Explaining Your Monetary Policy Decision based on Economic and Monetary Analysis

SOME GUIDANCE FOR WRITING YOUR ESSAY: i.e., THE INTRODUCTORY STATEMENT TO THE PRESS CONFERENCE
FP Mongelli 24 September 2012
Thanks to Raffaella Traverso, Moritz Karber, Alessandro Cugnasca and Bjrn Fischer for assistance.

What you have to do

Imagine that you are in charge of securing price stability over the medium-term for the euro area. Your objective is to write an essay i.e., an Introductory Statement to the Press Conference (IS) explaining the reasons for your policy decisions by referring to the underlying economic and monetary analysis, as well as the unfolding of the crisis. This is not easy:
on one hand, you need to explain your inflation outlook as well as the various scenarios, risk factors (downside and upside), and so on; on the other hand, you need to have a view amongst others - on the factors that contributed to the crisis and its economic impact; today, more than ever, Central Banks - and the ECB in particular - need to have a Weltanschauung but also remain conscious of their mandate and limits.

The aim of this presentation is to give you some tips!

1st, what is the medium-term (MT)? It is a time frame between the short-term i.e., a period of one or at most two years - and the longterm which can last several more years say the completion of a business cycle: According to JM Keynes: in the LT we all passed away. According to P. Krugman: only productivity matters in the L-T. Thus, for all practical purposes your time frame is of about 2-3 years.

What you have to do

2nd, your mandate is to maintain inflation close but below 2% over the medium term: This is your price stability objective a year-on-year increase of HICPs < 2% over MT If there is no incompatibility, then you can consider also other objectives that are ancillary, like economic growth and employment this essay focus on price stability (that is complex enough) 3rd, why does the choice of time-frame in which you need to achieve your objective greatly matter? Because every month, or quarter, price dynamics are affected by a great variety of shocks, or news, or self-reverting events (like a strike, some temporary disruption, or other short lived blips) These are often called noise by statisticians and economists Instead, you need to correctly interpret underlying price signals that emerge from the very structure of the economic, monetary and financial systems

What you have to do

4th, what is your geographic domain? It is the euro area as a whole: i.e., considering it as a single geographic entity Some comments on the concept of economic and financial integration, versus divergence. In fact, the analysis of heterogeneity and/or uneven transmission of monetary impulses greatly matters for your Essay 5th, now imagine that you were the President of the ECB and thus the Chair of the Governing Council all types of data, statistics, information, facts about the euro area economy would be available to you as well as all other Governing Council members moreover, you would have at your disposal the best economic and monetary analysis possible for the euro area, and also other regions. it is also important to note that this wealth of data and information is also available to all beyond the Eurosystem, i.e., it is publicly available information

What you have to do

6th, Imagine that its the first Thursday of the month: the day of the voting Governing Council (GC). the GC has just met, and conducted the economic and monetary analysis plus the cross checking You need to explain your decision to a vast public ranging from the media, skilled ECB watchers, other policy makers, and the public at large. Explain in the Essay the monetary policy decisions that you have taken concerning the standard monetary measures (appropriate interest rate level) and non-standard measures (like unlimited refinancing against good collateral, purchase of specific assets, and so on); Moreover, as soon as you have finished your statement, questions from the media attending the Press Conference start flocking: about 100-150 journalists. Intimidating. Questions can range from something in your essay, or anything that you have publicly discussed over recent days/weeks, or anything said by some other Board/Governing Council members, or anything even indirectly related to the decision(s) you took. Be ready to explain how the voting went: colleagiality, unanimity, dissent, differences in views, and so on 7th , how can you organise both your analysis, Governing Council discussion, deliberation and explanation to the above vast public? Is there an organising device? Yes, it is shown in the picture in the next slide: we call it a Monetary Policy Strategy. It shows what is frequently called as two-pillar analysis plus the cross checking.

