Preparation of a single monetary policy in the third stage

European Monetary Institute (*)

Under Article 109f of the Treaty, the EMI is required to "prepare the instruments and procedures necessary for carrying out a single monetary policy in the third stage" and is required to "specify the regulatory, organisational and logistical framework necessary for the ESCB to perform its tasks in the third stage. This framework shall be submitted for decision to the ECB at the date of its establishment." The ECB will then make the final decision. As implied in Article 2 of the Statute of the ESCB and of the ECB, the legally stated primary objective of the ESCB to maintain price stability has to be the focus of the preparation of Stage Three while the corresponding instruments and procedures should be consistent with the principle of an open market economy with free competition, favouring an efficient allocation of resources. Furthermore, the operational framework should be consistent with the principle of decentralisation, i.e. that the national central banks are to be involved in the operations of the ESCB to the extent deemed possible and appropriate. The following describes successively the strategy of preparation adopted, the general issues regarding monetary policy strategy, and the progress made on the preparation of the monetary (and foreign exchange) policy operational frameworks...

The current report does not cover all the aspects of preparatory work in which the EMI is engaged. Details of the state of progress at that time, such as the preparation of the European banknote, may be found in the EMl's Annual Report, which was published in April 1995.


The issue as to how the ESCB should operate so as to achieve the objective of price stability is to be tackled at two levels: in terms of the instruments and operational procedures to be employed, on the one hand, and in terms of the overall monetary policy strategy, on the other hand. As regards possible links between the choice of the monetary policy strategy and the design of monetary policy instruments and operating procedures, it is broadly accepted that such links are relatively loose. In the case of an intermediate monetary target or a final target, the link is even less direct than in the case of an exchange rate target. Thus, in general, a decision on the monetary policy strategy of the ESCB is not a prerequisite for the definition of its operational framework. It should only be ensured that the operational framework made available to the ESCB will be flexible enough to adjust to various situations, but those adjustments are not likely to be major even for quite different strategies. This gives the EMI the option to concentrate its work first on issues which may require a somewhat longer lead time for implementation, i.e. particularly specific features of monetary policy instruments and operational procedures.

The approach taken by the EMI in the preparations involves a number of steps. Firstly, monetary policy instruments, the evolution of which is monitored by the EMI, were compared across member countries and examined individually to assess whether they should be employed and, if so, what precise features they should have if they are to contribute to fulfilling certain functions. Most of this detailed examination of instruments has already been completed for the main generic types of instruments. The next step, to which much effort is currently being devoted, is to examine how the instruments can be optimally combined to form an operational framework for the conduct of monetary policy in Stage Three. Apart from the choice and the specification of the instruments' features, this includes issues of general relevance for the operational framework, such as the specification of the operational target, the degree of decentralisation of the execution of the ESCB monetary policy, and the possibility of remote access across the EU. Furthermore, other factors such as, for example, the structural liquidity position of the interbank market and its volatility, the structure of the financial markets, the integration of money markets or the legal environment, are also under consideration.

In addition, examination of various 'technical aspects' of instruments - such as a study of the lead time required for implementation of the operational framework, and a review of the assets which may be employed as collateral against the provision of central bank credit and of the supporting payments and securities settlement systems - is also under way.

Finally, work has recently been intensified on the issue of the monetary policy strategy in Stage Three. This work, which will deal with the general issues described below, currently involves the assessment of patterns of EU-wide money demand and the identification of the transmission mechanism of monetary policy in the EU.


The key problem facing central banks in general is that the response of inflation to actions taken by the central bank occurs indirectly and with a significant lag. This means that actual inflation cannot be the guide for assessing the appropriate stance of monetary policy. Instead, the central bank must focus on additional information available to forecast future inflation and set its stance accordingly. This forward-looking approach enables central banks to take pre-emptive action against inflation, preventing it from emerging and becoming ingrained in people's expectations which, if it were to happen, would make it costly to eradicate. A monetary policy strategy has to meet two principal requirements. First and foremost, it should be effective in the sense that its pursuit leads to the desired outcome in terms of price stability. Secondly, it should be credible in the sense that market participants and other agents are confident of both the central bank's commitment to the final objective and its ability to achieve that objective.

