoming president, will sustain this process of clarification of the current definition in order to safeguard the bank's credibility and that of its monetary policy strategy.

83. The task remains of communicating the ECB's new strategy effectively. It is with a view to improving this external communication that we recommend that the ECB should in due course adopt an inflation target, expressed as a symmetric range around a central figure. Such a target would constitute a natural focal point that could be observed and understood by the public; it would provide observers with a more precise focus for forming inflation expectations and taking forward-looking decisions. An explicit target for inflation would be entirely transparent and so would reduce the uncertainties for other economic agents, by giving clearer guidance for their inflation expectations, which should in turn help to stabilise the economy. A symmetrical inflation target would also provide a clearer benchmark against which the bank could be held to account.

84. The two main criticisms of the ECB that concern its definition of price stability are the related claims that the ECB has not focused enough on growth and employment and that the ECB is not sufficiently vigilant in fighting deflation. We think that these claims are unfounded. A symmetrical inflation target would, however, address these two fears directly. The lack of symmetry to the ECB's definition of price stability has contributed to the perception that the bank does not take sufficient account of deflationary risks, pays inadequate attention to growth and is only concerned with achieving a low rate of inflation; a symmetrical inflation target would reduce these uncertainties over the ECB's aims.


85. The ECB's original announcement of its monetary policy strategy referred to developments in the HICP "over the medium term". In announcing the outcome of its review of the strategy, the central bank confirmed this timescale, which some of our witnesses complained was rather ambiguous. They wanted clarification of the phrase 'medium term'. Without an explicit time span for the horizon over which price stability was to be achieved, the bank could not be held properly to account. As Professor Wyplosz put it: "Accountability is meaningless unless the agent can be blamed or sanctioned in the event that it does not deliver on its mission."[59] Professor Giavazzi complained that it was "very difficult" to hold the ECB accountable. Yet, he pointed out, the ECB's lack of clarity over this issue could also work the other way, causing the bank to be blamed for changes in the level of inflation for which it should not be blamed: "We know that monetary policy works with lags of a year or a year and a half. […] Assume that inflation jumps up three months from now. They could be held responsible for this even if they do not have an influence on the situation." (QQ 1, 49, 85, 88; p.86)

86. The ECB, however, explicitly rejected "the choice of a pre-specified, fixed horizon for the conduct of monetary policy". Monetary policy did not have an immediate impact on the rate of inflation; it worked with lags of a year or more, depending on the specific nature and size of the shock affecting the economy to which it was trying to respond. The bank argued that the choice of any explicit figure for a time horizon would be "arbitrary" since the transmission mechanism spanned "a variable, uncertain period of time."[60] The ECB did, however, acknowledge the concern of critics:

"You might ask what 'medium term' means exactly. It is certainly not a fixed time horizon, as some have argued. Experience in recent years has taught us that flexibility in this respect is very important. From this point of view, the ECB's monetary policy strategy is different from pure forms of inflation targeting."[61]

87. UNICE noted that the ECB's monetary policy strategy was less precise in this regard than that of central banks, such as the Bank of England, but it did not consider that that had had a detrimental effect on the ECB's ability to shape inflation expectations because the bank had shown that it was committed to price stability and had proved itself credible in delivering this. Director General Regling of the Directorate-General for Economic & Financial Affairs at the European Commission agreed that the absence of a precise definition of a specific number of months or years for the concept medium term "should not be seen as a disadvantage." (pp.88, 90-91)


88. We agree that the medium term is the right period of time for the ECB to be aiming to achieve price stability. Monetary policy should dampen or smooth fluctuation in both output and inflation without causing undesirable volatility in interest rates, employment or GDP. The medium-term orientation of the ECB's strategy allows such a flexible response to temporary shocks.

Should the ECB maintain its two-pillar monetary policy strategy?

89. In October 1998, when the Governing Council first announced its monetary policy strategy, it declared that, in order to assess risks to price stability, the ECB would use a 'two-pillar' approach. This would involve, under the first pillar, a prominent role for money, as signalled by a reference value for the growth of the broad monetary aggregate M3, and, under the second pillar, a broadly-based assessment of the outlook for future price developments.

90. Having reviewed its monetary policy strategy, the Governing Council confirmed on 8 May 2003 that its monetary policy decisions would continue to be based on an analysis of the risks to price stability founded on a two-pillar framework. However, henceforth the order in which these two pillars would be presented would be reversed, and they would be referred to as the 'economic analysis' and the 'monetary analysis'.


