1. THE ECB AND MONETARY POLICY IMPLEMENTATION Week 4 Chapters 8, 9

2. READING MATERIAL Scheller (2006), “The ECB:History, Role and Functions” ECB. “The Monetary Policy of ECB” ECB. “The implementation of monetary policy in the euro-area. General Documentation on Eurosystem monetary policy instruments and procedures”. January’s Monthly Bulletin

3. WHAT WE KNOW SO FAR EU integration steps The role of macroeconomic policy Costs and benefits of a Monetary Union - OCA theory - demand-side policies should be handled carefully (effectiveness, crediblity) Countries wishing to form a monetary union must harmonize their inflation rates, and thus central bank’s preferences on inflation/unemployment.

4. Lecture plan Which model for ECB and why? ECB institutional framework ECB monetary policy implementation

5. Two alternative models of CB Anglo-French model: - price stability is one of the CB’s goals - low degree of independence from political power German model: - price stability is the main objective - CB’s independence from political power So they differ along two dimension: the objectives and the institutional design of CB.

6. When forming EMU, a decision had to be made on the best model to adopt. 1) Main objective is price stability (below 2% in the medium run, Art.105 of Maastricht Treaty), but the same articles specifies: “Without prejudice to the objective of price stability, the ECB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Art 105 (1) (among them, “a high level of employment”). The Maastricht Treaty recognizes the need for ECB to pursue other objectives. However, these are seen as secondary with the respect to the primary objective of price stability. FED System has a dual mandate (price stability and growth).

7. Regarding political independence: Art. 107 “When exercising the powers and carrying out the tasks and duties conferred upon Them by the Treaty….neither the ECB nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body”. Political independence is a necessary condition for price stability (Barro-Gordon). “Overdraft facilities or any other type of credit facility with the ECB or with the national central banks of the Member States….with Community institutions or bodies, central governments, regional or local authorities, public authorities…shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instrument”.

8. So the German model prevailed. Actually over-prevailed (the Bundesbank statute can be changed by simple majority in the German Parliament, ECB’s statute require a revision of the Maastricht Treaty). Possible problems of democratic accountability and governments-ECB conflicts (more on this later). Why has the German model (over) prevailed?

9. Recent history of macroeconomics 50s and 60s: Keynesian era - high growth and low unemployment can be achieved using macroeconomic policy - this approach was feasible because of international conditions of general stability 70s: oil shocks, monetarist revolution - macroeconomic policies (when they are not used to merely offset a demand shock) contain inflation bias. Authorities cannot systematically lower unemployment below the natural level (Barro-Gordon). The only way to lower unemployment below the natural level is to reduce the natural level (supply-side policies).

10. Monetarist revolution implied a separation in macro-policy-makers: since pressures to follow expansionary policies typically come from politicians/government pursuing short-term goals, CB should be protected from these political pressures by being independent. “Division of labour” we mentioned in Week 1: - governments/ fiscal policy: short-term output stabilization - CB/monetary policy: inflation There is empirical evidence that independent CB are more successful in fighting inflation.

11. The above considerations, coupled with the political and economic weight of Germany in Europe, led to the establishment of ECB as a: CONSERVATIVE (“hard-nosed”) and INDEPENDENT CENTRAL BANK “Conservative”: a CB that attaches greater weight to price stability (and lesser weight to output/unemployment stabilization) than the rest of society Rogoff (1985): this is exactly the way to eliminate the inflation bias, since it makes possible to achieve and mantain the credibility of low inflation policies.

