ECB hunts the inflationary ‘black cat’

Date: 03/09/1998

'Price stability' will be the prime objective for European bankers after the launch of monetary union, reports Tim Jones. But developing a reliable strategy for predicting inflation across the euro-11 is testing the ingenuity of the European Central Bank's experts

IN A world of automation, it is comforting to learn that the human element - the skill of the artist - is still in demand.

As they piece together their monetary policy strategy for the impending kick-off of the euro in January, the technicians at the European Central Bank are already realising that even a jumbo jet needs a pilot.

This is more true than ever as the financial crisis engulfing Russia threatens to destabilise world equity markets and banking systems, and possibly feed through into slower rates of growth in the euro zone.

On the face of it, the European System of Central Banks (ESCB) - the combination of the ECB and the national central banks - has a simple task. The trend over the past ten years to wrest control of monetary policy away from politicians and place it in the hands of technocratic bankers has simplified its job hugely.

Being told to control inflation while at the same time creating jobs and allowing sufficient demand to exist in the economy can be confusing.

ECB President Wim Duisenberg summed it up in a recent speech: "The primary goal of monetary policy has increasingly become the achievement and maintenance of price stability, with any other objective receiving emphasis only to the extent that price stability is not endangered."

This makes the central banker's life much easier. Under the fashionable definition, all he or she has to do is prevent the general level of prices from rising by more than 2% every year or from falling below the level of a year earlier.

This, of course, is not as simple as it seems. Willem Buiter, who sits on the monetary policy committee of the Bank of England, has likened spotting inflation trends in a trillion-ecu open economy to "a blind man in a dark room looking for a black cat which isn't there".

They can number-crunch and slide-rule as much as they like but, eventually, monetary policy practitioners have to go with their gut instinct in determining whether there is a threat that inflation could creep into the economy.

Once inflation is in the economy, it is easy to spot since the rate of price increases will accelerate and they will start to feed off each other.

Dowsing inflation once it is under way requires extreme measures. Interest rates have to be raised sharply, demand for credit choked off, public spending squeezed and jobs lost.

As Alan Greenspan, chairman of the US Federal Reserve, has put it: "If you wait until you can see the whites of inflation's eyes, then it's too late."

The job of the skilled central banker is to spot elements which might generate inflation or instil expectations of inflation and nip them in the bud.

This is difficult enough in a nation state where bankers understand the economic traditions and the sometimes unique ways in which demand manifests itself. Performing this feat of anticipation for a 6-trillion-ecu trading bloc of 11 states, all with their own economic structures and different traditions of saving and spending, will be fearsome.

Responsibility for devising a strategy for doing this is in the hands of Otmar Issing, the former head of economics at the Bundesbank who is now reprising his role at the ECB.

When it met earlier this week, the governing council of the ECB discussed the work carried out over the summer by the team of central bank economists working under Issing.

He is not yet ready to unveil his blueprint, but one essential element is already clear: the ECB will rely to a large extent on the experience and expertise which people such as Issing, Bundesbank president Hans Tietmeyer and Duisenberg have built up over the years of pursuing an unerring policy in favour of price stability.

The reason for this is the unreliability of their potential 'autopilots'.

Because there is so much 'noise', or conflicting data, regarding inflationary threats in the economy, the ECB has already decided to pick a set of tools which it will use to judge whether to raise or lower interest rates.

The central bankers' ultimate aim will be price stability, a term which Issing wants to define numerically but is unlikely to differ much from the commonly accepted definition of 0-2% inflation per annum.

To hit this, they need what they call 'intermediate' targets: benchmarks against which to discern embryonic inflation. First among these will be a target for the rate of growth of 'broad money' in the euro area.

After that will come the usual suspects: whether long-term interest rates are higher or lower than those for short-term lending, data on credit-creation, the level of the euro exchange rate, price trends in the equity, savings and housing markets, how much industrialists are using their potential production capacity and the balance of payments.

IT IS, however, the broad money measure which will take pride of place. The ECB assumes that there is a strong connection between the rate of growth of the quantity of money in circulation in the economy and inflation.

The bank's favoured measure is Issing's old friend from the Bundesbank, M3. This assesses the value of notes and coins in circulation with the public, deposits held in domestic currency which can be withdrawn immediately or within three months and private sector holdings of tradable claims issued by banks in return for deposits in domestic currency.

The trouble is that there exists as yet no M3 measurement for the euro area.

The ECB's economics and research departments have been working flat-out to hone down the data and put together something reliable and manageable, but the success of their efforts is virtually impossible to judge.

In the early days after their jobs were created in June, Issing and his team had to rely on the national M3 figures, but these were mostly calculated on an annual basis and often according to different methods. Combining them into a harmonised euro-11 M3 measurement was laborious and meant they were months out of date.

Even now the bank is trying to work with its own M3 'aggregate', Issing concedes that only time will tell him whether it is reliable, particularly regarding his ability to adjust the figures for the seasonal behaviour of the market.

"We will lack [historical data]; that is simply the case," admitted Issing during the summer. "We have to realise that when it comes to data, we are working in an environment which is weighed down by a whole series of uncertainties."

As a result, he said, it would be foolish of the ECB to pin everything on this new money supply target, at least in the early days of the bank's operations.

His Spanish colleague Eugenio Domingo has said that use of the M3 target will depend crucially on the bank's ability to predict people's preference for money over other stores of wealth right across the euro-11 - a phenomenon known as 'money demand'. He says this will be the "key element" in deciding whether to proceed with a monetary aggregate or switch to targeting a forecast rate of inflation.

The ECB is almost certain to proceed with an intermediate monetary growth target, but with one big rider: if the balance of evidence elsewhere tells the governing council that the measurement is off course, then it will not follow it slavishly.

At that point, it be will vital to explain to financial market operators why the council has ignored the M3 figure.

This, more than anything else, is the motivation behind the ECB's desire to open the key elements of its deliberations to the public.

Major feature. 'Price stability' will be the prime objective for European bankers after the launch of monetary union. But developing a reliable strategy for predicting inflation across the euro-11 is testing the ingenuity of the ECB's experts.