91. The 'economic analysis' would focus on the most proximate causes of inflation, as President Duisenberg explained:

"The broadly based economic analysis focuses mainly on the assessment of current economic and financial developments and the implied short to medium-term risks to price stability from the perspective of the interplay between supply and demand at those horizons. In this respect due attention is paid to the need to identify shocks hitting the economy. To this end, the developments analysed include a broad range of information on, for example, wages, commodity prices and exchange rates, asset prices, wealth, external demand, fiscal policy, and domestic financing conditions and costs."[62]

92. Mr Eugenio Solans, the Member of the Executive Board of the bank responsible for amongst other things statistics, added that:

"The economic and financial statistics supporting the 'economic analysis' include, for example, national accounts' main aggregates, government finance statistics, short-term business and labour market indicators, exchange rates, the balance of payments for the euro area, financial market statistics and the financial balance sheets of euro area sectors."[63]

The ECB aimed to use all of these statistics to help the Governing Council to assess the dynamics of real economic activity within the euro area and the global economy, and the likely development of prices over short-term horizons. Mr Solans explained that in contrast to, and complementing, the economic analysis:

"The 'monetary analysis' focuses on money and liquidity considerations and mainly serves as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications resulting from the 'economic analysis'. The statistics supporting the 'monetary analysis' include, for example, the sufficiently detailed consolidated balance sheet of the euro area banks, in particular the monetary aggregates and counterparts, the balance sheet of euro area investment funds, securities issues statistics and the financial balance sheets of the non-financial sectors, including any changes."[64]

93. The monetary analysis would thereby look at longer term developments and would be used to 'cross-check' the short to medium-term indications coming from the economic analysis to make an overall and unified assessment of the risks to price stability. The ECB also announced that, as previously, its monetary analysis would take into account "developments in a wide range of monetary indicators including M3, its components and counterparts, notably credit, and various measures of excess liquidity."[65]

94. The ECB further announced that whilst it would continue to publish a reference value for M3 as part of its monetary analysis (which was currently 4.5%), it would discontinue the practice of the Governing Council reviewing the reference value in December each year. This was because the bank was worried that this process had led to the "misperception" that the yearly review would lead to a yearly reference value indicator, which people outside the ECB had taken as a kind of normative indicator for the development of money, which had never been the bank's intention.[66]


95. Professor Issing explained that the ECB's two-pillar strategy had two main functions. First, it informed the Governing Council's decisions on setting interest rates for the euro area, by providing a framework for the internal analysis of information and thus facilitating the debate within this decision-making body. The two pillars provided a structure that ensured that the Governing Council examined and weighed all relevant information and did so in a considered manner.

96. Secondly, the two pillars also performed an outward-looking function by providing a framework for external communication. In relation to this second function of the two-pillar strategy, Professor Issing was keen to stress that by giving weight to both monetary and economic analyses, the bank aimed to avoid the impression that its decisions on interest rates for the euro area came from a single analysis. The ECB argued that it should not deny the complexity of its setting monetary policy: "a strong focus on a single inflation forecast would not do justice to the complexity of the decision-making process and would also not provide a transparent means to communicate this complexity."[67] The final assessment was indeed a single one, but the Governing Council's approach was based on its two pillars. The bank's aim was to make this process transparent through a thorough explanation of the rationale for its decision, which would thereby improve the public's understanding of how the bank conducted monetary policy. In that regard, UNICE noted that the ECB's two-pillar strategy required the central bank to provide "a more in-depth and comprehensive analysis than inflation targeting" (p.91). Effective communication of monetary policy decisions would have a further benefit in that it would facilitate the transmission of those decisions to the economy.[68]


97. The role accorded to money and monetary analyses in the monetary policy strategy of the ECB generated particular controversy among ECB watchers. Many of our witnesses questioned whether money was a sound indicator for price developments and questioned the correlation between money growth and the Governing Council's decisions on interest rates. They claimed that, contrary to the ECB's aim, the two-pillar strategy had confused the communication of the Governing Council's interest rate decisions.

98. Several witnesses explained that before the ECB's review of its monetary policy strategy, the bank had appeared to disregard the information from its money supply pillar. The Governing Council seemed not to place much weight on the growth rate of the monetary aggregate M3, which had been above the reference value almost continuously since the start of the bank's operations in January 1999 (see Box 3). Despite money growth being at times substantially above the reference value, the ECB had never taken any action in order to resolve that issue. The relationship between monetary growth and the bank's interest rate at times even appeared to be inverse, in that when M3 had grown faster than the reference value, the ECB had cut interest rates (QQ 36, 66, 72, 166, 182; pp.23, 85-86).

