The single monetary policy


José Viñals


The recently enacted Treaty on European Union contemplates the creation of a Monetary Union in Europe within the present decade. Coinciding with the beginning of Stage Three there will be a change from the coexistence of national monetary policies, formulated in the pursuit of national objectives and implemented through different procedures, to a single monetary policy, set by the European System of Central Banks (ESCB) with Union-wide objectives and operated in a consistent way throughout the area. In addition, in Stage Three exchange rates among the participating currencies will be irrevocably locked and appropriate steps will be taken for the rapid introduction of the ECU as the single currency.

Since the preparation of the future European monetary policy is a very complex affair, the European Monetary Institute (EMI) has been entrusted with the mandate of preparing at the latest by end 1996 the regulatory, organisational and logistical framework necessary for the ESCB to carry out the single monetary policy. Clearly, the preparation of the future single monetary policy is a most complex and important task. It is complex because it involves many strategic and technical issues which have to be adequately dealt with before the ESCB starts operating. And it is important because the success of the EMU project ultimately depends on the quality of European monetary policy.

This article examines some of the main strategic and tactical issues concerning the single monetary policy by drawing heavily on recent papers of the author. Section 1 discusses the statutory objectives and independence of the ESCB and their likely impact on the conduct of monetary policy. Section 2 reviews the main strategic and tactical questions which have to be faced in preparing the single monetary policy. The final section summarises the main conclusions.


1. The ESCB: objectives and independence

1.1. Price stability as the primary objective

The Statute of the ESCB sets price stability as its primary objective, and establishes that the general economic policies in the Community shall be supported as long as this does not conflict with price stability. There is no specific definition in the Statute of "price stability" nor of the criteria to judge whether the support for other policies "conflicts" with price stability. Yet the aim is clear: to avoid the potential trade-offs which arise when all the objectives are at par.

Regarding the desirability of price stability, there is an established consensus that inflation is viewed as costly by the public. More importantly, both economic principles and historical experience suggest that higher inflation is not conducive to higher output growth on a medium-term basis. Indeed, as shown by the literature on the "time-consistency problem", when the authorities are expected to follow the short-sighted strategy of engineering surprise inflation to achieve a higher output level, the resulting time-consistent equilibrium is not characterised by higher output but by an inflationary bias. And, contrary to the past, there is now a broad consensus among policy-makers that price stability constitutes a precondition for achieving sustained economic growth. For all of the above reasons, it is very important that the ESCB pursues a strongly anti-inflationary policy. Otherwise, a worsening of inflation performance in EMU could more than offset the economic benefits of the single currency, thus threatening the economic viability of the whole integration project.

1.2. The quest for anti-inflationary credibility: Does independence suffice?

A credible commitment to fight inflation firmly reduces the inflationary bias resulting from the time-consistency problem and the short-term output costs of converging towards price stability. Moreover, it increases the freedom of the monetary authorities to respond to well-identified shocks without damaging anti-inflationary credibility, as the risk that the public may misinterpret a temporary change in liquidity conditions for a shift in the stance of monetary policy is reduced.

The existence of conflicting policy goals is at the root of the inflationary-bias problem. Placing price stability as the primary objective of the ESCB creates a statutory commitment which minimises the risk that several objectives conflict in the shorter run and thus reduces the vulnerability of the new monetary institution to external pressures to accommodate inflation. However, the System must also enjoy independence if price stability is to be achieved.

A distinction can be made between political and economic independence. As concerns political independence, several provisions in the Statute try to ensure that the decision-making bodies of the ESCB will be able to perform their duties without being subject to constraints or influence by governments: prohibition of instructions from government bodies; compatibility of the statutes of national central banks with the Statute of the ESCB; assured tenure for the members of the Council and the Executive Board; financial autonomy of the ESCB; and stringent legal conditions to amend the Statute in any fundamental way. As concerns economic independence, the Statute endows the ESCB with the powers to use monetary policy instruments without restrictions: freedom to conduct open market and credit operations and to use other appropriate instruments; power to conduct foreign exchange market operations; and the exclusive right to authorise the issue of bank-notes in the Community.

The ESCB ranks quite high in terms of formal independence on the basis of a comparison between the statutes of central banks, as confirmed by recent analyses. This is important because empirical evidence indicates that the average rate of inflation is generally lower in the countries with more independent central banks. However, even a high degree of formal independence is not enough to establish the anti-inflationary credibility of the new institution.

