ECB takes note of monetary growth

By Stewart Fleming

Date: 04/11/04

Why money stills matters and the ECB is right to care.

REMEMBER money? At least the European Central Bank (ECB) does.

Back in the 1970s monetarists believed that if a central bank kept the money supply growing, but only steadily, inflation would be brought under control.

Paul Volcker, who was brought in as chairman of the US Federal Reserve Bank to control double-digit inflation, incorporated explicit money-supply guidelines into the Fed's interest-rate setting mechanism.

But that was in 1979. Today, the ECB is the only major central bank in the world which gives the growth of the money supply - on one key definition the amount of cash, bank deposits and liquid funds in the economy - a prominent role in controlling inflation.

The ECB's monetary policy strategy starts with a definition of price stability as "inflation rates below but close to 2% over the medium term". It then uses the two pillars of 'monetary analysis' and 'economic analysis' to guide it in setting interest rates.

Most central banks do not emphasize the role of money in the inflationary process.

Since the early 1990s, when the Reserve Bank of New Zealand pioneered the idea of setting a direct inflation target as the best monetary policy strategy, around twenty of the world's central banks have opted instead for this approach, including, famously, the Bank of England.

Supporters of inflation-targeting argue that today's modest levels of inflation show that the central banks' inflation targeting strategy has been a success.

The ECB is different. In May 2003 it reviewed its monetary strategy and effectively downgraded money, but monetary analysis still shares equal place alongside economic analysis in the inflation-fighting strategy.

This is why an article in the latest issue of the European Central Bank's Monthly Bulletin has caused such controversy. Commenting on the bulletin, Joachim Fels, co-head of European economics at investment bankers Morgan Stanley, writes: "The risks to price stability coming from monetary growth are thus virtually all on the upside [inflationary]. In my view, the ECB council will, over the next few months, shift the emphasis towards these upside risks in order to justify the beginning of the end of its zero real interest rate policy."

In other words, the ECB will eventually begin to use monetary growth measures to help legitimize raising interest rates.

Thomas Mayer, chief European economist at Deutsche Bank, is more sceptical. In his assessment of the Monthly Bulletin article, he writes: "The monetary analysis gives a warning signal to price stability…but the intensity of this signal is not entirely clear." Because economic analysis suggests that recent inflation increases are likely to remain temporary, "the ECB, is likely to 'wait and see'," he says, predicting that rates will remain steady (at 2%) until the second half of 2005.

Today's (4 November) ECB council meeting will not produce a rate increase but the issue of money supply has not gone away, even though there are plenty of private economists who wish it would or have convinced themselves that the ECB is an 'inflation targeter' in disguise.

In its Monthly Bulletin, the ECB states that there is fairly conclusive research showing that "over the medium term inflation is a monetary phenomenon", and that therefore it "has assigned a very important role" to monetary analysis in its pursuit of price stability. The ECB reaffirms that it uses data about the money supply to "cross-check" what it learns from analyzing developments in the real economy such as signs - virtually non-existent at the moment - of incipient wage inflation.

ECB President Jean Claude Trichet pointed out last month that "the monetary analysis also supports the case for strong vigilance" so far as price stability is concerned, because "there is substantially more liquidity in the euro area than is needed to finance non-inflationary growth".

Two speeches from Otmar Issing, the ECB's chief economist, set out the importance of money to the bank. "Rethinking Stabilization Policy" was delivered in August 2002 at Jackson Hole in America's Grand Teton Mountains, arguably the most beautiful venue to which the world's central bankers regularly retreat. "Monetary and Financial Stability: is there a Trade-off?" was delivered in March 2003 in the less scenic surroundings of the Bank of International Settlements in Basle.

But a more succinct commentary from Issing came in a Wall Street Journal article on 18 February.

Issing describes the problem of designing a monetary policy in an era when asset price bubbles and slumps play such a major role in the performance of the global economy as "the biggest challenge for central banks in our time".

Traditionally, inflation was defined by economists as "too much money chasing too few goods".

But, the experts conclude, today's problem is as much about asset price inflation as goods inflation.

Issing says that today asset-price inflation can be defined as "too much money chasing too few assets".

He observes that historically most stock or real estate bubbles "were accompanied by strong expansion of money and/or credit".

In today's economies, driven by the financial markets, watching what is happening to money and credit is vital.

Money still matters and the ECB is right to care.

• Stewart Fleming is a freelance journalist based in Brussels.

Analytical feature on the importance of money supply criteria in the European Central Bank's price stability policy.