99. Mr Walton concluded that it was "pretty clear" that M3 had not been a very good guide to the ECB's interest rate decisions. The ECB evidently regarded money and credit as important indicators for inflation, but it was not obvious that they merited a particular status in the bank's strategy over and above everything else which the ECB examined as part of its economic analysis. He therefore supported the ECB's decision to 'downgrade' the first pillar by presenting the monetary analysis after the economic analysis and ascribing to it only a cross-checking role. He suggested that this reform should make the bank's communication strategy a lot easier. The UK Government also welcomed the fact that ECB had "explicitly downgraded their monetary pillar to the second pillar rather than the first pillar of monetary policy" (QQ 1, 13, 224).

100. The ECB placed greater emphasis on money as a medium to long-term benchmark for inflation "in view of the robust relationship between money and prices over extended horizons."[69] A build-up of excessive liquidity could pose an inflationary threat two years or more down the road, and so the monetary analysis provided a cross-check, which allowed the Governing Council to evaluate the impact of monetary growth over a longer time horizon than that of the staff projections that the bank published. Moreover, the ECB stressed that although the reference value for M3 had been misinterpreted by many to be a target, it was in fact only "a benchmark" against which monetary developments could be assessed and described to the public.[70] That was why the ECB had not and would not react "mechanistically" to deviations of M3 growth from its reference value.[71]

101. A number of witnesses accepted this explanation from the ECB, which appeared to de-emphasise what had been the first pillar. They agreed that the focus on money remained of relevance for monetary policy; there was some medium or long-term relationship between the money supply and inflation. The monetary analysis could ensure that the Governing Council maintained a focus on the medium-term and long-term consequences in terms of price stability of its monetary policies. These witnesses accepted that the monetary analysis provided the Governing Council with a useful check that discouraged it from responding to a series of specific situations in a way which could create an inflationary threat in the long term. The Governing Council would now examine not just M3 but a range of monetary and credit variables as well. This was welcomed, but Professor Goodhart called for great clarity as to what the components of the monetary analysis were, and what weights were ascribed to the different monetary aggregates. Witnesses considered that decision to 'downplay' the role of monetary aggregates would make the ECB's communication of its monetary policy decisions easier and more effective (QQ 36, 45, 180, 182; pp.82, 85).

102. For the Bank of England, inflation was "ultimately a monetary phenomenon," and economic forecasts were "necessarily uncertain and often wrong." Monetary developments might therefore be "used as a complement to the broad-based analysis of inflation prospects" that took place under the ECB's economic analysis. Sir Samuel Brittan too would keep the monetary analysis where it now was: "in the background". He saw it as providing the Governing Council with a useful "amber light" that said: "'Do not forget about the money supply'". Professor Thygesen considered that the two pillars had been modified in a way that was reasonable and which could provide "an intelligent longer term framework for monetary policy" (p.84; QQ 66, 165, 170).


103. Some witnesses questioned whether it was useful to have a separate 'money' pillar or analysis. They suggested that inflation forecasts could include all of the relevant information about how prices would develop that those making decisions on monetary policy needed in order to take a well-informed judgement about the risks to price stability. Whilst recognising that money could provide an indication of future rates of inflation, these witnesses maintained that this information could simply be included in the inflation forecasts. They proposed that the risks to overall price stability should be assessed on the basis of a comprehensive judgement encompassing all available evidence.

104. Dr Schmieding, for example, agreed that the ECB had gone in the right direction by emphasising that money was a long-term concern and that money would be used to cross-check the information from the economic analysis, but, he argued, "it would be better if the ECB were to go further. The ECB should leave the old Bundesbank model […] further behind and come to what one could call a unified assessment of future inflation prospects in one rather than two pillars" (Q 66). The Bank of England, however, claimed that the contrast with its own procedures could be "overstated":

"The regular monthly briefing provided to the MPC always includes an analysis of monetary developments. And while projections of inflation (and growth) two years out are a key ingredient of our quarterly Inflation Report, the process of preparing those projections incorporates a detailed consideration of monetary developments (see A. Hauser and A. Brigden, "Money and credit in an inflation-targeting regime", Bank of England Quarterly Bulletin, Autumn 2002). Consideration as to the appropriate setting for interest rates also takes on board considerations about possible developments beyond the two-year forecast horizon." (p.84)

105. In contrast though, the ECB insisted that the role it gave to money demanded explicit and separate reflection so that it was given due consideration in the assessment of risks to price stability:

"The short to medium-term economic analysis - with its focus on real activity and financial conditions - is well equipped to study shorter-run deviations of inflation from its long-term trend. However, it often fails to track the mechanisms by which monetary factors act over extended horizons and thus to pin down such trends. There is, therefore, a need for monetary policy to explicitly take information from monetary developments, which might otherwise risk being overlooked or underestimated, into due account in policy considerations."[72]