In this respect, some observers have warned that since the Treaty places decisions on the exchange rate policy outside the ESCB, the effective independence of the new monetary institution might be compromised, as the monetary stance required to maintain price stability may conflict with exchange rate objectives. Although there is more than a grain of truth in this argument, it should nevertheless be noted that the wording of the relevant articles in the Statute addresses this concern. In particular, although the decisions on the conclusion of formal exchange rate arrangements, the adjustment or the abandonment of the central rate, and the formulation of general orientations of exchange rate policy rest with the Council of the European Community, these decisions will be taken only after consulting the ESCB in an attempt to reach a consensus consistent with the objective of price stability.

Another source of concern regarding the performance of the ESCB is that the degree of tolerance for inflation may be higher in the Union than it is now in the country(ies) which at present exert the main influence on the monetary conditions in the Community. In particular, if the votes in the ESCB Council reflect national attitudes to inflation, there is a risk that the anti-inflationary stance of the ESCB might be softened, interpreting "price stability" in a looser way. However, the standards set in the Treaty for entry into EMU will act as a screening device for Union membership and may thus mitigate this problem.

Finally, the success of the ESCB in fighting inflation will not only depend on itself but also on the behaviour of the fiscal authorities. As evidenced by the recent experience of Germany following unification, even an independent and reputable central bank like the Bundesbank can face difficulties in achieving its anti-inflationary objectives as a result of overly expansionary fiscal policies. For this reason, it is crucial that monetary and fiscal policies work together towards the pursuit of the overall goal of sustained non-inflationary growth. Furthermore, while the inflationary risks posed by an "inadequate policy mix" for the Community as a whole exist, the provisions in the Maastricht Treaty oriented towards avoiding excessive budget deficit and public debt levels limit these risks. In addition, it should be recalled that the Statute explicitly prohibits monetary financing of the public sector by ruling out the granting of overdrafts (or any other type of credit facility) and the purchase of public debt instruments in the primary market.

2. The formulation and execution of the single monetary policy

Having discussed the objectives and independence of the ESCB, I now turn to examining the main issues involved in the formulation and execution of the future European monetary policy. As already mentioned, settling these issues is fundamental for the ESCB to run monetary policy efficiently and effectively from the beginning of Stage Three. This is why the EMI has been entrusted with the responsibility of preparing the single monetary policy during the transition.

The scale and complexity of the task facing the EMI can be readily gauged on the basis of the following considerations. Firstly, since the Treaty of Maastricht rules out any transfer of monetary powers to the EMI during the transition, Stage Three will imply a sort of "Big Bang" in the passage to the single monetary policy. And secondly, although the Statute of the ESCB provides the broad guidelines for the operation of the future monetary policy, there are numerous strategic and tactical issues which are left fully open in the Statute and which have yet to be addressed.

Fortunately, the EMI is not starting from scratch. Over the past couple of years, the national central banks of the Community have, within the framework of the Committee of Governors of European Central Banks, studied a number of key issues related to the future single monetary policy. In particular, they have explored: the relative advantages of different procedures for implementing monetary policy in EMU; the problems associated with the adaptation and the interconnection of national payment systems throughout the Union; the creation of an adequate statistical basis which would provide in a timely manner to the ESCB the information required to carry out monetary policy; the printing and distributing of the ECU note; the harmonisation of central banks' accounting standards and practices; and the inter-connection of the information and communication systems of national central banks.

In preparing the single monetary policy, the EMI must address several concerns. On the one hand, it must develop an adequate framework for formulating monetary policy. This involves considering whether intermediate targets in general, and monetary targets in particular, will be useful in the conduct of the future monetary policy as well as exploring which variable is most suited to play that role. On the other hand, the EMI must study the tactical aspects of the execution of monetary policy so as to ensure that the single monetary policy is effectively and efficiently run from the very first day in full EMU. This involves identifying the minimum requirements for guaranteeing the uniformity of monetary conditions throughout the Union and exploring the options available to execute the single policy in a decentralised form through national central banks.

I have examined the above issues in detail in two recent papers (see note 1). Therefore, I will confine myself to recalling briefly their main conclusions.

