Too slow to react?

In 2001 the ECB faced a sharp deterioration in the economic outlook, both globally and in the Euro Area. These circumstances gave the ECB its sternest test to date. Critics have argued that the ECB cut interest rates both too little and too late. Does this stand up to scrutiny? Or did the Fed, by comparison, respond too vigorously; or was the problem simply larger in the US? Does the existence of global linkages justify a role for international coordination of monetary policies? The authors of the latest MECB Report conclude:

• The problem was larger in the US. While there is evidence that the ECB was slow to cut rates, by late 2001 it had made up lost ground. A Fed-in-Frankfurt would not have cut interest rates more, but might have cut them earlier. 

• Greater uncertainty about the transmission mechanism may have been a reason to use policy more cautiously, but this applies as much to the US as the Euro Area. However, those calling for the ECB to take a more active role in output stabilization in the short run must recognize that for half its life to date the ECB has allowed inflation to exceed its inflationary target range. Any simple charge of a deflationary bias in monetary policy is not justified.

• As credibility grows, the ECB will have more scope to engage in output stabilization without undermining its commitment to price stability. 

• International spillovers may not be sufficient to make a clear case for more coordination, but the ECB should clarify which circumstances give cause for future coordination and which do not.

A clean bill of health? – not quite

The Maastricht Treaty defines the primary objective of the ECB as the maintenance of price stability. It also adds that ‘ the ECB shall support the general economic policies’; these include ‘a high level of employment’. Thus the Treaty gives the ECB a double mandate. In its own words the ECB has fulfilled this mandate, given that: ‘ Maintaining price stability in itself contributes to the achievement of output and employment goals…’ ECB Monthly Report, January 1999. This remarkable interpretation is at best incomplete. The member countries of the Euro Area have experienced a largely symmetrical shock and, given the low inflation environment, the ECB now has considerable leeway to combat area-wide slowdowns without risking price instability. But to take advantage of the benefits of monetary union the ECB must have the confidence to act.

The poison pillar

As noted in previous MECB Reports, the M3 monetary pillar is flawed beyond repair and should be abandoned. The only possible justification for a monetary pillar is that it might be a useful leading indicator of inflation. But it is here that M3 fails spectacularly, even after cosmetic adjustment. M3 growth has had no bearing on the setting of interest rates by the ECB and has continued to baffle economic analysts.

More broadly, MECB 4 recommends: 

• If the European economy is more rigid than the US or if its fiscal policy is more constrained, then a more activist monetary policy is required. 

• The ECB needs to do better in incorporating international macroeconomic conditions into its monetary policy strategy, in order to take into account the transatlantic business cycle and policy spillovers between the Fed and the ECB.

• Any increase in systemic uncertainty which has taken place may require the ECB to exert more leadership in guiding Euro Area financial markets.

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