The ECB monetary policy: Choices and challenges

Journal of Policy Modeling 29 (2007) 181–194

The ECB monetary policy: Choices and challenges

Andre Fourcans, Radu Vranceanu ∗ESSEC Business School, Department of Economics, PB 50105, 95021 Cergy-Pontoise, France

Received 15 May 2006; received in revised form 21 August 2006; accepted 6 December 2006Available online 16 January 2007

Abstract

This paper analyses the European central bank (ECB) monetary policy over the period 1999–2006, witha special emphasis on the recent years. The first part of the paper underlines the declared goals, decisionvariables and procedures, as can be inferred from various speeches of Jean-Claude Trichet, the President ofthe ECB. These statements are then weighted against the data, mainly through estimates of possible ECBinterest rate rules. While in many respects the bank has performed reasonably well, several issues may beraised, mainly because the inflation objective has not been reached during the last period and monetarydevelopments are not in line with economic stability. Policy recommendations follow, built on a renewedmonetarist tradition: the reduction of the weight of real activity in the conduct of monetary policy, whilefurther emphasising money via a money growth intermediate target.© 2006 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.

JEL classification: E52; E58; F01

Keywords: Monetary policy; ECB; Euro area; Taylor rule

1. Introduction

A fruitful debate on monetary policy processes, whatever the central bank under scrutiny, needsto unveil the variables that affect the banker’s behaviour, and analyse how these variables affectsuch behaviour. This is a crucial endeavour to get an understanding of any consistent (or incon-sistent) decision-making process, to evaluate this process and to make policy recommendations.

Economists often resort to linear models of the interest rate determination in order to describethe essentials of a central bank’s monetary policy. Yet, in day-to-day decision-making, centralbankers follow a rather pragmatic approach in formulating their policy decisions. They take into

∗ Corresponding author. Tel.: +33 134433017; fax: +33 134433001.E-mail addresses: [email protected] (A. Fourcans), [email protected] (R. Vranceanu).

0161-8938/$ – see front matter © 2006 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.doi:10.1016/j.jpolmod.2006.12.004

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182 A. Fourcans, R. Vranceanu / Journal of Policy Modeling 29 (2007) 181–194

consideration a variety of variables and even “hunches” that are not necessarily captured by simplerules. Hence, the necessity to carry out not only a quantitative but also a qualitative analysis of thecentral banker behaviour.1 By considering both the quantitative and the qualitative analyses onegets a better view of a central bank’s monetary policy framework and is able to use these analysesas a basis for policy proposals.

One objective of this paper is an attempt at unveiling the ECB decision-making process,building upon both a qualitative analysis and an empirical analysis of its main monetary policydecisions. From these analyses we infer an evaluation of the ECB monetary policy and proposepolicy reforms which, we believe, would enhance and sustain over time the bank’s credibility aswell as improve its role and achievements as a “money watcher”.

The qualitative analysis is conducted by studying the public statements and positions (pressconferences and speeches) given by the President of the ECB, Jean-Claude Trichet, speaking forthe governing council of the central bank. The quantitative analysis seeks to extract from the datathe basic responses of the ECB to main macroeconomic variables; this extraction process enablesus to compare the empirical results with principles deducted from the qualitative analysis. Thequantitative analysis is conducted essentially via estimates of interest rate rules, be they in theexisting literature or our own new estimates.

Following this introduction, Section 2 presents a qualitative analysis of the European centralbanker’s behaviour, as inferred from his policy statements. Section 3 pursues this analysis througha discussion of the art of central banking and the credibility building essential to a new centralbank. The empirical analysis is developed in Sections 4 and 5; first by evaluating the existingliterature, second by a set of new estimates including the most recent period. Section 6 is devotedto further evaluation and discussion of the ECB policy process and to propositions for institutionaland policy reforms. Finally, Section 7 concludes by highlighting our key points.

2. European monetary policy in action: a qualitative analysis

This section aims to unveil the different variables that seem to come into play when the ECBdetermines monetary policy in the euro area, and the qualitative role that such variables play inthis determination, as can be deducted by reviewing the official statements of the President of thecentral bank.2

2.1. Inflation and inflationary expectations

No doubt, inflation and inflationary expectations of private agents are the core variables influ-encing practical monetary policy choices in the euro zone. A typical Trichet’s quote: “It is ofthe essence (of monetary policy) that the increase in the current inflation rate does not translateinto inflationary pressures over the medium term and to ensure that inflation expectations remainfirmly anchored at levels consistent with price stability.”3

1 Furthermore, Heinemann and Ullrich (2004) have shown that these qualitative analyses do convey relevant informationabout monetary policy making.

2 The references are essentially the Press Conferences given by J.C. Trichet after each meeting of the Governing Councilover the year 2005 until July 2006, and the Reports to the European Parliament. When other references are used, they areexplicitly mentioned.

