FRANKFURT, March 29 - Two key euro zone central bankers on Saturday defended the European Central Bank's policy framework that it is currently reviewing, saying its complex nature enhances financial stability. The strategy could help to prevent financial crises and to deflate asset price bubbles because it allows the bank to temporarily deviate from low inflation levels, the ECB's chief economist Otmar Issing said in a speech.
"Truly optimal monetary policy cannot avoid that, at times, strains in the financial system might be such that deviations from the desired inflation rate during shorter periods of time have to be accepted in order to preserve price stability over the medium to long term," he said to an audience in Basle. Some analysts have suggested the bank might abandon its so-called two pillar strategy which gives an equal weighting to monetary and real economy data, after it announced last year that it would look into the framework. Others have said it might raise its two-percent tolerance ceiling for inflation. But Bundesbank Vice-President Juergen Stark in a newspaper interview also strongly objected to changing the ECB's strategy, with which it gauges whether rates are at the right level. "I want both pillars to be maintained and want to see the first pillar, the monetary aggregates, given clearly more prominence in public debate," Stark told Boersen Zeitung newspaper in an interview. Stark is not a member of the ECB's Governing Council that makes a decision on which strategy to follow in May, but his words show that any proposal to change the strategy might still meet fierce opposition.
COMPLEX WORLD, COMPLEX STRATEGY
A simpler strategy, for instance one that directly targets inflation such as that of the Bank of England, would not have the advantages inherent to the ECB's monetary framework and would lack important information from money data, Issing said. If financial institutions were in danger, risking a collapse of the financial system, it could be wise to keep interest rates low, thus giving them a low cost base, even though this would mean a temporary inflation blip, Issing said. Likewise, it could be advantageous to live through short times of disinflation, or deflation, if that would help to deflate asset price bubbles, such as those the stock market had seen in the 1990s, which could also threaten stability. Money supply and credit growth were important ingredients of the strategy, as they provided information about financial strains, for instance that a price bubble was taking shape, even at times when inflation was still behaving in line. "The ECB two pillars strategy would send a 'warning signal' in cases when the forecast for consumer price development is benign, but monetary and credit aggregates rise strongly," Issing said in his speech.
While price bubbles were very hard to assess while they were still occurring, central banks should still try to warn markets if they think prices are exaggerated, though they should not directly target asset prices, Issing said. "The central bank might have a role to play in providing a noisy but unbiased opinion about equilibrium prices to the public," Issing said. The bank had followed a similar strategy to prop up the low exchange rate of the euro right after its introduction, by saying that a strong euro was in the interest of the euro zone, even though it was very hard to asses a fair value. Issing's words threw cold water on the hopes of those analysts calling for the ECB to give less prominence to money growth, which has consistently overshot the ECB's self-set "reference" levels since the launch of the euro in 1999 and provided a poor guide to ECB policy. Some have also argued for an increase in the ECB's two-percent inflation tolerance ceiling, warning the current divergence in inflation rates across the euro zone can only get worse once the currency area expands to eastern Europe.
Stark also argued, in line with Bundesbank tradition, that money growth continued to be an important guide to future inflation or asset price bubbles and that fears surrounding euro zone enlargement did not justify relaxing the inflation goal.//