---- by STEVE WHITEHOUSE ----
PARIS (AFX) - The European Central Bank will once again leave its reference value for M3 money supply growth unchanged when it carries out its annual review of the figure, economists said. None of the elements underpinning the 4.5 pct reference value have changed significantly, so the ECB will see no reason to alter it, they said.
But some economists said the ECB should think about abandoning the key role assigned to M3 in ECB monetary policy because it is proving a poor indicator of inflation pressures. The M3 reference value is likely to be discussed at the ECB governing council meeting today, although the ECB itself will not confirm that the issue is on the agenda of the meeting. In previous years the reference value has been reviewed at the December council meeting, which is followed by a news conference, as will be the case on Thursday.
The ECB assigns a prominent role to M3 growth in its monetary policy, with a monitoring of the M3 data representing one of the two pillars of its strategy for assessing risks to price stability. The reference value is intended to reflect the rate of year-on-year M3 growth which is consistent over the medium term with the ECB's price stability goal of an inflation rate of less than 2 pct. The ECB therefore uses the reference value as a benchmark against which actual M3 growth can be measured, rather than as a target. But many economists say there are growing doubts about the wisdom of placing so much emphasis on M3 growth and of the usefulness of the reference value.
"It is getting harder and harder to defend the ECB's two pillar strategy as only one pillar seems to do its job reliably," said Holger Fahrinkrug of UBS Warburg. The reference value has been set at 4.5 pct since the start of monetary union in Jan 1999, but actual M3 growth has often been well above the reference figure. And recently the ECB has been cutting interest rates at a time when M3 growth has actually been accelerating away from the reference value. Fully adjusted M3 growth has been climbing steadily since May and reached 7.4 pct in October. The ECB says that the recent acceleration in M3 is due to factors which do not carry inflation risks, particularly a shift of funds out of equities and longer-dated debt securities into more liquid short-dated assets.
Joachim Fels and Elga Bartsch of Morgan Stanley said M3 growth could accelerate even further in the coming months. "Unless we see a considerable slowdown in the monthly rate of increase, annual M3 growth could even touch upon the 8 pct mark. Meanwhile, the smoothed three-month moving average will likely leap to around 7.5 pct, a full three points above the reference value," they said.
But M3 growth should return towards the reference value once financial market uncertainty subsides, they said. However, the distortions and volatility in the data mean that financial markets regard the figures as providing little in the way of informative content at present, said Michael Schubert of Commerzbank. "Although M3 growth continues to gain momentum, the ECB has lowered key interest rates on a generous scale in recent weeks," he said. "Any major distortion of this kind obviously makes it more difficult to establish the reference value."
Some economists said the ECB might be best advised to simply drop the reference value and abandon the prominent role given to M3, although there is little realistic expectation that the central bank will do this.
"Setting a medium-term objective that you measure badly and which has not been respected for the past few quarters really makes no sense," said Marc Touati of Natexis Banques Populaires. "If it wants to increase its credibility, the ECB should therefore abandon this objective."
"It would be better to temporarily suspend the use of M3, perhaps using the switch to euro notes and coins as a pretext, or they should at least play down its role as the first pillar (of the monetary policy strategy). The best thing would be to create a single pillar by merging the two pillars. But they won't do it," said Philippe Weber of CPR. If the ECB decides to maintain the role of M3, then now is not the time to change the reference value, with actual M3 growth running so far above the reference figure, he said.
M3 growth would be even higher if the ECB had not twice revised the way it calculates the data to eliminate distortions. In May it took non-resident holdings of money market fund shares and units out of the data and then in October it excluded non-resident holdings of money market paper and short-term debt securities.
It estimated that the first distortion boosted M3 growth by 0.5 percentage points, while the second distortion added 0.6-0.7 points to the headline figure in recent months.
A fully corrected series of M3 data, adjusted for both distortions, has only just been published and shows M3 growth actually running below the reference value between Sept 2000 and May 2001, whereas the unadjusted series had shown M3 growth running above the reference value since the start of monetary union.
But even after both adjustments, the growth rate has been well above the reference value since June. Given the extensive adjustments to the data that have been implemented over the past year, markets would be suspicious if the ECB also revised the reference value in a way which brought it closer to current M3 growth, said Stephan Rieke of BHF Bank. The ECB also needs to stick to the reference value for more general reasons of credibility, said Schubert.
"The financial markets would welcome an adjustment in the short term, because it would signal the ECB's willingness to introduce additional rate cuts. However, in the longer term doubts would probably arise as to whether the bank intended to adhere to its stability standards, as it would no doubt prove extremely difficult to convey the reasons for changing the reference value," he said. The main reason which the ECB will use for keeping the reference value at 4.5 pct will be that there has been no change in the assumptions which underpin it.
The 4.5 pct figure was based on a euro zone potential growth rate of 2.0-2.5 pct, inflation of less than 2.0 pct and a decline in the velocity of money circulation of 0.5-1.0 pct.
A decline in the velocity of circulation means that more money is required in the economy for a given level of GDP, and the 0.5-1.0 pct figure is therefore added to potential growth and inflation, not subtracted, in the calculation of the reference value.
At the time of last year's review, there was some speculation that the ECB might raise the reference value to reflect an increase in the euro zone's growth potential or a sharper decline in velocity, but it rejected both arguments, with ECB president Wim Duisenberg saying that the assumptions behind the calculation remained valid.
There are no more signs now than a year ago that the ECB believes that the euro zone has increased its growth potential, or that it believes in the existence of a euro zone "new economy". "Last year's criticism that the ECB was underestimating productivity growth in the new economy world has lost power, so we see no reason to change the assumptions underlying the reference value," said Fahrinkrug. "A year ago the ECB hinted that it was seeing rather an upside than downside risk to the reference rate of 4.5 pct. The reason was that the potential output growth might have accelerated a bit. We do not see that the picture of the potential output growth would have become clearer this year due to the quick slowdown in the economy," said Sirpa Wallius of Nordea. And there is also no need for the ECB to revise its estimate of the decline in the velocity of money circulation, said Schubert. He said the ECB has calculated that velocity of circulation has been declining by just under 0.9 pct from 1980 to the third quarter of this year, with a rate of decline of just over 0.5 pct since 1992. One other factor which the council may consider is the so-called money gap. This is the difference between the actual accumulated stock of M3 and the level that would have been reached if M3 had grown in line with the reference value since the start of monetary union. Klaus Baader of Lehman Brothers said the real money gap has increased a lot in the past year and now stands at around 1 pct, and this would justify a cut in the reference value to 4 pct. "Unless the ECB cuts the reference target ... they could be very easily accused of having lost faith in the stable relationship between money and GDP," he said. A cut in the reference value would also make it easier for the ECB to resist pressure for rate cuts when M3 growth falls next year as the current, temporary surge in the M3 data unwinds, he said.