3 Private agents’ expectations are not easy to grasp (they may be captured by the yield gap between standard andinflation-indexed bonds), and are extremely volatile. Keeping them under control is possible only if private agents havetrust in their central bank.

A. Fourcans, R. Vranceanu / Journal of Policy Modeling 29 (2007) 181–194 183

It is also clear that the policymaker draws a distinction between the short-term inflation rateand the expected long-term value of inflation. The latter is the key objective, the former beingonly a useful piece of information. Indeed, when deciding on its monetary policy, the ECB takesinto consideration “forward-looking price developments.” The process by which the ECB makesthese expectations of future inflation developments is not explicitly developed, yet there seem tobe different variables influencing the policymaker’s long-run price expectations.

On that respect, uncertainties surrounding oil market developments are monitored, not only inthe short-run but also over longer periods. The same can be said about the value of the euro on theforeign exchange market. Inflationary expectations also depend on “the second pillar” of monetarypolicy, that is monetary developments: “We (Mr. Trichet) believe that in the long-run inflation isa monetary phenomenon.”4 One cannot be clearer. This topic deserves special emphasis.

2.2. Monetary developments

In the first years of the European Monetary Union (EMU) money growth was explicitly consid-ered as a “reference value” (a yearly growth of 4.5% for M3) in the conduct of monetary policy.Even if this explicit reference value was eliminated in 2003, the growth of the M3 monetaryaggregate still appears to be a variable taken into consideration by the policymaker. A typicalposition of the president of the ECB, presented in a consistent manner, using almost the samewords over the (latest) months: “Monetary analysis . . . points to increase upside risks to pricestability over the medium to longer term”, and the “strengthening of monetary growth observedsince mid-2004 has gained momentum over the past few months.” The low level of interest ratesis, in Mr. Trichet’s words, the dominant factor explaining this acceleration in money (and credit)growth: “The stimulative impact of the low level of interest rates in the euro area remains animportant driving factor behind the high trend rate of monetary expansion”.

As is often said by ECB officials, particularly its President, and as is explicitly stated on theECB web site,5 “it is widely agreed that in the long run . . . a change in the quantity of moneyin the economy will be reflected in a change in the general level of prices. But it will not inducepermanent changes in real variables such as real output or unemployment.” It stresses the point byadding that “it (a central bank) cannot enhance economic growth by expanding the money supply. . .”. Of course, this position has (or should have) consequences on the conduct of monetary policyin terms of controlling the evolution of money growth.

2.3. Real activity: output growth and unemployment

The role of output growth and unemployment in making monetary policy decisions is lessclear and less clearly expressed by our policymaker. Not that these variables are not taken intoconsideration, but they come second in terms of priority, after price developments. In other words,if these variables are taken into consideration, the reason appears to be more because of what theymay imply in terms of future price developments than because of their value per se, at least in theshort-run. The price stability objective seems to override the short-term rate of real growth (or ofunemployment) in the determination of monetary policy.

4 Jean-Claude Trichet, Interview with the Irish Time, Le Figaro, El Mundo and Frankfurter Allgemeine Zeitung, 21September, 2005.

5 See http://www.ecb.int/mopo/intro/html/role.en.html.

http://www.ecb.int/mopo/intro/html/role.en.html


Another issue concerns the role that the growth potential and the output gap play in terms ofmonetary policy. “We have to be humble in front of facts and figures. We are very cautious whenmonitoring the twin concepts of growth potential and output gap. Experience has demonstratedthat that they could be dramatically revised over time.”6 For Mr. Trichet, a central bank overlyinfluenced by such indicators could follow an erratic policy process that would be detrimental tostability and growth. It is difficult, from this sort of statement, to infer these variables having astrong impact in the monetary policy process.

Finally, the economic profession’s mainstream view, shared by the ECB, that long-run growthand unemployment do not depend on monetary policy but on structural factors of the economy,must have an influence on the conduct of monetary policy. Following this (and Mr. Trichet’s)view, the main contribution a central bank can make in order to sustain growth and employmentis by stabilising prices: “. . . price stability (is) a necessary condition for sustainable growth andjob creation: the central bank is called upon to deliver price stability . . . thereby contributing tomaximizing sustainable growth”.7 From this type of statement, one can deduct that the direct roleassigned to real activity statistics (e.g. the output gap, output growth gap, unemployment rate) inthe conduct of monetary policy would be rather marginal, or at least uncertain.

2.4. Wages, fiscal policies and structural factors

The evolution of wages is looked at insofar as it can be a vector of inflation transmission overthe economy. These “secondary effects”, viewed as the “main enemy” by the central banker arewatched with “extreme care” in order to avoid the spread of inflationary pressure, especially inperiods of external shocks such as an oil shock or an exchange rate shock.