What you have to do

8th, now you have to explain your decision in an Essay of up to 2,000 words (roughly two-three A4 pages). You have to be concise and convincing. Thus remember that you have to: Explain also the pros and cons of your decisions, Lay out the various risks you see (both bad risks and positive risks), and, looking ahead, also present some possible scenarios 9th, your goal is to explain principally what has changed since your last Essay (the IS). You meet with your peers at least once a month. Meetings are about interpreting new data/information and whether it changes your price stability scenarios. an underlying consensus builds up over time and new evidence confirms it or requires some adaptations. focus is on new data/information or developments that have occurred over recent weeks and that require changes in your baseline scenario. 10th, unless there is a crisis like the ongoing financial crisis - or a substantial shock: Then you need to assess the severity of the shocks/events unfolding Be ready to operate with standard monetary policy measures as well as non-traditional ones. The significance of data and information that you have already looses partly in significance

and why is it difficult?

The exercise that you are about to engage in, is rendered more challenging by various difficulties: 1st, you will be deciding in real time You dont know precisely the current state of the economy right now. I.e., the data you are using has some lag with respect to what is happening now. an analogy would be that you know your body temperature of last week (and not today) and yet you need to decide whether you stay home and take medicines (and/or go to the doctor) You may have to undertake some guessing work and use projecting/forecasting. You can use leading indicators (surveys, electricity consumption, industrial production, and so on). 2nd, there is also what we call model uncertainty i.e. our analytical tools only provide an interpretation of reality while the economy may be changing over time An increase in oil prices today may be reverted soon or be the start of a trend Similarly if you misjudge the pace of innovation, you may unduly keep monetary policy too tight. 3rd, there is also the policy debate, interaction among policy makers and voting outcome Most times Governing Council decisions are by consensus and for a long time this has been the main outcome More recently some dissent has emerged: some public and some latent For the purpose of your essay we only look at consensual decisions: i.e., your team agrees on one decision which it then explains.

and why is it difficult?

4th, there is the sovereign debt crisis unfolding and the policy decision of the Governing Council have an impact on financial markets but also acquire a broader meaning aimed at fostering a completion of EMUs architecture As implementation takes time and financial markets often only adjust once success becomes clearly visible, governments must stand ready to activate the EFSF/ESM with strict and effective conditionality. The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions. 5th there is dissent in the Council and there are public criticisms in the media, by various experts and policy-makers and so on. 6th the IS also sens signals and messages to other policy makers and the informed public.

The rest of this presentation is about some key elements for the Essay

The Introductory Statement (IS) preceding the ECBs Press Conferences is a model essay

Introductory paragraph

Monetary policy decisions Key monetary policy messages / intentions / signals in recent times this section has hosted also remarks concerning the sovereign crisis, the irreversibility of the euro, and the integrity of the euro area (see examples in next 2 slides).

Economic analysis

Growth and employment developments Price developments Once a quarter, summary of staff projections Money growth Credit growth

Monetary analysis

Cross-checking / summing-up

See http://www.ecb.europa.eu/press/pressconf/2011/html/index.en.html

 The Governing Council discussed the policy options to address malfunctioning in euro area bond markets. Exceptionally high risk premia are observed in sovereign bond prices in several countries, and financial fragmentation hinders the effective working of monetary policy. Risk premia resulting from fears of the reversibility of the euro are unacceptable. The euro is irreversible. Policy-makers in the euro area need to push ahead with fiscal consolidation, structural reforms and European institution-building with great determination. The Governing Council may undertake outright open market operations of a size adequate to reach its objective. The concerns of private investors about seniority will be addressed, and so on.