In the discussions so far, three candidate strategies for Stage Three have been identified. These are exchange rate targeting, monetary targeting and inflation targeting. Exchange rate targeting is a strategy currently followed by many EU countries as a means of obtaining and maintaining price stability. This approach finds particular favour in smaller open economies where external influences on inflation are an important factor. For the single currency area as a whole, however, such an approach would not be appropriate. Monetary targeting and inflation targeting strategies - in contrast - seem more relevant candidates for Stage Three. The fundamental idea underlying the monetary targeting approach is that the principal source of inflation is excessive monetary growth and that, by controlling the growth of the money supply, price stability can be achieved. Therefore, for the adoption of such a strategy, it is necessary to have a stable, or at least predictable, relationship between the growth of the money supply and inflation. An inflation targeting strategy has been adopted by a number of EU and non-EU countries in recent years. In this case, the approach is to focus directly on expected future inflation. This involves the use of a wide range of available indicators to arrive at a projection of inflation in the future. Monetary policy is then set so as to be consistent with the achievement of price stability as defined by the target. In order to implement such an inflation target strategy, it is necessary that a predictable relationship exists between the set of indicators used and future inflation and that this relationship can be clearly explained.

The switch to Stage Three will represent a major regime shift which could result in significant changes in the behaviour of economic agents. Both approaches require further study of the transmission mechanism and the information content of various variables. The EMI will focus on the necessary background for both strategies in 1996.


3.1 Trends and recent evolutions in EU countries

Recent developments of monetary policy instruments and procedures in EU countries, in general, underline the progress towards convergence across EU countries. This progress was already evidenced by the increasing weight of open market transactions in central bank operations and the widening use of repurchase agreements across the EU. It was confirmed by the introduction of a regular gilt repo facility by the Bank of England. Similarly, the Bank of Greece extended the range of its monetary policy instruments by employing regular repurchase agreements based on a tender procedure. The Austrian central bank also introduced a regular open market facility based on repos. In addition, credit lines of standing facilities have been revised.

The Banque de France intends to adopt some changes in the framework of its interventions in the money market. As part of these reforms, the central bank will be allowed to withdraw liquidity by issuing its own debt paper, in line with the practice in several other countries.

Convergence can also be seen in the field of reserve requirements. The Bank of Finland, for example, introduced averaging provisions into its system of required reserves. The lowering of minimum reserve requirements in Portugal, Germany and Austria continued the trend towards reduced spreads between reserve ratios across EU countries. An exception, however, was Greece, where the reserve requirement ratio was increased (and the basis for the calculation of reserve requirements was broadened) in order to control liquidity and restrain credit expansion.

3.2 Guiding principles for the selection of monetary policy instruments

On the basis of national experience and following the provisions of the Treaty as well as the Statute of the ESCB and of the ECB, central banks have approved a number of general principles which may guide, in support of the overriding objective of price stability, the selection of monetary policy instruments:

3.3 Financial market structure and implications for monetary policy instruments

Apart from these principles, other factors will eventually have an impact on the shape of the operational framework of monetary policy. For example, account must be taken of the existence of differences in financial market structure across EU countries. These differences relate, inter alia, to the degree of development of financial markets, the use of certain forms of debt instruments, and the structure of the banking and financial system. At the same time, the full integration of money markets in Stage Three is necessary in order to ensure the emergence of a single monetary policy stance.

The operational framework of the ESCB has to be prepared against the background of uncertainty about the financial market structure in Stage Three which results, for example, from the rapid evolution of EU financial markets under the influence of deregulation, innovation, globalisation and the Single Market. This general uncertainty calls for the design of an operational framework which will allow the ESCB to exercise flexibility when deciding on the use and features of instruments to be implemented.

In general, however, the structure of financial markets may not necessarily be a major constraint on the selection of the operational framework. Financial market structure may also adjust to features of the operational framework. While the operational framework can influence financial market structure, the choice of the framework should not be based on the aim of encouraging particular market structure developments. The choice of the operational framework must rather be made on the grounds of operational efficiency and adherence to the guiding principles enshrined in the Statute of the ESCB and of the ECB, most notably to those of operational efficiency and confornity with market principles.

3.4 Monetary policy instruments

Following all the above considerations, the EMI has examined, without coming to final conclusions, the usefulness and desirable properties of the three main generic types of instruments available: open market operations, standing facilities and reserve requirements.

3.4.1 Open market operations

In the overwhelming majority of EU countries, open market operations play a pivotal role in the operation of monetary policy, being the primary instrument by which money market interest rates are steered. This approach reflects the increasing flexibility and market orientation of monetary policy in EU countries and the desire to promote the development of interbank markets as an efficient means of allocating liquidity. It is widely believed that this approach should be continued in Stage Three and that open market operations should play the dominant role in the management of money market conditions.

Reversed transactions (repos) currently play a dominant role in EU countries and this is likely to continue in Stage Three. The main advantage of this instrument is the flexibility with which it can be employed, with the central bank retaining the initiative regarding the timing, frequency, amounts and maturity of the operations. Also, repos have no direct effect on the price of the underlying asset and enable a wide spectrum of paper to be employed in the operations.