Too lenient fiscal policies are also subject to criticism by J.C. Trichet. Excessive deficits are“a matter of great concern” and too much lightness in implementing the Stability and GrowthPact is seen as undermining the credibility of the Pact and thus long-term prospects of growth andunemployment. It is interesting to notice that the decision maker does not appear to pay particularattention to the upward pressure on interest rates that budget deficits may induce, and consequentlythe pressure on monetary policy that may result. He prefers to emphasize its “direct” impact ongrowth and employment, probably to counter criticism that during the last downturn monetarypolicy may not have been supportive enough to growth. In spite of this type of statement, thePresident of the ECB rarely, if ever, comments on the impact that budget deficits may have on theconduct of monetary policy.

As far as structural reforms are concerned, the ECB insists on “the urgent need to increase theflexibility of labour and product markets” so as to better capture “the opportunities arising fromglobalization and rapid technological change”, rather than on the way they can influence monetarypolicy. Labour costs are also considered, and in some cases “it could be good to have nominalwages and salaries moving more slowly than the labour productivity increases”, but they are seenmore in terms of their impact on competitiveness and employment than in terms of their monetarypolicy impact. Productivity per se does not seem to be taken into consideration in the conduct ofmonetary policy either, even though boosting labour productivity growth must be “another centralcomponent . . . to enhance Europe’s growth potential.”

6 Jean-Claude Trichet, Interview, op. cit.7 Jean-Claude Trichet, “Key Issues for Monetary Policy: an ECB View”, National Association of Business Economics,

Philadelphia, 5 October, 2004.


As to asset prices, the governing council “is monitoring closely what happens” and they mustbe “looked at very closely.” But that does not mean that these variables have a direct impact uponthe monetary policy process, they merely enter the analysis through the two pillar strategy. Assetprices may also have an important informative role as to the evolution of inflationary expectations(through, for example, the measure of the break-even inflation rate), the assessment of theseexpectations playing a central role in the conduct of monetary policy.

3. The art of central banking and the building of credibility

Central banking is an “art” as well as a “science”.8 The policymaker must take into consider-ation the economic facts and have an underlying model of the economy (be it explicit or implicit,structured or informal), in order to make and implement decisions. But it must also deal with more“fuzzy” variables and concepts such as credibility, transparency, market reaction, fundamentalsand short-run versus long-run horizons. Where does the ECB stand on these matters and how dothey influence its decision-making process?

The European central banking process appears to focus on two related issues: anchoring long-run inflationary expectations as well as building the credibility of the central bank on this matter.“Anchoring inflation expectations is not only important for low medium and long-term marketinterest rates. It is also crucial for reducing macroeconomic fluctuations in response to economicshocks.”9 And this anchoring of inflationary expectations is best achieved, in the central banker’sviews, through an explicitly defined and credible price stability objective. And this stability objec-tive is reached through the two pillar approach of monetary policy (the economic and the monetarypillars). The loop is closed.

Building credibility is not an easy task, especially for a young central bank. Hence the strong andrepeated statements made by Mr. Trichet that monetary policy should not be too sensitive to short-run shocks to the economy, except if they may affect long-run expectations or economic variables,but should rather be geared towards the fundamentals, and their expected changes: “. . . it pays toadopt a systematic policy focused on responding to the fundamental forces at work in the economyin a predictable manner, disregarding the vagaries of expectations and markets.”10 If the Presidentof the ECB acknowledges that expectations instability may imply a more “aggressive” monetarypolicy, i.e., more variability in the interest rate, to stabilise these expectations, he immediatelyadds that this type of reaction would be unnecessary “in many circumstances” as long as thecentral bank has a clear price stability objective and does not pretend to fine-tune the economy.Hence the emphasis on credibility in maintaining inflation “at levels consistent with the pricestability objective.”

Communication, and the transparency that goes along with it is also “an integral part of mone-tary policy . . . as it contributes considerably to the efficiency of its policies”.11 For the policymaker,

8 On the “science” matter, it is interesting to notice that in a speech more “academic” than the usual ones, J.C. Trichetmakes explicit reference and pays special tribute to the “stars” of the economists’ profession: Robert Lucas, ThomasSargent, Neil Wallace, Robert Barro, Robert Gordon, Kenneth Rogoff, Richard Clarida, Anastasios Orphanides, etc.“Monetary Policy and Private Expectations”, Zolotas Lecture, Bank of Greece, Athens, 25 February 2005.

9 Jean-Claude Trichet, “Monetary Policy in EMU, Views and Challenges”, ZEW, Mannheim, 24 June, 2005.10 Jean-Claude Trichet, “Monetary Policy and ‘Credible Alertness”’, Symposium sponsored by the Federal Reserve

Bank of Kansas City, Jackson Hole, Wyoming, 27 August, 2005.11 Jean-Claude Trichet, “Communication, Transparency and the ECB’s Monetary Policy”, The International Club of

Frankfurt Economic Journalists, Frankfurt, 24 January, 2005.


communication is important in two ways: (1) as a verbal reminder and an active demonstrationthat the bank follows a consistent rule of policy along the lines of the price stability objective andthe two pillar strategy; and (2) as a means of explaining its views on the economy so as to driveas much as possible market expectations without necessarily “engineering policy actions”, thatis, without changing the interest rate.