The Introductory Statement of 2nd August contained the following (edited) remarks:

The Introductory Statement of 6th September contains following edited remarks:

The Governing Council today decided on the modalities for undertaking Outright Monetary Transactions (OMTs) in secondary markets for sovereign bonds in the euro area. we need to be in the position to safeguard the monetary policy transmission mechanism in all countries of the euro area. We aim to preserve the singleness of our monetary policy and to ensure the proper transmission of our policy stance to the real economy throughout the area. OMTs will enable us to address severe distortions in government bond markets which originate from, in particular, unfounded fears on the part of investors of the reversibility of the euro. Hence, under appropriate conditions, we will have a fully effective backstop to avoid destructive scenarios with potentially severe challenges for price stability in the euro area. we act strictly within our mandate to maintain price stability over the medium term; we act independently in determining monetary policy; and the euro is irreversible.

 but the IS is also a highly policy-intense and politically dense statement

the IS often contains fiscal and structural policy messages You need to instil confidence but also be realistic Yet, the desire of the organisers of the Generation uro Students Award is not to receive a copy and paste with some editing exercise from the IS. This happened to some extent in the pilot exercise and the first edition. Hence, while it is OK to seek inspirations from the Introductory Statement to the Press Conference (IS) and also some ECB Monthly Bulletin articles or text, you should attempt to provide your own thoughts

In the rest of this presentation we show some examples of recent time series that have a bearing on your essay and present the main features of the economic and monetary analysis

Here are key interest rate facts: what decision do you recommend next?
It currently stands at 0.75% It is reviewed monthly but only changed occasionally (35 changes since 1999) It is changed in discrete steps of 25, 50 and rarely 75 basis points

6.0 5.0

marginal lending rate

6.0 5.0
EONIA

4.0 3.0 2.0 1.0

deposit rate main refinancing rate/minimum bid rate

4.0 3.0 2.0 1.0 0.0

0.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Example: HICP Inflation and pipeline pressures

HICP inflation: overall and exclusion-based measures (annual growth rates)
HICP HICP excluding unprocessed food and energy 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 HICP excluding food and energy

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Source: Eurostat. Latest observation: August 2012 for headline HICP.

2012

Example: Long-term inflation expectations from surveys and break-even inflation rates (role of credibility)
3.0 2.8 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0
5-year forward 5 years ahead BEIR 5-year I/L swap rate 5 years ahead ECB Survey of Professional Forecasters (long-term)

3.0 2.8 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0

Jan-08

Jan-09

Jan-10

Jan-11

Apr-08

Apr-09

Apr-10

Apr-11

Jan-12

Oct-08

Oct-09

Oct-10

Oct-11

Apr-12

Jul-08

Jul-09

Jul-10

Jul-11

Sources: ECB and Reuters. Latest observation: BEIR and I/L swaps 17 September 2012 and 2012Q3 SPF July 2012.

Jul-12

The two-pillar approach

The two Pillar Approach shown in the previous picture consists of two complementary perspectives: The economic analysis (EA) that is aimed at assessing short to medium-term risks to price stability. Its focus is on real activity and financial conditions in the economy. The monetary analysis (MA) focuses on a longer-term horizon, exploiting the long-run link between money and prices. MA also serves as a means of cross-checking, from a medium to long-term perspective, the short to medium-term indications from the economic analysis. This dual approach secures robustness and works as an insurance mechanism It allows a close mapping between the Monetary Policy Strategy and the Communication policy.

Economic analysis (I)

The Economic Analysis takes account of the fact that price developments over the short and medium term are influenced largely by the interplay of supply and demand in the goods, services and factor markets (see next picture) To conduct the economic analysis, the ECB regularly reviews amongst others various hardcore macro indicators such as: developments in overall output, demand and labour market conditions, a broad range of price and cost indicators, fiscal policy, and the balance of payments for the euro area.

Economic analysis (II)

Asset prices and financial yields Financial variables are analysed to derive information about the expectations of financial markets, including expected future price developments. Using a variety of techniques, financial prices permit to extract the markets implicit expectations about future developments. Macroeconomic projections Projections, a synonym of forecasts, are produced under the responsibility of the ECB and the Eurosystem staff using analytical tools and empirical models. The projections help to structure and synthesise a large amount of economic data. They ensure consistency across different sources of economic evidence. Permit to sharpen the assessment of economic prospects and the short to medium-term fluctuations of inflation around its trend.