106. The monetary analysis could not simply be seen as part and parcel of a single economic analysis. To critics who argued that the ECB should combine both analyses into one single assessment or pillar, Professor Issing retorted that there was no easy way to combine the analysis of real economic trends with that of phenomena that were broadly "monetary" in nature. It was not yet possible to bring these two analyses together in a unified framework:

"I think that anybody who can solve this problem of integrating money into the usual models deserves the Nobel Prize. So far there has been no approach which, in a satisfactory, comprehensive way, combines monetary and the usual economic forecasting analysis. And so, we are keeping this two-pillar structure unchanged."[73]

107. The ECB was committed to ensuring that monetary phenomena - which it claimed were "likely to be overlooked within a framework centred on short-term inflation forecast procedures" - were sufficiently considered in the policy deliberations of the Governing Council.[74] Mr Trichet and Professor Issing also argued that "the very complex problem of asset prices" was "more naturally and better taken into account" in the bank's two-pillar strategy.[75] Although Mr Walton countered that the best way to observe whether or not there might be an asset price bubble was "actually to watch the asset prices themselves rather than to look at it indirectly through some money supply indicator" (Q 13).

108. Some witnesses criticised the two-pillar strategy as being confusing, saying that it was unclear what weight the Governing Council placed on each of the pillars. Professor Von Hagen, for example, was concerned that there had not even been an attempt to clarify how the two pillars would be combined into a consistent decision-making process (Q 182). The ECB argued though that at the end of the day monetary policy always involved judgment; it was not a mechanistic operation, and the bank did not want to over-simplify it. The ECB claimed that its two-pillar approach was the clearest way "to convey the notion of diversification of analysis to the public."[76]


109. The monetary pillar does not appear to have significantly affected the ECB's interest rate decisions. The prominent position of this monetary analysis in the ECB's presentation of these decisions did, however, cause problems and hindered the bank's communication of its monetary policy. We therefore welcome the changes in the President's press statement and the editorial in the bank's monthly bulletin, in which the monetary growth pillar plays a less prominent role, which helps the bank's communication strategy.

110. We believe that it is sensible that the Governing Council continue to monitor monetary developments in order to inform its decisions on interest rates. We accept that the two pillars of the ECB's monetary policy strategy provide a useful framework for the internal analysis of information that facilitates the debate within the Governing Council. We respect the ECB's view that it does not want to create the wrong impression that controlling inflation is an exact science. However, the ECB's decision to reject inflation targeting and maintain its two-pillar framework does not imply that the bank is prevented from adopting an inflation target. The ECB could announce an explicitly symmetrical inflation target and state that that its actions in trying to achieve this target will be based upon its two-pillar framework rather than be guided solely by the relationship between forecasted and target inflation.

111. The ECB has said that its "two-pillar framework has over time become the hallmark of the strategy in conjunction with the medium-term orientation of the ECB's policy framework."[77] Our proposals do not necessarily call for either of these aspects of ECB's monetary policy strategy to be changed. We believe that our recommendations represent a sensible compromise between the ECB's determined attachment to its two pillars and calls for the bank to change to an inflation-targeting regime. The ECB could combine what it considers to be the organisational advantages of its two-pillar framework with the important communication benefits associated with the anchoring role of an inflation target. Were the ECB to adopt a symmetrical inflation target, however, it might reconsider the role and necessity of its monetary analysis.

Should the ECB conduct further reviews of its monetary policy in the future?

112. Mr Walton told us that "the ECB should not regard this review of monetary strategy as the only review it ever conducts into its monetary strategy." He suggested that this was a procedure that the bank should follow every few years or every time another Member State joined the euro area. There was a precedent for conducting regular periodical reviews of monetary policy, he pointed out, citing the example of the central bank of New Zealand, which conducted such a review every time a new governor was appointed or the governor was re-appointed:

"These things should never be fixed in stone. There are always going to be advancements in economic thinking and there are always going to be changed circumstances. The ECB should never think that this is a one-off shot at trying to get the system right." (Q 29)

113. Whilst stressing that the Governing Council's reflection on its monetary policy strategy was "an ongoing process",[78] Professor Issing said that he did not expect the ECB to conduct another review of its monetary policy during his term at the bank (which ran until 2006).[79]


114. We are encouraged that the ECB has said that the process of review is ongoing. We hope that the bank will adopt the practice of conducting regular reviews of its monetary policy strategy. By the time such a review next takes place, the perceived dangers to the bank's credibility of changing its definition of price stability should have receded and the bank might at that point find it made sense to adopt a symmetrical inflation target.