Short-run macroeconomic shocks should not make the European central banker change hisviews on this matter. Consistency on this type of policy is more important, for our Banker, thanover-reacting to economic fluctuations and to the business cycle. Credibility must stem more fromthis policy process than changes in the interest rate. Hence the repeated position of the ECB thatit does not pre-announce a change in the interest rate, be it an increase or a decrease, that it doesnot “promise anything in advance” on that respect. But that it will act, and “the markets mustknow that”, and move the rate if there is a need to move so as to stabilise inflation expectations.In J.C. Trichet and his colleagues’ view, the credibility in stabilising these expectations and the“vigilance” of the central bank on the matter are the fundamental clues in determining monetarypolicy, whatever the means used to achieve that policy may end up being.

4. Interest rate rules and the ECB: an evaluation of previous empirical estimates

This section and the following one analyse to what extent quantitative estimates corroborate ornot the qualitative positions taken by the European central banker, the objective being to be able tojudge more clearly and rigorously the monetary policy process, explicit or implicit, followed bythe monetary authorities. Among different tools, estimates of interest rate rules (or Taylor rules),are useful on that respect.

To clarify our discussion, let us be reminded that the basic interest rate rule (Taylor, 1993)takes the form:

i∗t = i + β(E[πt+k|It] − π) + γyt (1)

where i∗t is the target interest rate, E[ ] is the expectation operator, It the information set at thetime the interest rate is chosen (i.e., at time t), πt+k the inflation rate k periods ahead, π the targetinflation rate, and yt the output gap; i,β andγ are given parameters. In so called “contemporaneous”rules, k is set to zero; it is positive in “forward looking rules” and negative in “backward lookingrules”. Variables other than inflation and the output gap, that may have a bearing on interest ratedetermination, could also be included in this type of rules.

The important role played by the β coefficient on the stability of the macroeconomic systemhas often been pointed to within the framework of simple macroeconomic dynamic models. Whena shock pushes inflation above the target, the central bank increases its interest rate according tothe policy rule. If β < 1, the increase is not strong enough to bring about a higher real interestrate, investment and demand are kept strong, and, via some Phillips curve mechanism, inflationis further enhanced. On the other hand, if β > 1, the strong response of the central bank tempersdemand and inflation.

If the central banker is also concerned by the fact that overly abrupt changes in interest ratesmay disrupt bond and equity markets, he would smooth changes in interest rates such as to reachthe desired i∗t after a more or less lengthy period. For instance, the effective interest rate chosenby the central bank, it, might follow the dynamics: it = ρit−1 + (1 − ρ)i∗t , with ρ ∈ [0, 1]. In thiscase, the (effective) interest rate rule can be written:

it = ρit−1 + (1 − ρ){i + β(E[πt+k|It] − π) + γyt} (2)


Table 1A review of main Taylor rules estimates for the ECB

Study Type of rule Freq. Period β γ Obs.

Gerdesmeier and Roffia(2003)

Contemporaneous M 99.01–02.01 0.45 0.30

Ullrich (2003) Contemporaneous M 99.01–02.08 0.25 0.63 0.08 coefficient of thereal ex. rate

Fourcans and Vranceanu(2004)

Contemporaneous M 99.04–03.10 0.43 0.26 0.08 coefficient on thenominal exchange rate

Forward (+6) M 99.01–03.10 2.8 0.19

Surico (2003) Contemporaneous M 97.07–02.10 0.58 0.60 Quadratic term ininflation

Forward (+3) M 97.07–02.10 0.85 0.60 Quadratic term ininflation

Sauer and Sturm (2003) Contemporaneous M 99.01–03.03 0.51 0.37 OLS ex-post dataForward (+3) M 99.01–03.03 0.86 0.86 GMM ex-post dataForward (+3) M 99.01–03.03 2.14 1.84 GMM real time data

Belke, Kosters, Leschke,and Polleit (2005)

Contemporaneous Q 99.1–05.4 0.49 1.94

Fendel and Frenkel(2006)

Forward (+12) M 99.01–02.12 2.54 1.69 Quadratic trend inindustrial output

Forward (+12) M 99.01–02.12 1.43 0.29 Linear trend inindustrial output

The coefficient (1 − ρ) may then be interpreted as a measure of the effective change in interestrate as compared to the desired change.

Table 1 summarizes the findings of previous estimates of ECB interest rate rules.All estimates point out to the sensitivity of the ECB to real activity (measured by the γ

coefficient): if the current output goes below its trend (or the output growth rate falls below itslong-run value) the bank will reduce interest rates and vice-versa.