2.1. Strategic aspects in monetary policy formulation

As regards the strategic aspects of formulating the single monetary policy, it is likely that national central banks will settle for a framework which combines considerable measures of simplicity and transparency and which enhances the anti-inflationary credibility of the ESCB. According to some, these principles will be best served through the use of intermediate targets given their relative advantages in terms of simplicity, transparency, and of helping the public to monitor monetary policy and the central bank to avoid external pressures. Furthermore, it is argued that since some of the most successful central banks in the Community rely at present on intermediate monetary targets, this could allow a degree of continuity in the practical conduct of monetary policy and, possibly, also the transfer of some degree of anti-inflationary credibility to the ESCB. Those who argue against monetary targets point out that recent experience with monetary targets in a number of European countries has been less than fully satisfactory, as financial innovation has tended to progressively erode the stability of the national demand functions for these aggregates. While it is too early to say whether monetary aggregates will end up playing a central role in the formulation of the future European monetary policy, in any case I think that it is very important to avoid a mechanistic interpretation of monetary aggregates, especially at the start of Stage Three and if such aggregates are explicitly targeted. In particular, the regime-change resulting from the irrevocable locking of parities may lead to shifts in liquidity preference for the area as a whole, complicating the management of monetary policy at the very time where the ESCB has to start establishing its anti-inflationary record.

2.2. Tactical aspects in monetary policy execution

As regards tactical aspects, it is reasonable to assume that monetary policy instruments and procedures will still differ across member countries at the start of Stage Three, and that substantive decentralisation will characterise, at least in the early years, the execution of the European monetary policy. The first assumption is justified because central banks feel comfortable with their own way of executing monetary policy and can thus be expected to maintain their customary practices, which reflect specific market and institutional features. The second assumption rests on the fact that central banks have accumulated considerable human capital in terms of knowledge of national financial institutions which would not be used if operations were to be centralised fully. Over time, I would expect the above arguments gradually to lose some force, thus allowing -if so wished- greater centralisation in the execution of monetary policy.

a) Minimal requirements

In the light of the above considerations, what would be the minimal requirements for the conduct of the single monetary policy?

The most important one is to achieve the integration of national interbank markets so as to ensure that interest rate arbitrage brings about a single monetary stance throughout the Union. This must rest, in turn, on the integration of national payment systems, which permits credit institutions rapidly to transfer their interbank positions across borders and to achieve final settlement within the same day.

Although not strictly necessary for the above purpose, achieving a greater degree of similarity among national monetary policy instruments and procedures may also be advocated to prevent regulatory arbitrage and shifts in financial location resulting from differences in the cost-subsidy mix implicit in the way monetary policy is managed; and to facilitate the understanding of monetary policy signals on the part of market participants. These arguments, however, merely point to the benefits of harmonisation and leave the standard and terms of harmonisation indeterminate.

b) Choice of instruments and degree of decentralisation

There are two final key issues which need to be tackled in preparing the technical infrastructure for the future monetary policy: the choice of instruments (reserve requirements, standing facilities and open market operations), and the degree to which policy execution can be delegated to national central banks.

Regarding the choice of instruments, over the past years open market operations have generally become the main channel through which monetary conditions are influenced in European countries, and money market interest rates the principal operational target in the daily conduct of national monetary policies. Nevertheless, there are still very significant differences in the use made by countries of two other channels for regulating liquidity conditions: reserve requirements and standing facilities. Thus, a most crucial question is which should be the importance of these two instruments vis-à-vis open market operations in the execution of the single monetary policy.

The Statute of the ESCB contemplates the use of reserve requirements in EMU since it states that "the ECB may require credit institutions established in Member States to hold minimum reserves on accounts with the ECB and national central banks in pursuance of monetary policy objectives" (Article 19.1).

As is well-known, reserve requirements are not strictly necessary to control the evolution of monetary variables since this can be achieved through open market operations. Furthermore, when not fully remunerated, reserve requirements may encourage socially sub-optimal financial behaviour since they constitute a distortionary tax on banking activities which drives a wedge between deposit and lending rates. Where reserve requirements could be useful is in facilitating the management of the money market. In particular, when instrumented with averaging provisions, reserve requirements allows the banking system to "cope with temporary liquidity shortages or surpluses in the market without central bank intervention". This is found presently useful by many central banks because it gives them the freedom to choose how frequently they should be in the market to steer money market interest rates in the appropriate direction.

