Bankers target euro money supply

Date: 09/10/1997

By Tim Jones

GERMANY's central bankers have only one victory left to score in the single currency debate, and they are about to win it.

Having established a European Central Bank (ECB) free of political influence and clarified its control of the euro's rate abroad, the Bundesbank needs to put only one more piece in place in the single currency jigsaw to ensure that its successor lives up to the family name.

The ECB must, the Bundesbankers believe, monitor the speed at which the supply of money grows and use this variable above all others to determine when to adjust interest rates, and by how much.

As ever, the gentlemen who run Europe's most successful central bank are convinced that their way is righteous. They have long set interest rates by the use of monetary targeting and theirs is the central bank that the financial markets have learned to trust.

Now they simply want to share the secret of their success with the rest of us.

A decision does not have to be taken on this issue until next year but already Otmar Issing, the Bundesbank's formidable chief economist, is laying down his marker.

In a recent public speech, Issing claimed that aiming for a set amount of monetary growth rather than seeking to cap inflation at a specified level was the best way for the ECB to establish its credibility with the markets.

“By announcing a money supply target, the ECB would inform the public about the course of monetary policy as well as anchoring inflation expectations at a particular level,” he said.

In order to maintain 'price stability' - a concept rarely specified by policy-makers, but once defined by Federal Reserve chairman Alan Greenspan as annual inflation below 2&percent; - central banks must have 'intermediate' targets.

Although the ultimate goal is stable prices and a hard currency, targets must be set for other economic variables which can predict inflation before it really gets under way. Any central bank which waited for consumer price indices to be published before it raised the cost of lending and borrowing money would be in serious trouble.

Instead, intermediate targets must be used even though they are notoriously unreliable. As Willem Buiter, a Dutch economist on the Bank of England's monetary policy committee, recently put it: “We are a bit like the blind man in a dark room looking for a black cat that is not there.”

For much of the lifetime of the Exchange Rate Mechanism, European central bankers had one very simply intermediate target - their currency's nominal exchange rate.

Indeed, the man who is tipped to become the ECB's first president has no experience of conducting monetary policy in any other way.

European Monetary Institute (EMI) president Wim Duisenberg, who espouses the cause of money supply targeting, spent his 15-year career at the Nederlandsche Bank raising and lowering interest rates whenever the guilder deviated from its ERM central rate against the deutschemark.

But this would be an irrelevance in the euro-zone. In a relatively closed economy where currency fluctuations would have a cushioned impact on domestic inflation, the ECB would be wasting its time by following the euro's movements on the foreign exchange market.

Instead, the real choice is between the monetary targeting of the Bundesbank and the more pragmatic anticipation of inflation practised first in New Zealand but which has now spread to Canada, the UK, Sweden, Finland and Spain.

These central banks do not wait for inflation to happen. Rather, they use all the evidence at their disposal - from trends in manufacturing output to the price of raw materials, consumer confidence, asset yields and even house prices - to glean whether inflation is accelerating.

Each of the countries which adopted the inflation targeting approach did so because they found that the monetary aggregates (see box) they were watching so closely were chronically prone to distortions which made them ultimately unusable.

Even in Germany, the Bundesbank's preferred target M3 - banknotes and coins in circulation together with easily-withdrawn deposits at banks - has managed to go haywire more than once.

The most notorious, albeit forgivable occasion was after German reunification, when published M3 was seen to be growing at more than twice the speed permitted by the Bundesbank's target range. When interest rate changes were not made, the central bank had to admit that the massive growth of M3 was caused by distortions.

Indeed, in 1992-93 they had to change their target in mid-year because the distorting effects of reunification were so great that there was no point persisting with this charade. They simply decided to make up for the excess growth a year later.

None of this has put off the Bundesbank or Duisenberg. In spite of the claims of the inflation-targeters, the Frankfurt orthodoxy is winning the day within the EMI.

“That does not mean that the central bank will focus exclusively on monetary growth,” said Duisenberg in a keynote speech on monetary strategy in May. “Other aggregates containing information about inflationary prospects, especially in the near future, will be monitored as well.”

The difference between this approach and pragmatic inflation targeting is that these other indicators will be classed as 'qualifiers' to the almighty money growth target. They will be used to prevent the ECB falling asleep at the wheel once the cruise-control is switched on.

What these qualifiers will not have is equal status to money growth. This is because, in the view of the EMI hierarchy, too many targets spoil the broth.

“The explicit use of a variety of indicators poses a threat to the transparency and credibility of monetary policy because there is then no immediate way of knowing which information has prompted interest rate decisions,” said Duisenberg.

This makes you wonder what world central bankers live in. German labour union IG Metall and its members think of little else when they are formulating their wage demand at Volkswagen than the performance of the M3 money growth aggregate during the previous six months.

Officially, the EMI has not yet decided which aggregate to target. They will only say that it must be controllable through interest rate increases, it must predict future inflation accurately and it should reflect a stable long-term relationship between demand for money and prices, income and interest rates. In reality, it will be M3.

Indeed, it can be argued that the problems associated with monetary targeting in the past would fade away once monetary union begins.

Adding together M3 in Germany and France gives a much more accurate picture of money growth than taking each individual national figure. Where the aggregate rockets one side of the border, it will tend to shrink on the other since the economies are so deeply integrated.

Internal EMI studies show that using M3 as an intermediate target will be most successful among the most integrated economies (Germany, France, the Netherlands, Austria, Belgium and Luxembourg) - yet another reason for Italian ministers to lie awake at night.