Even if, from most of these studies, the ECB increases interest rates if the inflation rate exceedsthe 2% objective, it is not clear whether the bank’s action is stabilising or not: the β coefficientis bigger or smaller than one, depending on the study and the estimates. Yet β is much biggerin forward looking rules than in contemporaneous rules. Moreover, in some estimates of con-temporaneous rules, variables other than inflation and the output gap turned out to be significant(e.g. the nominal or the real exchange rate). This outcome is not surprising. If the policymakeris concerned about future inflation, contemporaneous inflation and other variables that have abearing on future inflation must be significant.

This being said, in the estimates of forward looking policy rules, the impact of the variables thathave been found to have an influence on the expected inflation rate in contemporaneous rules mustbe captured by the coefficient of future inflation (a proxy for expected inflation). In other words,if the output gap (or another real activity measure) is significant in forward looking interest raterules, together with future inflation, this might suggest that real activity may be an autonomousgoal of the bank.

Finally, most empirical studies show that, despites its verbal commitment to the former moneystock growth “reference value” (4.5% a year), or to money growth in general, the bank seemsto pays little attention to this indicator, at least directly (Fendel & Frenkel, 2006; Fourcans &


Vranceanu, 2004), as this variable is never significant in estimates of contemporaneous interestrate rules.

5. New estimates of the ECB interest rate rule (1999–2006)

In this section we carry out new estimates of the ECB interest rate rules over the interval1999.01–2006.03. Data are monthly and come from Thomson Datastream. The dependent variableis a relevant measure of the target short-term interest rate (INTRA). In this paper, we use as aproxy the monthly average of EONIA, the overnight interest rate in the euro area.

The main exogenous variables are: INF, the inflation rate, calculated as the yearly percentagechange of the representative price index from one month to the same month of the previous year,and a real activity measure, Y.

An empirically testable variant of Eq. (2) is:

INTRAt = a1 + a2INTRAt−1 + a3INFt+k + a4Yt + εt (3)

where future inflation (INFt+k) stands as a proxy for the policymaker’s inflationary expectations kmonths ahead; as an indicator for real activity (available with a monthly frequency), we use eitherthe industrial output gap IPGAP, measured as the monthly percent deviation of the industrialproduction index from the Hodrick-Prescott trend, or GRGAP, the deviation of the industrialproduction growth rate from the over-the-period average (of 1.7%); the growth rate is calculatedas the percentage change of the industrial output index from one month to the same month ofthe previous year. Also, εt is an i.i.d. composite error term that captures shocks and, in forwardlooking rules, expectation errors. The regression coefficients relate to implied coefficients in Eq.(2) such as: a1 = (1 − ρ)(i − βπ), a2 = ρ, a3 = (1 − ρ)β, a4 = (1 − ρ)γ .

Table 2 displays the main OLS estimates. Variables are denoted by NAME(n), where n is thenumber of leads (or lags, for a negative number). For each measure of real activity, we showa contemporaneous rule (inflation is measured at time t), and a forward looking rules (with a12-month inflation lead).

Contemporaneous rules (Rules 1 and 3) do not seem to be supported by the data, the coefficienton inflation is not significant. It is worth mentioning also that, like in the formerly presented studies,the money growth rate does not appear to be significant in our estimates of contemporaneous rules.

Forward looking rules (Rules 2 and 4) seem to be reliable: both the inflation rate one-yearahead and real activity seem to be relevant determinants of the central bank’s policy.

Table 2Interest rate rule estimates for the ECB, 1999–2006

Rule 1 Rule 2 Rule 3 Rule 4

C 0.195** −0.264* 0.001ns −0.262*INTRA(−1) 0.962*** 0.960*** 0.973*** 0.979***INF −0.043ns – 0.034 ns –INF(+12) – 0.170*** – 0.143**IPGAP 0.066*** 0.051*** – –GRGAP – – 0.039*** 0.034***Nr obs. 86 74 86 74R2-adj 0.97 0.97 0.98 0.98

***Significant at 1%, **significant at 5%, *significant at 10%; ns, non-significant. The LM Test shows no residualautocorrelation with lag order 2.


This type of estimates may be criticized on the ground that the right hand side variables are notindependent. To address this problem, we also estimated a small model of the euro area economyby using the Full Information Maximum Likelihood (FIML) method. The model is made up of: aforward looking interest rate rule; an IS equation, where output depends on the real interest rateand the stock market index (as a proxy for wealth), denoted by STOCK; and a standard Phillipscurve where inflation depends on past inflation and the output gap.

