What the bank looks for when it sets interest rate policy

Date: 08/03/01

The ECB has a two-pronged strategy in setting monetary policy: monitoring the harmonised index of consumer prices (HICP) to ensure that it stays within a 0-2% annual growth rate, and keeping the annual growth of M3 'broad money' close to a 'reference value' of 4.5%.

Alan Greenspan has said that once you can see "the whites of inflation's eyes, it's too late" because policy changes tend to have no impact on economic behaviour for about 18 months.

So, in the same way that the angle of a foot on a car gas pedal presages the acceleration of the car, central bankers are always looking for 'intermediate' targets that will warn them of oncoming inflation a year or two hence.

The ECB assumes there is a strong link between the rate at which the quantity of money in circulation grows and inflation. The most reliable of the various money supply measures, so the bank's economists believe, is M3 'broad money'. This comprises notes and coins in circulation, overnight deposits, those with agreed maturity up to two years and redeemable up to three months' notice, repurchase agreements, money market funds and debt securities issued up to two years.

Output gap: This is a nebulous concept but is used all the same. Economists calculate over a long period the level of national output an economy has tended to achieve before it started to generate inflation. The ECB will monitor the euro zone's 'positive output gap' - more output than the historical non-inflationary output level - since it may well mean the same again.

Euro exchange rate: As last year's collapse in the external value of the euro showed, there comes a point when the ECB starts to worry about importing inflation. The bank uses the Organisation for Economic Cooperation and Development's rule of thumb: that a sustained 10% nominal depreciation of the euro adds 0.6 percentage point to inflation in the first year. The converse is also the case.

Asset prices: The rising price of assets like stock or house prices can accelerate consumer price inflation if people start to feel richer on the basis of the assets they own. Until now, this phenomenon in the euro zone has been restricted to Ireland and the Netherlands.

Expectations surveys: These are all the rage now since the best of them interview people at the cutting edge of the economy such as company purchasing managers who can feel a market turning long before it shows up in statistics. Their weakness is that they are often based on gut feelings and lack the reliability of outturn data.