In principle, reserve requirements could be set in EMU so that they facilitate money market management without creating excessive distortions on financial behaviour. Specifically, a uniform zero average reserve requirement in the Union would accomplish these goals provided banks find it costly not to meet the requirement and provided there is a large enough overdraft facility at the central bank.

Another potential instrument at the disposal of the ESCB to regulate liquidity conditions are standing facilities. These are offered on a bilateral basis by the central bank to specific financial institutions to cushion their liquidity shortages or surpluses. In general, these facilities play a similar role to that of reserve requirements; that is, to stabilise money market conditions and to lower short-term interest rate volatility. Thus, in this regard, their usefulness is to some extent contingent on the specific arrangements made regarding reserve requirements. In addition to the above, the pre-announced rates as which standing facilities are offered can be used - as is the case now in several European countries- to signal changes in the policy intentions of the monetary authorities. In other countries, however, this latter function is exercised instead through open market operations.

Open market operations are the third instruments available to the ESCB to execute the single monetary policy. While a number of important decisions will have to be made regarding the nature and frequence of operations, the eligible underlying assets, the number of counterparties, and the auction procedures, there are well-known efficiency reasons in favour of open market operations playing a very important role in the execution of the single monetary policy.

Having briefly described the main available instruments, I now turn to discussing the potential role of open market operations vis-à-vis those of reserve requirements and standing facilities in the execution of the future monetary policy.

In practice, the choice of instruments should be made on grounds of economic and operational efficiency and, once a specific decision has been taken, the selected instruments should be varied over time to achieve the desired objectives. In the case of EMU, however, the diversity of initial conditions as regards national monetary instruments and procedures and the provisions in the Statute are likely to imply that the centrally-decided single monetary policy will be executed in a rather decentralised way, at least in the early years.

If, as seems very likely, the issue of decentralisation plays an important role in deciding how to execute future monetary policy, this could be crucial in determining the relative importance of the various instruments. The reason is that the management of both reserve requirements and standing facilities can be decentralised to a much greater extent than open market operations. On the one hand, provided reserve requirements are the same throughout the Union, there are no difficulties in delegating the management of this instrument in national central banks. In turn, since reserve requirements permit a lower frequency of intervention of central banks in the money market, this makes it easier to decentralise the execution of the single monetary policy. On the other hand, the decentralisation of standing facilities presents operational advantages and does not seem difficult to reconcile with the overall control of central bank money injected or withdrawn through this channel. The ECB would be relieved from the burden of keeping account with all banks operating in the Union, while the capital of knowledge on the specific credit institutions that national central banks have accumulated over the years would be better exploited.

In contrast to the above, the decentralised execution of open market operations is much more difficult to contemplate from a purely practical point of view. Indeed, as it happens to be the case with foreign exchange operations, open market operations must be executed in a timely and flexible fashion to offset liquidity shocks. This makes it advisable that they are carried out in a centralized fashion, their monetary effects nonetheless being uniformly speed through the Union.

In sum, although very complex technical issues are involved in comparing the merits of alternative models for executing the future monetary policy, it is not unreasonable to expect that an evolutionary model is chosen which, starting from a relatively higher degree of decentralisation, can evolve over time towards a more centralised system if this is judged appropriate. Therefore, while open market operations are likely to be the main instrument for regulating liquidity conditions, as is now the case in most European countries, reserve requirements cum standing facilities could play a more important role in the early rather than the later stages of EMU.


This paper has examined some of the main strategic and tactical issues regarding the future single monetary policy.

As it has been mentioned, the whole balance between the costs and benefits to be obtained from EMU depends critically on the orientation of the future monetary policy to be conducted by the European System of Central Banks. Accordingly, the institutional design of the future European monetary authority gives primacy to the objective of price stability and goes a long way towards ensuring the economic and political independence which is required to establish the anti-inflationary credibility of the new monetary institution. In addition, the role played by the European Monetary Institute in the next few years in preparing the technical and logistical framework needed to conduct the future monetary policy is of paramount importance. In this regard, the decisions which are finally taken regarding to the strategy and tactics of the European monetary policy will be crucial in shaping its effectiveness and underpinning its overall anti-inflationary orientation.