INTRAt = a1 + a2INTRAt−1 + a3INFt+12 + a4Yt + εt, (Interest rate rule),

Yt = c1 + c2(INTRAt−12 − INFt−12) + c3STOCKt−6 + zt, (IS relationship),

INFt = b1 + b2INFt−1 + b3Yt−6 + μt, (Phillips curve)

where ε, μ and z are i.i.d. shocks.When the industrial production gap (IPGAP) is used as a proxy for real activity (Y), the tests

lead to:

INTRAt = −0.21 + 0.95INTRAt−1 + 0.16INFt+12 + 0.08IPGAPt ,

IPGAPt = −2.65 − 0.64(INTRAt−12 − INFt−12) + 0.04STOCKt−6,

INFt = 0.81 + 0.62INFt−1 + 0.07IPGAPt−6

All coefficients are statistically significant (at a 5% confidence interval or narrower). For eachof the three equations, the adjusted R-squared are respectively 0.98, 0.46 and 0.45.

When the industrial production growth gap (GRGAP) is the proxy for real activity, the estimatesare:

INTRAt = −0.25 + 0.97INTRAt−1 + 0.14INFt+12 + 0.03GRGAPt ,

GRGAPt = −3.67 − 1.50(INTRAt−12 − INFt−12) + 0.05STOCKt−6,

INFt = 0.78 + 0.64INFt−1 + 0.02GRGAPt−6

Here too the coefficients are significant at the 5% level, except the coefficient on GRGAP inthe first equation. The adjusted R-squared are 0.98, 0.31 and 0.47.

Both former models imply a positive wealth effect (the coefficient on the stock index in theoutput equation is positive and significant), and emphasize the relationship between real interestrates and real activity.

It must be noticed that the interest rate rule coefficients are closed to those estimated from aone equation model, as can be seen from Table 3. This table displays the implied coefficients ρ

and β in the forward looking rules, as well as γ , connected to the two measures of real activity,both from the OLS and the FIML estimates.

Table 3Implied coefficients in the forward looking rule

OLS FIML OLS FIML

ρ 0.04 0.05 0.02 0.02β INF(12) 4.3 3.1 6.80 6.63γ on IPGAP 1.28 1.57 – –γ on GRGAP – – 1.63 1.45


As shown by γ , the response of the central banker to the real activity indicator is economicallysignificant, no matter whether its level or its growth rate deviation is taken into account: a onepercentage point decline in the output below potential output (or output growth) would trigger afall in the desired interest rate about 0.66 percentage point.

Furthermore, as real activity is both statistically and economically significant at the same timeas future inflation (a proxy for inflationary expectations) is, it can be inferred that the ECB pursuesa direct real activity objective. This finding is somehow at odds with the official statements thatplay down the role of real activity in the conduct in monetary policy (such as presented in Section2.3).

Quite consistent with the goal of price stability in the medium run, over the period underscrutiny, the bank seems to react strongly to future inflation deviations from the objective. Whenreal activity is measured by the industrial output deviation from its long-run trend, the ECB wouldraise the desired interest rate by one percentage point if the inflation forecast exceeds the objectiveby about 1/3 to 1/4 percentage point. The response appears to be even stronger when real activityis measured by the industrial output growth rate deviation.

Also, the bank seems to smooth its intervention in the money market, the effective adjustmentper quarter representing between 8% and 20% of the desired change, depending on the estimate(coefficient ρ).

6. The ECB policymaking process: some propositions for reform

The quantitative analysis has underlined that, in keeping with the bank’s official position,inflation and inflationary expectations are the core variables influencing policy choices; and that,in contradiction with the official position, economic activity seems to be a direct objective of thepolicymaker.

This being said, several issues can be raised as to the conduct of monetary policy, especiallywith respect to the discrepancy that may exist between what the central banker says and what heaccomplishes, and therefore the credibility of such policy. On that matter we see three main pointsto argue about: the evolution of inflation and the respect of the quantitative inflation objective;the two pillar strategy and the implementation of it, especially as far as the monetary pillar isconcerned; the role played by real activity in the conduct of monetary policy.

6.1. Inflation and the price stability objective

Since the birth of the euro in the beginning of 1999 the inflation rate has almost always beenabove the objective of approximately 2% a year, except for the first few months – but then theECB policy is barely responsible for this occurrence. Fig. 1 shows the distribution of inflationrates (this month over the same month of previous year) from 01.2001 to 03.2006. Over the 63observations taken into account, in 50 months the inflation rate exceeded 2% (with an average of2.2%).

At the time of this writing (summer of 2006) the forecasts for the inflation rate (included thoseof the European central bank staff) remain above the objective at least until 2008, and significantlyso – some projections by the Euro system itself go up to 2.8% in 2007.

In view of these facts, how can the ECB pretend to be in line with its inflation objective of“below but close to 2% a year” whereas it has (almost) always been above this value? True, thebank is careful enough to pinpoint the fact that the objective is a medium term objective, andtherefore that if it has not reached it today, it will reach it tomorrow. But after seven years in


Fig. 1. The distribution of inflation rates, recorded between 01.2001 and 03.2006.

function, have we not reached yet the medium term? Even if inflation has been maintained withinreasonable limits since 1999, and the central bank must be praised for that, it does remain thatthe objective, as formulated by the bank itself, has not been reached. What can be and what willbe the impact of such a situation on the credibility of the ECB, credibility so dear to Mr. Trichet,and rightly so?