Should the ECB have an Exchange Rate Policy?


115. The international monetary system is one of floating exchange rates. The main international currencies (notably the euro, US dollar, yen, pound sterling, Canadian dollar and Swiss franc) float freely as demand for and supply of the various currencies increases or decreases. The central banks concerned conduct policies that aim at maintaining price stability in their respective domestic economies, which can lead to quite large exchange rate fluctuations over the short to medium term.

116. Exchange rates fall within the competence of the Council rather than the ECB. Article 111 TEC states that the Council, acting unanimously, may "on a recommendation from the ECB or from the Commission, and after consulting the ECB in an endeavour to reach consensus consistent with the objective price stability, […] conclude formal agreements on an exchange rate system for the ecu in relation to non-Community currencies". In addition, it provides that the Council, acting with a qualified majority, either on a recommendation from the Commission and after consulting the ECB or on a recommendation from the ECB, can also formulate "general orientations" for exchange rate policy in relation to one or more non-community currencies. A resolution of the Luxembourg European Council of 13 December 1997 further elaborates the relationships between the Council, the Commission and the ESCB in the matter of exchange rates. [80] The resolution states:

"While in general exchange rates should be seen as the outcome of all other economic policies, the Council may, in exceptional circumstances, for example in the case of a clear misalignment, formulate general orientations for exchange rate policy in relation to non-EC currencies […]. These general orientations should always respect the independence of the ESCB and be consistent with the primary objective of the ESCB to maintain price stability."


117. Exchange rate fluctuations impact on price stability in the world's different currency areas: when a currency depreciates, there is what can be termed "imported inflation"; when a currency appreciates there is "imported disinflation". Dr Schmieding explained that the exchange rate thereby matters "significantly for economic growth and the inflation outlook". He argued that the main potential cause of deflation in the euro area would be the exchange rate, because according to some economic models "a rise of 10% of the euro in effective rate terms, would depress the price level by something like 1% over a period of a couple of years," which would temporarily reduce inflation quite sharply." Large fluctuations might therefore require some offsetting monetary action (QQ 68, 84; p.24).

118. Mr Volcker argued that large exchange rate movements between the euro and the dollar had had a negative impact on the structure of the economy and economic activity. He was concerned that central banks and governments - and "particularly in the big countries and particularly in the biggest economic areas, Europe and the United States" - had been "very blasé, to say the least, about exchange rate movements." He thought that central banks could become preoccupied with delivering internal stability of the price index and the absence of inflation in their currency area; and, if that happened, they could not afford to worry much about the exchange rate. The institutional arrangements were partly to blame:

"If the Government is in charge of exchange rate policy, but the biggest most fundamental influence on the exchange rate policy is monetary policy, it is inherently a strange and difficult situation, which basically every country has faced and reached its own kind of practical compromise, or sometimes conflict. I do not have any solution to it, except I do believe whoever controls the policy it is unfortunate more attention has not been paid to the desirability of not fixing the exchange rate but avoiding these really extreme movements." (Q 131)


119. Our witnesses welcomed the fact that the euro area did not have a formal exchange rate policy. They did not consider that it was possible for the central bank to try systematically to steer the level of the exchange rate towards some ideal level and at the same time maintain price stability. They did not want the central bank to have to aim for two nominal targets, because the exchange rate might suggest monetary policy go one way and inflation considerations within the euro area might suggest that it should go the other way.[81] As Mr Smith, Chief Economist at KPMG, put it: "you either have to have a very strong exchange rate policy if you are going to have one or you do not have one at all, because anything in the middle normally leads to some sort of disaster". The Government stressed, however, that despite the absence of an exchange rate target the ECB might occasionally want to intervene in the markets (QQ 24-25, 48, 189, 225). Professor Draghi agreed that all previous experience of setting an exchange rate target showed that it was "pointless" and very often had even been the source of "serious policy mistakes". He explained that whilst in the past it had always been "very difficult" to steer exchange rates towards ideal targets or ranges, nowadays it was "practically impossible", unless there was a concerted multilateral effort by all central banks towards the targets. He warned that even in a multilateral framework, there had been cases of failure, because capital markets were "simply too big." (Q 195)

120. All of our witnesses agreed that the ECB could never adopt a 'strong exchange rate policy', such as an exchange rate target with the dollar, because any attempt at such a policy could only be achieved by bilateral negotiation between the EU and the US, which would inevitably flounder on the difficulties of the EU reaching an understanding with the US on how to effect the policy. Dr Schmieding explained that such an arrangement was only practicable in an asymmetric relationship when a small country pegged its currency itself to a bigger one, so that there was no question as to who was following whom (Q 84). Professor Goodhart said:

"On an exchange rate target it takes two to tango, and that means if there is a fixed exchange rate between the US and the euro (and that is the only one that is really relevant) then there is a question of who follows whom. There is no question in my mind that the Fed would insist on maintaining its complete independence in deciding interest rates and monetary conditions. That would mean, if you wanted an exchange rate target, the ECB would have to follow, effectively pretty slavishly, exactly what the Americans were doing. I do not see the euro zone, when faced with that possibility, wanting to go down that road at all." (Q 48)

Sir Samuel Brittan expressed this view most bluntly when he said that "any attempt to have an exchange rate policy against the dollar would lead to an almighty row with the United States" (Q 172).

