Union itself. The transition to Stage Three is a unique event, and will create unique opportunities for many - but it will also create some unique problems for monetary policy makers. At the ECB, we are addressing these problems and are confident that the risks can be managed successfully. Many of the difficulties we face will be overcome through our own efforts over the coming months.
Among these problems are the difficulties involved in creating a comprehensive and accurate database of euro area-wide statistics. Running a single monetary policy for the euro area requires timely, reliable and accurate euro area data. In some cases, the euro area statistics simply did not exist until quite recently. In others, the statistics are based on new concepts, and the properties of the data series are not yet well known. The long runs of high quality back-data required for empirical economic analysis may be unavailable. Those that do exist are likely to have been constructed using some degree of estimation and judgement, possibly rendering the econometric results produced with them questionable.
Furthermore, the regime shift associated with the adoption of the single monetary policy may change the way expectations are formed in the euro area, and thereby alter forward-looking economic behaviour. Monetary policy's effects on consumption, investment, and wage bargaining - and therefore the whole transmission mechanism of monetary policy to developments in the price level - would be among the important economic relationships to be affected in this way.
This may be no bad thing. Indeed, using the regime shift implied by the transition to Stage Three to change both public and private sector behaviour in favourable directions may be one of the largest gains that the euro area can extract from Monetary Union. Nevertheless, these changes are likely to complicate the implementation of certain important elements of a monetary strategy, at least in the short term, as past relationships between macroeconomic variables may break down. What is good for the euro area economy as a whole may create some practical problems for the ESCB.
One example of this so-called 'Lucas critique' phenomenon is the impact of current, very low rates of inflation on private behaviour. For many countries participating in Monetary Union, there is simply no - or only very recent - experience of how the private sector will behave in an environment of sustained and credible low inflation. Instability in past relationships may result, should behaviour change in this new, low inflation environment. I have already argued that these structural changes will benefit Europe's citizens - price stability will allow markets to work more efficiently, thereby raising growth, and improving employment prospects. But these changes may also complicate the ESCB's assessment of economic and financial conditions.
These uncertainties - arising directly from the transition to Stage
Three itself - are both compounded by, and inter-related with, the broader
economic context in which Monetary Union will be established. The
increasing internationalisation of the global economy, and the current
rapid pace of technological change, have affected all sectors of the
economy, and the banking and financial systems in particular. For example,
at present there are many, inter-related innovations in the payments
system, such as:
* the introduction of TARGET (directly related to EMU itself);
* greater technological sophistication of payments mechanisms, as use of computers and information technology becomes more widespread and advanced;
* the additional incentive for cash-less payments that may arise from the fact that for some time to come - approximately three years - the new euro-denominated notes and coin will not come into circulation. In particular, narrow monetary aggregates might be affected by this development; and,
* increased competition among banks and settlements systems, arising from globalisation and the breakdown of barriers between previously segmented national markets, which may drive down the margins and fees charged to customers.
At the ESCB we will need to keep abreast of these developments, both for their immediate impact on one of our "basic tasks" - promoting the smooth operation of the payments system - and because of their broader implications for the euro area economy. Reducing transactions costs in the way I just described will benefit European consumers and producers - but it may also change the indicator properties of monetary, financial and economic variables that national central banks have looked to as guides for monetary policy in the past.
Finally, in Monetary Union there will be some heterogeneity across
countries within the euro area. Europe's diversity is one of its greatest
assets. But this diversity is greater than is typically the case between
different regions in the same country using a single currency.
Nevertheless, the ECB Governing Council will have to concentrate on
monetary and economic developments in the euro area as a whole when
discussing and taking monetary policy decisions.
How should a monetary policy strategy be selected in this - for
monetary policy makers, at least - potentially difficult environment? The
EMI outlined a number of 'guiding principles' for the selection of a
monetary strategy by the ESCB. Foremost amongst these was the principle of
'effectiveness'. The best monetary policy strategy for the ESCB is the one
which best signals a credible and realistic commitment to, and ensures
achievement of, the primary objective of price stability.