The European central banker cannot repeatedly mention, and again rightly so, the importanceof building credibility towards the ECB’s monetary policy process, and not consider what theoutcome of his policy with respect to his own inflation objectives may have on this credibility. Inan attempt to be consistent, two solutions are possible: either to follow a policy that will reallydrive the inflation rate in line with the stated objective or . . . change the objective.12 If we do notdebate here the respective virtues of these alternatives it still must be maintained that consistencyis necessary. With the current objective, it means that the ECB should adapt its behaviour in apersistent and consistent way, and not only periodically, so as to be, indeed, in the medium run(let’s say over the cycle) in line with the inflation objective.

6.2. The monetary pillar of the policy process

As demonstrated above, time and again the President of the European central bank presents theview that, for the governing council of the bank, the evolution of the money stock is of a crucialimportance in terms of controlling inflation. In spite of this repeatedly stated position, M3 growthhas in general been quite high, notably since January 2005, as can be seen from Fig. 2, at anyrate higher than what the 2% inflation objective would require. Again, our central banker shouldbehave in a more consistent way and “do as he says”, i.e., act in accordance with the mediumterm inflation objective.

As mentioned above, no empirical estimate of interest rate rules could find a significant rela-tionship between the money growth rate and the interest rate, despite of the verbal commitmentof ECB officials to monitor the evolution of the M3 aggregate.

12 The 2% inflation objective could be kept as the central value within a 1.75–2.25% band, for example.


Fig. 2. Money (M3) growth rates over the period 1999.01–2006.03.

According to officials’ statements, the bank shares the mainstream view that inflation is amonetary phenomenon and that monetary growth is the main driving force behind inflation in themedium and long terms.13

The ECB also recognizes that the interest rate it sets is the dominant factor explaining thechanges in M3 growth, especially that this interest rate explains the more current high trend rateof monetary expansion. Why then, over the years, has the ECB set up the interest rate at suchlevels that monetary policy has been accommodative, and too much so in view of the inflationobjective? Indeed, as our qualitative and quantitative analysis shows, the bank has not been inerton that question and even though it has taken into consideration the “inflation gap” in his policyprocess, from a monetary standpoint it has not done so consistently, for a long enough time, andin a rigorous enough way.

This behaviour can be explained by at least three rationales. First, the economic analysismade by the central bank has had on the average a stronger impact on monetary policy than themonetary analysis, leading to a kind of “benign neglect” of the evolution of the monetary (andcredit) aggregates. Second, there may be a discrepancy between the ECB’s official statementson the role of money and the steps it is willing to take in term of controlling the money stock.Third, our bank may not dispose yet of a satisfactory model (explicit or implicit) of monetarymechanisms, for example, in term of the quantitative influence of the interest rate (and otherpolicy variables such as the volume of open market interventions) on the money stock. Whateverthe reason, this lack of consistency in controlling the monetary aggregates weakens the search forcredibility that the ECB is striving for.

This being said, in order to increase and maintain its credibility we believe that the bank shouldbring the monetary pillar more to the forefront of its monetary policy. On that respect one canregret that the idea of the “reference value” of money growth that existed before the spring of2003 was suppressed. Is it pure “chance” that a few months after that date (around mid-2004) the

13 Recent empirical analyses performed by ECB’s economists unveil a strong relationship between inflation and the M3growth rate, adjusted for portofolio reallocations (ECB Monthly Bulletin, June 2006).


growth of money has risen in a significant way? Our argument is not to go back to the referencevalue in its former formulation, but to formulate it in a different way: for example by establishingreasonable upper and lower limits for money growth. The bank should then commit itself in termsof aiming for these values over time.

Of course, within this institutional background the European central bank should follow aninterest rate policy (and an open market policy) in line with such money growth values and withthe inflation objective. We believe that the credibility of monetary policy would significantly beenhanced and maintained through time with such a strategy.

A word of caution, though. We do not recommend that the ECB should go back to the typeof monetary policy used in the past whereby money growth was the final target of the process.This strategy has also its drawbacks and difficulties, such as the choice of the “right” monetaryaggregate or the sometimes difficult to predict changes in the velocity of money.14 What we sayis that money growth should be used more explicitly than it is the case now as an intermediatetarget variable while inflation remains the main target. The money stock could then play moreexplicitly and more consistently its informational role as to the movements in yields that drivethe economy, with the favourable consequences on prices, growth and employment.15

6.3. The role of real activity in the policy process

Estimates of forward looking interest rate rules point to the economically significant roleplayed by real activity in the conduct of monetary policy. The ECB seems to be concerned by theeconomic outlook as an independent objective of its policy making, despite what it announces viaits communication strategy. Our Taylor rule estimates (Table 3) show that the central bank wouldnot raise the desired interest rate if future inflation goes up by one third to one half percentagepoint, provided that at the same time industrial output declines by one percentage point.