121. Professor Draghi cautioned that the rejection of an exchange rate target did not mean that the ECB could be indifferent to what happened to the exchange rate. Professor Thygesen said that the central bank did take movements in the exchange rate into account, although he considered the ECB tended to underplay their importance. He questioned whether the ECB was "too sanguine about the disinflationary impact of euro appreciation" and thought that the ECB should provide a "more explicit commentary" on movements in the exchange rate, "particularly when the speed of movement of currencies is rapid" (Q 84; p.24). The ECB's remarks when announcing interest rate decisions clearly demonstrated that the bank kept watch on developments in the exchange rate. Mr Trichet clarified how this process worked within the Governing Council:

"The Governing Council takes into account all the available information, relevant data and analyses provided in the report by the member of the Executive Board in charge of the economic and monetary analysis. Exchange rates and their impact on monetary and financial conditions and price developments of course feature in these data and are factored into the analyses and assessment of the outlook for price stability together with all the other elements."[82]

122. One further argument put forward against the euro area adopting an exchange rate target was that it was impossible to say with any confidence what the correct exchange rate should be. As Sir Samuel Brittan put it, "you will find as many economists saying that the European exchange rate is still too low as those saying that it is now too high" (Q 172). Nonetheless, Mr Volcker argued that the policy makers concerned ought to be able to arrive at some conclusion about what constituted "a reasonable range of exchange rates that could be relatively accommodated and would give the market room to go up and down". They should try and reach agreement on some such range, which could be as wide as 10% or 20% from an agreed figure, because although that was still a lot of fluctuation, it was only half of what was being seen in practice and would be "much less damaging" to the economy. He admitted, however, that judgments differed as to whether such a range could be sustained:

"My own view is that the exchange markets presently have no sense of conviction about what is a sustainable equilibrium exchange rate. They take great pleasure in making money out of these fluctuations. In terms of political dynamics, the great difference in my professional lifetime has been that Wall Street was a great defender of stability and fixed exchange rates, but when they found out how much money they could make from instability, they are now the big proponents of no government intervention and instability, which makes it difficult to take action. But, without any sense of what the right exchange rate is, and the Government is completely agnostic about what the right exchange rate is by their performance, the markets just carried it to extremes. That is the way markets go. I would think if Governments were able to give some reasonable indication of what they thought was a kind of central tendency, the market would give some weight to that. You would have to build up some credibility over time." (Q 142)

Mr Volcker confessed that, in fact, he saw no realistic possibility of either an EU or a US administration being prepared to co-ordinate their actions together in the way that he suggested was desirable to avoid excessive volatility of exchange rates (Q 146).


  1. It would be a mistake for the euro area to adopt an exchange-rate target. We are satisfied that the ECB has paid attention to the exchange rate when making its interest rate decisions, but it is clear that affecting the exchange rate has not been the primary aim of the bank's monetary policy. This has not, and should not, preclude occasional interventions by the ECB in the markets to dampen excessively rapid swings. We are convinced that this is the correct policy for the ECB to pursue.

Monetary Dialogue with the Economic and Monetary Affairs Committee of the European Parliament, Brussels, 10 September 2003 Back

21   'Changing Fortunes: Financing World Growth', Speech by President Duisenberg at the 2003 Spruce Meadows Round Table, Calgary, Friday 5 September 2003. (All the key speeches of the members of the Executive Board are available on the ECB's website.) Back

22   UK Membership of the single currency: An assessment of the five economic tests (Cm 5776), p. 183. Back

23   'The first lustrum of the ECB', Speech by the President of the ECB at the International Frankfurt Banking Evening, Frankfurt, 16 June 2003. Back

24   Professor Alberto Alesina (Professor of Political Economy at Harvard University) and Professor Guido Tabellini (Professor of Economics at Bocconi University) explained that politicians were particularly to blame for the perception that the ECB did not pay enough regard to growth: "Often bureaucrats are used by politicians as scapegoats. For instance, 'excessive' monetary tightening is often invoked by politicians to justify poor economic conditions even when monetary policy has nothing to do with it." According to Professor Alesina et al., this was precisely what had happened in Europe since the creation of the ECB (Designing Macroeconomic Policy for Europe, CEPR London, 2001). Back