12. A B C B’ U U’ UNUN U1U1 U2U2 Unemployment Inflation π1π1 The Barro-Gordon model and optimal stabilisation Inflation equilibrium in point A Unemployment is at its natural level The short-term Phillips curve is tangent to the authorities’ indifference curve. Authorities have no incentive any more to create surprise inflation. The upward sloping dotted line is the optimal stabilization line. Slope of the optimal stabilization line is determined by the weight the authorities attach to the stabilization of unemployment. The higher this weight the steeper is stabilization line With a steep stabilization line authorities stabilize a lot at the cost of a high inflation bias

13. Euroland’s preferences ECB preferences Unemployment Inflation UNUN How to eliminate the inflation bias? Appointing a conservative central bank The steep stabilization line represents the preferences of society. The flatter stabilization line is the one of the conservative central bank, the ECB. On average Euroland will have lower inflation without any loss in employment. However, there will be less concern for stabilization This leads to a potential conflict between the ECB and elected politicians

14. Since unemployment is determined by structural factors, pursuing activist monetary policy will just increase the average inflation. So monetary policy shouldn’t be used to lower unemployment below the natural level: politicians are responsible for that, by implementing structural policies such as flexibility in the labour market, lowering labour tax, TFP-augmenting policies. There are three problems here.

15. Three problems (conflict between ECB and national governments) 1) What happens after a shock? (see graphs) 2) How do we estimate natural level of unemployment (corresponing to the potential level of output?) 3) What if a temporary shock (rightward shift of short-run Phillips curve) becomes a permament shock to the natural level of unemployment (rightward shift of long-run Phillips curve)? Labour market hysteresis.

16. A new problem arises: the new conservatism Unemployment Inflation UNUN ECB’ s new estimate U N U N Initial natural unemployment rate and observed unemployment rate coincides with it. Target unemployment rate is at its natural level. Suppose a temporary increase in unemployment. ECB interprets this as an increase in the natural unemployment rate, and increase its target unemployment rate. Optimal stabilization path shifts to the right: the ECB will not attempt any stabilization. ECB behaves as super- conservative by attaching a zero weight to unemployment stabilization.

17. Fed Vs Ecb Good discussion and comparisons (pp. 171-173) Evidence (even very recent) seems to point out that ECB appears to be more conservative that FED, since it seems to attach greater importance to price stability and to be more cautios in reacting to movements in the business cycle. This is, after all, consistent with the differences in the mandate given to them by political authorities: - ECB: to maintain price stability - FED: to maintain price stability and to promote growth

18. Independence Vs accountability As often happens, we might have gone a little bit too far in the struggle to ensure independence. Independence does not necessarily mean lack of accountability. Tests of independence: - who sets the target? - who formulates the policy? - what are the limitations on lending to governments? - what is the lenght of the terms of office?

19. Tests of accountability: - how many times does the chairman of ECB appears in front of Parliament? - what does it take to change the CB’s statute? - how easy is to monitor the activities of CB and the degree of achievement of its targets? - how transparent is CB decision making process? In one sentence….who is the central bank accountable to? SUMMING UP: ECB IS MORE INDEPENDENT FED IS MORE ACCOUNTABLE.

20. ECB INSTITUTIONAL FRAMEWORK The Eurosystem it consists of –the European Central Bank (ECB) –the national central banks (NCBs) of the EU-countries Governing bodies are –the Executive Board –the Governing Council. The Executive Board consists of the President, the Vice-President, and the four Directors of the ECB. The Governing Council consists of the six members of the Executive Board and the governors of the twelve national central banks.

22. Governing Council is the main decision-making body of the Eurosystem. It formulates monetary policies and takes decisions concerning interest rates, reserve requirements, and the provision of liquidity into the system. It meets every two weeks in Frankfurt. During these meetings, the members of the Governing Council deliberate and take the appropriate decisions. Each of the members has one vote. –Note : with enlargement this will change

23. There is no qualified voting in the Governing Council of the Eurosystem. The rationale for this is in the Treaty. This mandates that the members of the Governing Council should be concerned with the interests of Euroland as a whole, and not with the interests of the country from which they originate. Qualified voting would have suggested that the members of the Governing Council represent national interests.

24. The Executive Board of the ECB implements the monetary policy decisions taken by the Governing Council. This includes giving instructions to the NCBs. In addition, the Executive Board sets the agenda for the meetings of the Governing Council. As such, it has a strategic position and can have a large influence on the decision-making process in the Governing Council.