Outright transactions are employed in a number of EU countries and are also likely to be available to the ESCB. If such transactions were undertaken in longer-term assets this would enable the central bank to achieve a longer-term change in its overall lending/borrowing position vis-à-vis the commercial banks. However, the instrument is in some respects less flexible than repos.

Foreign exchange swaps are also likely to be available, in principle, to the ESCB and may be particularly useful in certain circumstances, for example, when there is a shortage of domestic collateral or when stabilising the central bank's balance sheet in the face of significant changes in foreign reserves is desirable. However. potential disadvantages of this instrument, including a relatively long settlement lag and the tendency for the instrument to inhibit the development of domestic money markets, have to be considered.

As regards the withdrawal of liquidity, the issue of central bank paper or the collection of fixed-term deposits should be available, with the former being particularly useful for absorbing more structural surpluses in the money market while the latter may be more suited to dealing with temporary surpluses.

In addition to regular open market operations, which should be based on a predetermined timetable in order to facilitate banks' liquidity planning and to enhance the ability to convey signals, a need may arise from time to time to engage in additional open market operations to offset large unexpected liquidity shocks and, if circumstances require, to actively guide the short-term money market rates on a day-to-day basis. The option of conducting such fine-tuning operations should be available to the ESCB. A range of instruments and techniques could be employed in order to maximise the flexibility of the central bank in this regard.

3.4.2 Standing facilities

In line with the increasing market orientation of monetary policy, and in order to ensure maximum flexibility for the ESCB, open market operations are seen as being the pivotal instrument in the conduct of monetary policy, providing the main means of supplying/withdrawing liquidity and steering interest rates. As a result, standing facilities, i.e. facilities which may be used at the discretion of individual central bank counterparties, could include a marginal lending facility and a deposit facility.

Two other facilities, both of which involve the provision of liquidity by the central bank at rates normally below market rates are also being studied: a discount facility - involving the outright purchase of private bills of exchange - and a collateralised lending facility. Experience with these facilities is limited to only a few central banks.

3.4.3 Reserve requirements

The preliminary analysis started from an assessment of the advantages and disadvantages of reserve requirements, based primarily on the experience of national central banks. Two important functions of a compulsory reserve system pertain to money market management. The first is the creation and maintenance of a structural shortage in the money market when this is deemed necessary (enlarging function). The second is the stabilisation of money market interest rates if reserve requirements are combined with averaging provisions (stabilising function). Furthermore, compulsory reserves, if not fully remunerated, may increase the central bank's leverage over money demand by driving a wedge between the interest rates on monetary and non-monetary assets or by enlarging an existing wedge. On the other hand, less-than-fully remunerated reserves may diminish the information content of monetary aggregates and the potential relationship with final variables.

A full assessment of the relative merits of required reserves will only be possible with reference to the main features of the operational framework to be adopted. However, some basic principles which could govern decisions in the area of compulsory reserves for Stage Three have been discussed. Reserve requirements should figure among the set of monetary policy instruments potentially available to the ESCB, even though the decision on the actual use of this instrument, and on some of its features, will have to be taken in view of the operational framework of the ESCB, as well as the economic and financial conditions prevailing in Stage Three. Should a system of compulsory reserves be used, it should be fully harmonised across all Member States participating in the single currency area, so as to allow for its decentralised operation. In order to facilitate harmonisation, the system should be relatively simple. Furthemore, a decision on the possible use of reserve requirements should be based on an assessment of all the potential functions of such a system and of the extent to which these can be performed by alternative instruments. A system of reserve requirements should also be designed in such a way that it does not induce undesired delocation or disintermediation. Therefore, both the selection of the liabilities which may be subject to reserve requirements and the combination of reserve coefficients and rates of remuneration which may be specified will need to be studied carefully. Such a study is under way. Finally, while the system of compulsory reserves should be designed so as to perform potentially both money market management and monetary control functions, in cases of conflict between the two functions the technical features should be chosen so as to give priority to money market considerations.

3.5 Assessment

It should be reiterated that further preparatory work on the various types of instruments and their specific features must await the finalisation of the discussion on the operational framework.

Nonetheless, considerable progress has been made in the preparation of monetary policy instruments and procedures. This refers, in particular, to the examination of the main generic types of monetary policy instruments and to the issue of how the individual instruments will be combined to form an operational framework for monetary policy, as well as to the selection of eligible assets for mobilisation and pledging in monetary policy operations of the ESCB. Detailed blueprints for the use of the various types of monetary policy instruments will be drafted in 1996.

November 1995

(*) Report of the EMI " Progress towards convergence" published in November 1995. Excerpts (p. 70 to 77) from chapter II "Monetary policy instruments and the preparation of the procedures for carrying out a single monetary policy in the third stage". Reproduction has been authorized by the EMI.