This is not the best approach to credibility building. There is no need to recall here the well-known debate on rule versus discretion. But if a central bank with as long a history, as the Fed, maybe playing with the two (conflicting?) goals with a certain ease as far as its credibility is alreadyestablished, a young central bank such as the ECB should be more vigilant regarding the possibleimpact of its policy on its credibility. Credibility is more difficult to achieve if the inflation objectivemay be sacrificed to the objective of supporting real activity in bad times. Hence, the Europeancentral bank should focus more on the inflation objective and on monetary developments (withmonetary growth as an intermediate target, as explained above) than on short-term fluctuations inreal economic activity.

7. Conclusion

This paper presents an analysis of the ECB monetary policy both from a qualitative and aquantitative perspective. From these analyses we infer some policy recommendations.

14 Yet these questions are not more difficult to deal with than those related to output (or output gap) projections, forexample. This is another issue that cannot be analyzed here. Either way, more work, particularly empirical, needs to bedone on this matter taking into account euro zone institutions and data.15 It is not our intend in this article to develop on this point and on the question of the transmission mechanism of money

to the economy. Monetarists, such as Milton Friedman or, in a more explicit way, Karl Brunner and Allan Meltzer, havethoroughly analyzed these issues. Their analyses, unfortunately, seem to have been somewhat forgotten over the years bythe economic profession and central bankers. The interested reader can refer to the excellent paper by Nelson (2003) whorevisits the subject.


The qualitative approach builds on information extracted from various speeches of the Presi-dent of the ECB. It unveils the different variables that seem to be considered when determiningmonetary policy in the euro area, and the qualitative role that they seem to play in this determina-tion. This part presents the global “philosophy” of monetary policy making of the bank, stressesits need and desire to establish and reinforce its credibility as an overriding means to controlinflation, anchor inflationary expectations and sustain growth in the euro area.

In spite of what appears to be a strong reaction to inflationary changes, in the last six yearsthe inflation rate has almost always been above the official objective. Even if these deviationshave not been large, such inconsistency over time could erode the credibility of the bank. To beconsistent, the central banker should conduct a policy that would bring the inflation rate in linewith the objective.16 On that respect, he should bring the “monetary pillar” more to the forefrontof his policy, and control more efficiently over time the growth of the monetary aggregates. Away of implementing this policy change would be to establish reasonable upper and lower limitsfor money growth, and for the central bank to commit itself to have these limits respected. Themoney stock would then be an intermediate target while inflation would remain the final target.

The quantitative part analyses published estimates of the ECB possible interest rate rulesand presents new estimates we made, from both one and simultaneous equation models. Allthese analyses point out that the bank appears to react significantly to future inflation deviationsfrom the objective, but also directly to changes in real activity. This last finding is not withoutconsequence. For a new bank like the ECB, the main concern should be the building of credibility.However, credibility is hard to achieve if the policymaker might in the short-run trade-off inflationfor unemployment or other real activity measure. This focus on real activity may be premature,and may put at risk the euro zone performance in the long-run.

References

Belke, A., Kosters,W., Leschke, M., & Polleit, T. (2005). Back to the rules. ECB Observer, 8, http://www.ecb-observer.com.Fendel, R. M., & Frenkel, M. R. (2006). Five years of single European monetary policy in practice: Is the ECB rule-based.

Contemporary Economic Policy, 24(1), 106–115.Fourcans, A., & Vranceanu, R. (2004). The ECB interest rate rule under the Duisenberg presidency. European Journal of

Political Economy, 20, 579–595.Gerdesmeier, D., & Roffia, B. (2003). Empirical estimates of reaction functions for the euro area. ECB Working Paper

206, Frankfurt am Main.Heinemann, F., & Ullrich, K. (2004). Does it pay to watch central bankers’lips? The information content of ECB wording,

ZEW Discussion Paper 05-70.Nelson, E. (2003). The future of monetary aggregates in monetary policy analysis, CEPR Discussion Paper Series 3897,

London.Sauer, S., & Sturm, J.-E. (2003). Using Taylor rules to understand ECB monetary policy, CESifo Working Paper 1110,

December.Surico, P. (2003). How does the ECB target inflation? ECB Working Paper 229, Frankfurt am Main.Taylor, J. B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy,

39, 195–214.Ullrich, K. (2003). A comparison between the Fed and the ECB, ZEW Discussion Paper 03-19.

16 Serious thinking about the target itself may also be called for.

http://www.ecb-observer.com/

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The ECB monetary policy: Choices and challenges