Examples of economic analysis

Changes in inflation (year-on-year)

5.0 4.0 3.0 2.0 1.0 0.0 -1.0

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Latest observation: August 2012.

2012

Examples of economic analysis

Changes in real GDP (percentage changes)

Quarterly growth (rhr)
5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 -6.0

YoY growth (lhs)

2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0

Latest observation: 2012Q2

99 Q1 99 Q3 00 Q1 00 Q3 01 Q1 01 Q3 02 Q1 02 Q3 03 Q1 03 Q3 04 Q1 04 Q3 05 Q1 05 Q3 06 Q1 06 Q3 07 Q1 07 Q3 08 Q1 08 Q3 09 Q1 09 Q3 10 Q1 10 Q3 11 Q1 11 Q3 12 Q1 12 Q3

Examples of economic analysis

Changes in unemployment
Annual change (millions) (RHS) Unemployment rate (%) (LHS)

11.5 11.0 10.5 10.0 9.5 9.0 8.5 8.0 7.5 7.0 1999
Latest observation: July 2012

7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 2001 2003 2005 2007 2009 2011

Examples of economic analysis

Staff projections

Latest figures released in early September 2012 Next release at the December 2012 Press Conference (thus every 3 months) Important to check how the numbers have changed compared with the last release How do HICP projections compare with the definition of price stability?
2011 GDP September 2012 MPE June 2012 BMPE HICP September 2012 MPE June 2012 BMPE 2.7 2.7 2.4 - 2.6 2.3 - 2.5 1.3 - 2.5 1.0 - 2.2 1.5 1.5 -0.6 - -0.2 -0.5 - 0.3 -0.4 - 1.4 0.0 - 2.0 2012 2013

A remark: what type of data should you look at?

You will quickly notice an enormous number of data series and charts like the one below Look in fact at the relevance of seasonality: e.g., in euro area industrial production By necessity, the data we look at are not pure but they are filtered somehow: here is one useful example, while another example of filtering comes along with the monetary analysis.
120 110 100 90 80 70 60 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Monetary Analysis
The ECB is almost unique among the leading central banks in assigning a high importance to monetary aggregates. Why does the ECB do that? Reason 1: in the medium to long run monetary growth and inflation are closely related. Reason 2: the analysis of credit and liquidity conditions enables the ECB to see beyond the transient impact of the various shocks. Which monetary aggregates? M1 has been defined as currency in circulation plus overnight deposits. M2 comprises M1 plus deposits with an agreed maturity of up to and including two years and deposits redeemable at notice of up to and including three months. M3 comprises M2 plus repurchase agreements, money market fund shares and units as well as debt securities with a maturity of up to and including two years.

Monetary Analysis
Beyond assessing the growth of the broad monetary aggregate M3, diverse other monetary and financial variables are also informative, including: developments in the components of M3 (e.g. cash in circulation and time deposits) as they can offer an insight into the overall changes in M3; and narrower aggregates such as M1 may contain some information about real activity. Similarly, changes in credit extended to the private sector can also be informative about financial conditions and, through the monetary financial institutions (MFI) balance sheet, can provide additional information about money. Moreover, the analysis of money and credit may provide early information on developing financial instability. This is of relevance for SMP because over time the emergence of financial imbalances or asset price bubbles could have a destabilising effect on activity and, ultimately, prices.

