Inflation, which "is always and everywhere a monetary phenomenon" (Milton Friedman), has a significant impact on economic and financial behaviours as well as social welfares. Therefore, one of the main objectives of Central Banks throughout the world is to keep inflation undercontrol. Not being an exception, the primary objective of the European Central Bank is to sustain the price stability, while other targets can be considered as long as they do not violate the primary objective over the medium term. In order to achieve this ultimate target, ECB may use two monetary policy strategies, including monetary targeting and inflation targeting, which use monetary analysis and economics analysis respectively. The monetary policy strategy of the ECB has changed into inflation targeting from the monetary targeting in 2003 as the advantages of the inflation targeting. As a result, the role of monetary aggregate in monetary policy strategy of the ECB has gradually decreased. However, in light of the financial crisis, there have been arguments that the ECB should still take the monetary aggregate into consideration when implementing the monetary policy. Therefore, the purpose of this essay is to examining the role of the monetary aggregates in the European Monetary Policy strategy before and during the financial crisis.
1. The role of monetary aggregatebefore the recent financial crisis
According to ECB (2004) and OECD (2007), prior to 2004, in order to sustain price stability, the ECB had applied the two-pillar strategy, which incorporated both the monetary and economic analyses in analyzing the threat to price stability so as to conduct the most appropriate monetary policy. However, this strategy depended primarily upon the money pillar (Sénégas, 2010), in which broad monetary aggregate M3 is the most important element.The reason why money played an important part in this strategy was that money growth has a close relationship with inflation, and was believed to be the cause of inflation. Before 2000, studies tented to obtain the same result that money growth could help to predict future inflation.Broader aggregates seemed to do better in longer term, while some other indicators such as output gap and GDP growth did a better work at shorter horizons (OECD, 2007).
The framework of this strategy derived from the quantity theory equation. A normative value for money growth can be derived using the target of inflation, which is set at 2% in medium term, a forecast of future real GDP growth as well as future velocity of money. By so doing, a growth rate of money stock exceed the reference value of 4.5% per year would be regarded as a threat to the target inflation over the medium term. In other words, the money stock growth should keep below the reference value of 4.5% (De Grauwe, 2008).
However, according to Sénégas(2010), various problems had arisen when ECB chose money as the first pillar. Firstly, the broad monetary aggregate's variations cannot be controlled by the Central Bank due to the fact that monetary base accounts for a small proportion of M3, while other components of M3 may vary independently with the changes in monetary base, which ECB can directly managed. Secondly, the growth rate of M3 significantly exceeded the 4.5% benchmark, while inflation was close to its objective of 2% (Figure 1).The annual average growth rate of M3 was about 7.2% while that of inflation was just 2.1% during the period from 1999-2007 (Table 1). Therefore, it seems to be that the ECB strategy to stabilize price through money control had failed, probably due to the instability of velocity over time, especially in the last decade(Figure 2) (De Grauwe, 2008). Finally, OECD (2007) points out that monetary indicators became less reliable, generating more errors than other indicators such as output gap or GDP growth in forecasting inflation, and the "noise to signal" ratio of money growth was significant. As a result, the ECB seemed to disregard the money supply numbers, which caused credibility problem (De Grauwe, 2007).
Therefore, the prominence given to the money pillar has disappeared, and the ECB adjusted its strategy into the inflation targeting regime, in which monetary analysis became the second pillar, whereas the previous pillar, the economic analysis was evaluated to the first one. As a result, the role of monetary aggregates has gradually reduced in the monetary policy strategy.
2. The trade-off between price stability and financial stability
According to De Grauwe and Gros (2009), before the financial crisis, price stability was considered to be a method that could help to maintain financial stability. However, after the financial crisis of 2007-2008, one question is raised that whether there would be a trade-off between financial and price stability. Using the evidence in the dot-com bubble in the late of 1990s, they argue that by stimulating monetary to maintain price stability, the asset prices' level increased significantly, and created a risk to financial stability because of the dangerous of the bubble of asset prices. Moreover, they also claim that before the financial turmoil in 2007-2008, the output's expansion was not sustainable since it relied upon the credit creation, which associated with the asset bubble, leading to banking problems and financial turbulence. Although the trade-off between price and financial stability does not always happen, it is obvious that this trade-off did occur over the last decade and has been widely ignored.
3. Reappraisal the role of monetary aggregate after the crisis
Maintaining price stability does not ensure financial stability. Some recent studies argue that monetary aggregate should be considered when conduct the monetary policy to ensure the financial balances. Monetary aggregate, which is the total liabilities in bank's balance sheets,reflects the net domestics and foreign assets in the asset side of total bank's balance sheets, in which credit is an important component. Therefore, the excessive of broad monetary aggregate(M3) growth can be considered as the mirror image of bank credit expansion, which in turn may cause the assets bubble in the financial market (Sénégas, 2010).
From Figure 3, it can be seen that the total bank loans associated with the stock price index in euro area most of the time from 1999 up to now. In the dot-com bubble period, the total credit increased significantly, and so did the stock price in 1999-2000, and both of them then crashed until 2003. The period from 2003-2007 observed adramatic and unsustainable rise in total bank credit as well as stock price index, which could be a warning to the ECB to cool down the financial market. However, not until 2006 did the ECB increase the interest rate (Figure 4). Even when the FED raised the funds rate from 2004, the long-term interest rate was still lowsince the investors believed that there was a permanent change in the policy response to inflation (Lansing, 2008). On the other hand, De Grauwe and Gros (2009) argues that the ECB could have implemented some measures such as increasing the minimum reserve requirements, reducing the loan-to-value ratio, or imposing lower leverage ratios on the banking system, rather than increased the policy interest rate in order to reduce the expansion of total bank loans as well as the asset prices.
De Grauwe and Gros (2009) also pointed out that broad monetary and credit aggregate seem to move together. He uses the annual growth rate of those two indicators to GDP to detect risk of financial market, because only significant changes in this ratio could threaten the financial stability. Figure 5 shows that both the two ratios increase with a remarkable rate from 2003 until 2007.Moreover, Table 2 reveals that the correlation coefficients between these two ratios are so high, which imply that the ratio between total credits to monetary aggregate has been roughly constant. Thus, it could have been detected the financial instability from looking at monetary aggregates and credit aggregates. However, as the ECB focus on the price stability with inflation targeting regime and asset prices are not target variables (Svensson, 2009), they were not aware of the threat to financial stability.
De Grauwe (2008) argued that although broad monetary aggregate could be inappropriatein forecasting inflation, it is a good indicator to diagnose the asset bubbles apart from other indicators, including asset prices and total credit. As a result, a new "two-pillar system" has been proposed for monetary policy strategy of the ECB, which not only maintain the price stability but also prevent financial imbalances (De Grauwe and Gros, 2009). In this new system, interest rate would be used to achieve the inflation target, whereas other instruments such as reserve requirements and macro-prudential control could be applied to maintain financial stability. Sénégas(2010) also suggests that monetary indicators may be not used as a pillar in the inflation targeting regime but as an instrument in a new system to check financial instability.
CONCLUSION
In this essay, attempts have been made to examine the role of monetary aggregates in the European monetary policy strategy in light of the financial turmoil. Although monetary aggregate is not very important in the recent inflation targeting regime, its role has been re-evaluated and is consideredto be a signal of financial imbalances, along withother monetary indicators, such as total credit or asset prices. Therefore, the European Central Bank, while maintain the inflation objective, should keep track of monetary aggregates, as well as the total credit of banking system and asset prices, including stock and housing prices to ensure the soundness of the financial system.
REFERENCES
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