25   'Editorial', ECB Monthly Bulletin, April 1999, p.5. Back

26   'Editorial', ECB Monthly Bulletin, March 2003, p.5. Back

27   In their CER study, Fitoussi and Creel went even further, coming to the following conclusion: "If anything, the ECB's policy has stimulated economic growth, since real interest rates have been much lower than during the low-growth period of 1991-97" (op.cit., p.19). Back

28   This shows a greater degree of openness and transparency than some other central banks. The US Federal Reserve System and the Bank of Japan do not specify a quantitative definition of their price stability objectives. The Bundesbank operated without a public numerical definition of price stability. Back

29   This situation is not unique: in Sweden, for example, the Riksbank sets the value of its inflation target. Back

30   Known previously as euro-X, and then as euro-11, the Eurogroup is an informal body that was formed following a French initiative. Since the group was established, the Council has repeatedly reemphasised the fact that Ecofin, the meeting of the Finance Ministers of all the Member States, is the sole decision-making body at Council level on the economic matters which fall within its remit. The Eurogroup can currently only operate as a consultative grouping and normally meets informally before the formal meetings of Ecofin. It is possible that new Constitutional Treaty may ascribe formal status to the Eurogroup for the first time. Back

31   Monetary Dialogue with the Economic and Monetary Affairs Committee of the European Parliament, Brussels, 12 June 2003. Back

32   The ECB is not completely independent from political influence; it is open to Ecofin to ask the ECB to pay more attention to the exchange rate. On the ECB and the exchange rate of the euro, see below (paragraphs 115-23). Back

33   ECB Press Conference, Frankfurt, 5 December 2002. Back

34   Press seminar on the evaluation of the ECB's monetary policy strategy, Frankfurt, 8 May 2003. Back

35   'Editorial', ECB Monthly Bulletin, May 2003, p.5. Back

36   Reforming Britain's Economic and Financial Policy: Towards Greater Economic Stability, HM Treasury, Edited by Ed Balls and Gus O'Donnell (Palgrave, 2002), page 47. Back

37   Economists generally use the term deflation to refer to an extended period of continuous fall in the general price level. Disinflation is a lowering of the rate of inflation (but not necessarily to or below zero). Back

38   Monetary Dialogue with the Economic and Monetary Affairs Committee of the European Parliament, Brussels, 12 June 2003. Back

39   Press seminar on the evaluation of the ECB's monetary policy strategy, Frankfurt, 8 May 2003. Back

40   Monetary Dialogue with the Economic and Monetary Affairs Committee of the European Parliament, Brussels, 17 February 2003. The incoming President, Mr Trichet, has even said that the ECB "could legitimately make use of unorthodox monetary weapons" (in an answer to the questionnaire drawn up by the Economic and Monetary Affairs Committee of the European Parliament for its hearing on 11 September 2003 on the appointment of Mr Trichet as President of the ECB).  Back

41   'The definition of price stability: choosing a price measure', by G. Camba-Mendez, Background study for the ECB's review of its monetary policy strategy, 2003, p.4 (available on the ECB's website). Back

42   'Overview of the Background Studies for the Reflections on the ECB's Monetary Policy Strategy', ECB, 8 May 2003, p.5. Back

43   'Overview of the Background Studies for the Reflections on the ECB's Monetary Policy Strategy', ECB, 8 May 2003, p.7. Back

44   'The outcome of the ECB's evaluation of its monetary policy strategy', ECB Monthly Bulletin, June 2003, pp.85-86. See also the ECB report "Inflation differentials in the euro area: potential causes and policy implications", published 30 September 2003 (available on the ECB website). Back

45   Reforming Britain's Economic and Financial Policy: Towards Greater Economic Stability, HM Treasury, Edited by Ed Balls and Gus O'Donnell (Palgrave, 2002), p. 47. Back

46   Most recently President Duisenberg added some further clarification to the definition. He said that "close to but below 2% implies a rate which is close to below 2%, but higher than 1.3%, I can assure you." ECB Press Conference, Lisbon, 2 October 2003. Back

47   Professor Wyplosz, 'The Strategy Review', Briefing paper for the Economic and Monetary Affairs Committee of the European Parliament, second quarter 2003, p.4 (available on that committee's website). Back

48   Reforming Britain's Economic and Financial Policy: Towards Greater Economic Stability, op.cit., p.47. Back

49   Monetary Dialogue with the Economic and Monetary Affairs Committee of the European Parliament, Brussels, 12 June 2003. Back