For many commentators, this criterion points unambiguously in the
direction of so-called 'direct inflation targeting'. If monetary strategies
are to be judged according to how well they achieve price stability,
defined as a low rate of measured inflation, then advocates of inflation
targets argue an optimal strategy would surely target this low inflation
rate directly. These commentators would place explicit quantitative targets
for inflation itself at the centre of the ESCB's monetary policy strategy.
Their approach has been strongly endorsed in some academic and central
banking circles.
But, in the current circumstances, a pure 'direct inflation targeting' strategy is too simplistic for the ESCB, and possibly even mis- conceived. The ESCB well understands the primacy of price developments and price stability for monetary policy making. Indeed, the Treaty's mandate is unambiguous in this respect. We will signal our intentions on this dimension very clearly by making a transparent public announcement of our definition of price stability. The current low level of long-term nominal interest rates in the euro area suggests that the financial markets, at least, understand and believe the over-riding priority that we attach to achieving price stability.
Regarding strategy, our choice therefore need not be governed solely by a desire to signal our intent to maintain price stability. This has already been well-established - by the Treaty, and by the success of the convergence process in reducing inflation in Europe to its current low level. Rather than signalling our intent, the strategy must constitute a practical guide that ensures monetary policy is effective in achieving the goal we have been set.
In this respect, there are considerable problems with using inflation itself as the direct target within the ESCB's overall strategy. Because of the well-known lags in the transmission mechanism of monetary policy to the economy in general, and the price level in particular, it is impossible for a central bank to control inflation directly. Therefore, 'inflation targeting' in practice means 'inflation forecast targeting' where central banks set monetary policy to keep their best forecast of inflation at the target level deemed consistent with price stability.
But recognition of this need for forecasts in an inflation targeting strategy immediately raises practical difficulties. In the uncertain environment likely to exist at the outset of Monetary Union, forecasting inflation will be very difficult, not least for the conceptual, empirical and practical reasons I outlined a moment ago. Forecasting models estimated using historic data may not offer a reliable guide to the behaviour of the euro area economy under Monetary Union. Forecast uncertainty is likely to be relatively large, possibly rendering the whole inflation targeting strategy ineffective.
To address these uncertainties, a large element of judgement would have to be introduced into the forecasting process, in order to allow for the regime shifts and structural and institutional changes that are a seemingly inevitable consequence of EMU. Simply relying on historic relationships to forecast future developments is unlikely to prove accurate or effective. While introducing judgmental adjustments into forecasts in these circumstances would be both appropriate and necessary, such adjustments are likely to compromise the transparency of the inflation forecasts and, thus, of any inflation targeting strategy. Using judgement may prevent outside observers from readily assessing the reliability and robustness of the inflation forecasting procedures used by the ESCB.
I see a distinct bias in the academic discussion of the comparative
advantages of inflation targeting and monetary targeting. With good reason,
many arguments are presented against the ESCB adopting a monetary target.
But proponents of inflation targeting seem to forget that, in the current
context, most of these arguments could also be used against inflation
targeting. Above all, I have not seen any attempt thus far - even if only a
tentative one - to explain how the ESCB should deal with the specific
difficulties involved in making an inflation forecast at the outset of
Monetary Union that could be used as the centrepiece of an inflation
targeting strategy.
In many respects, a strategy giving a prominent role to monetary
aggregates has considerable advantages over direct inflation targeting.
Monetary aggregates are published. They are clearly not subject to various
kinds of 'judgmental manipulation' by policy makers or central bank staff
that might be possible with inflation forecasts. To the extent that policy
makers wish to depart from the signals offered by monetary growth because
of 'special factors' or 'distortions' to the data - including those
distortions arising from the transition to Monetary Union itself - they
will have to do so in a public, clear and transparent manner.
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