25. MONETARY POLICY IN PRACTICE We know from earlier theoretical discussion that the more asymmetric shocks are within the EMU, the more paralysed ECB is (because it has to stabilizie economic conditions EMU-wide). The fact that ECB hasn’t put too much weight in output stabilization can be interpreted: - conservative and hard-nosed CB - there were evidences of asymmetries in the first years of ECB activity (pp.193-197). If there were asymmetries (or, rather, less than perfect syncronization) they surely disappeared with the current crisis.

26. ECB target We mentioned several times that ECB’s primary objective is to maintain price stability. What does it exactly mean? Governing Council has adopted the following definition: “price stability shall be defined as year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro-area of below 2%”. Price stability has to be maintained over the medium run. …..but how long is medium run..?!?!?

27. The two-pillar approach FIRST PILLAR: money growth (inflation is ultimately a monetary phenomenon) Quantitative Theory of Money: MV=PY M= money mass V= money velocity P= price index Y=real GDP In logs: m+v=p+y

28. In first-differences: m=p+y-v ECB estimates: - future real output growth (y) - money velocity (v) (why is it likely to be negative?) And finds the growth rate of money consistent with p=2%. What money stock measure does ECB uses? M3. M1= monetary-base M2= M1 +savings deposits,money market deposits account for individual M3=M2+large time deposits,institutional money- market funds,short-term repurchases agreements

29. What’s (increasingly) wrong with Pillar 1? 1) M3 is no longer under full control of ECB 2) The link between m and p has been (at best) significantly weakened: M3 has grown by 8/9% while inflation has been much lower (around 2%). The fundamental reason is that money demand is not stable. So there is no longer a pre- determined and predictable relationship between change in the money stock and the resulting effects on interest rate (and thus on aggregate demand, and thus on inflation). That’s why FED has progressively abandoned the money stock target. It doesn’t even measure M3 anymore.

30. SECOND PILLAR: a number of variables providing useful information to forecast inflation: - wages - exchange rate (not per se) - bonds prices - yield curves - trade unions/business cycle negotiations

31. Evaluation of ECB strategy 1. Reaction to shocks 2. Is 2% too low?

32. 1. Reaction to shocks An excessive reliance on price stabilization can cause problems in case the economy is hit by a supply shock (monetary policy dilemma) and not by a demand shock (when there is no conflict between price and output stabilization). July 2008: after a supply shock, ECB raised interest rates and attempted to stabilize prices rather than output.

33. 2. Is 2% too low? 1950s: Milton Friedman: optimal inflation rate is zero, because “shoe-leather” costs need to be minimized (inflation erodes the real value of money). Things have evolved: we are now sure that some inflation is good for the economy. 1) It facilitates adjustments in real wages with no need of decreasing nominal wages. 2) Official estimates always tend to overstimate real inflation because of technological improvements and substitution effects.

34. Two remarks 1) A narrow band would probably be more adequate as target 2) But don’t forget inflation is bad: - it erodes all money’s roles - it favours debtors at the expenses of creditors - it creates tax inefficiencies - it makes more difficult to distinguish between relative and absolute price adjustments - it creates instability and uncertainty - the fact that nominal variables are adjusted at different moments in time creates distortions and purchasing power losses.

35. ECB instruments Read carefully “reading” material. ECB uses three instruments to implement monetary policy. All of them move at the same time. Always?

36. InstrumentInterest.rateRole in the corridor Standing facilities Marginal lending Facilities Upper ceiling Open market operations Main re- financing operations Main Minimum reserves Deposits facilities Lower ceiling

37. a) Interest rate on marginal lending facilities: they are used to absorb overnight liquidity (banks can borrow at this rate from ECB provided that they present the adequate collateral). Which collateral? b) Interest rate on main refinancing operations: it’s the true monetary policy instrument. CB sells/buys bonds in order to decrease/increase the interest rate. Two tender procedures (fixed, variable). c) Interest rate on deposit facilities. The interest rate CB applies to commercial banks’deposits at the ECB. Crucial role of c) now.

38. What’s the situation now? http://www.ecb.int/home/html/index.en.html