50   'The Strategy Review', op. cit., p.1. Back

51   ECB Press Conference, Frankfurt, 8 May 2003. Back

52   Press seminar on the evaluation of the ECB's monetary policy strategy, Frankfurt, 8 May 2003. Back

53   Monetary Dialogue with the Economic and Monetary Affairs Committee of the European Parliament, Brussels, 12 June 2003. Back

54   'The first lustrum of the ECB', Speech by the President of the ECB at the International Frankfurt Banking Evening, Frankfurt, 16 June 2003. Back

55   Answer to the questionnaire drawn up by the Economic and Monetary Affairs Committee of the European Parliament for its hearing on 11 September 2003 on the appointment of Mr Trichet as President of the ECB (available on that committee's website). Back

56   Press seminar on the evaluation of the ECB's monetary policy strategy, Frankfurt, 8 May 2003. Back

57   'Overview of the Background Studies for the Reflections on the ECB's Monetary Policy Strategy', ECB, 8 May 2003, p.10. (See also E. Castelnuovo, S. Nicoletti Altimari and D. Rodriguez-Palenzuela, 2003, 'Definition of price stability, range and point inflation targets: The anchoring of long-term inflation expectations', Background study for the ECB's review of its monetary policy strategy, 2003, available on the ECB's website.) Back

58   'The outcome of the ECB's evaluation of its monetary policy strategy', ECB Monthly Bulletin, June 2003, pp.79-80 (see also Chart One on p.81 of this edition). Back

59   'The Strategy Review', op.cit., p.4. Back

60   'The outcome of the ECB's evaluation of its monetary policy strategy', ECB Monthly Bulletin, June 2003, p.82. Back

61   'The first lustrum of the ECB', Speech by the President of the ECB at the International Frankfurt Banking Evening, Frankfurt, 16 June 2003. Back

62   'Overview of the Background Studies for the Reflections on the ECB's Monetary Policy Strategy', ECB, 8 May 2003, p.16. Back

63   'Official Statistics for a Global Economy', Speech delivered at the 54th Session of the International Statistical Institute, Berlin, 20 August 2003. Back

64   ibid. Back

65   'The ECB's monetary policy strategy', ECB Press Release, 8 May 2003. Back

66   'Overview of the Background Studies for the Reflections on the ECB's Monetary Policy Strategy', ECB, 8 May 2003, p.16. Back

67   ibid., p.17. Back

68   'ECB Watchers Conference: The evaluation of the strategy', Opening remarks by Professor Issing, Frankfurt, 11 July 2003. Back

69   'Overview of the Background Studies for the Reflections on the ECB's Monetary Policy Strategy', ECB, 8 May 2003, p.14. Back

70   ibid., p.15. Back

71   ibid., p.16. Back

72   'The outcome of the ECB's evaluation of its monetary policy strategy', ECB Monthly Bulletin, June 2003, p.87. Back

73   'Overview of the Background Studies for the Reflections on the ECB's Monetary Policy Strategy', ECB, 8 May 2003, p.19. Back

74   ibid., p.18. Back

75   Answer by Mr Trichet to the questionnaire drawn up by the Economic and Monetary Affairs Committee of the European Parliament for its hearing on 11 September 2003 on the appointment of Mr Trichet as President of the ECB (available on that committee's website); and 'ECB Watchers Conference: The evaluation of the strategy', Opening remarks by Professor Issing, Frankfurt, 11 July 2003. Back

76   'Overview of the Background Studies for the Reflections on the ECB's Monetary Policy Strategy', ECB, 8 May 2003, p.17. Back

77   'Overview of the Background Studies for the Reflections on the ECB's Monetary Policy Strategy', ECB, 8 May 2003, p.11. Back

78   'ECB Watchers Conference: The evaluation of the strategy', Opening remarks by Professor Issing, Frankfurt, 11 July 2003. Back

79   Press seminar on the evaluation of the ECB's monetary policy strategy, Frankfurt, 8 May 2003. Back

80   OJ C 35, 2.2.1998, p. 3. Back

81   The EC Treaty was quite clear about which objective would take priority. Article 4(2) of the Treaty stated that the activities of the Member States and the Community included "the definition and conduct of a single monetary policy and exchange-rate policy the primary objective of both of which shall be to maintain price stability and, without prejudice to this objective, to support the general economic policies in the Community". Back

82   Answer to the questionnaire drawn up by the Economic and Monetary Affairs Committee of the European Parliament for its hearing on 11 September 2003 on the appointment of Mr Trichet as President of the ECB. Back

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