A remark: what type of data should you look at? Monetary Analysis, annualised quarter-on-quarter changes, deviations from mean
8 8 6 6 6 6 6 6 4 4 3 3 3 3 3 3

-4

-4

-3

-3 -3

-3 -3

-3

-8 1974 1981 1988 1995

-8 2002 2009

-6 1974 1981

1988 1995

-6 -6 -6 -6 -6 2002 2009 1974 1981 1988 1995 2002 2009 1974 1981 1988 1995 2002 2009

M3

Low frequency component e.g. inflation (expectations)

Business cycle + frequency component e.g. economic activity

High frequency component e.g. bank behaviour

Example of monetary analysis

Actual current changes in M3 (annual percentage changes, adjusted for seasonal and calendar effects)
14 12 10 8 6 4 2 0 -2 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 14 12 10 8 6 4 2 0 -2

Latest observation: July 2012

Example of monetary analysis

Loans to households and non-financial corporations (annual % changes; seasonally adj.)

Households 20 Non-financial corporations 20

15

15

10

10

-5 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

-5

Latest observation: July 2012

Cross-checking

Are the messages from the economic analysis and the monetary analysis consistent? Sept 2012: To sum up, the economic analysis indicates that price developments should remain in line with price stability over the medium term. A cross-check with the signals from the monetary analysis confirms this picture.

October 2010: A cross-check of the outcome of our economic analysis with that of the monetary analysis confirms that inflationary pressures over the medium term remain contained, as suggested by weak money and credit growth.

The importance of expectations for the economy

Many points in the Introductory Statement refer to expectations and are forward-looking in nature, e.g.:

Statistical releases and survey evidence generally confirm our expectation of a moderation in the second half of this year in the euro area and elsewhere.

The global recovery is expected to go on.

This is due to the fact that monetary policy takes quite some time to have an effect on the economy (via the transmission mechanism).

The importance of expectations

Of course, we cannot be certain about the future. The Introductory Statement often contains statements like:

The risks to this economic outlook are slightly tilted to the downside with uncertainty still prevailing Risks to the outlook for price developments are slightly tilted to the upside

For monetary policy decision-making the red distribution of probabilities is probability / likelihood

preferable: it entails less uncertainty. probability / likelihood

less uncertainty

downside risks more uncertainty

Modal view

inflation

Modal view

inflation

Example: Distribution of Euro Area Barometer 2012 HICP Forecasts

Here a distribution hovering around 2% is best: like Jan & Feb 2012
ECB Jan 12 EZB Apr 12 EZB Jul 12 EZB Feb12 EZB May 12 EZB Aug 12 EZB Mar 12 EZB Jun 12 EZB Sep 12

5.00 4.50 4.00 3.50 3.00 2.50 2.00 1.50 1.00 0.50 0.00 1.5
Source: EZB. Latest observation: September 2012

Apr12, Jul12, Aug12: 2.3%

May12, Jun12, Sep12: 2.4% Feb: 2.0%Mar: 2.1% Jan: 1.8%

1.8

2.0

2.3

2.5

2.8

3.0

To sum-up: Careful consideration is needed

The Governing Council but also all other central banks - look and debate a very large amount of data information and analysis The discussion and deliberation plays an important role. Everything is considered very carefully: in fact, in the presence of doubts modern central bankers prefer to be cautious and move little steps at a time. 25-50 basis points at a time.

They also need to be forward-looking Unfortunately, there is no easy procedure that generates a correct monetary policy decision: in fact it may take some time months or even years to gauge the correctness of a MP decision today

Thus, do your best and remember that you have to upload your essay to the competition website by 8 p.m. CET

Thank you for participating and dedicating your time to broaden economic awareness

The latest data releases

Eurostat: Latest news releases http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/ ECB

Statistics, latest data http://www.ecb.europa.eu/stats/html/index.en.html Monthly Bulletin http://www.ecb.europa.eu/pub/mb/html/index.en.html Monetary developments http://www.ecb.europa.eu/press/pr/stats/md/html/index.en.html Bank lending survey http://www.ecb.europa.eu/stats/money/surveys/lend/html/index.en.html

Newspaper and analysts reports: its important to get a feeling for the news component in the releases