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In this context, I would once more like to underline how important it is that a consensus has emerged among European policy-makers on the virtues of price stability, fiscal discipline and market-oriented structural reform. In this way, we have already pushed the boundary significantly towards a macroeconomic environment conducive to growth and employment, although much still needs to be done in the years to come.

4. Pushing the boundaries in the development of financial markets

However, the success of the euro is not only in the hands of central bankers and policy-makers. An important area in which the private sector has an instrumental role in meeting the challenge of pushing the boundaries is in the development of the European financial markets. In order for the euro to be a success, it is important for the euro area financial markets to become wider, deeper and more diversified. The introduction of the euro has provided further input into this process; the elimination of exchange rate risks has removed one of the main barriers to financial market integration in Europe.

In most European countries, the financial markets have, traditionally, been rather shallow, with few participants and a narrow range of financial instruments on offer. A high degree of segmentation and a lack of cross-border competition have implied relatively low trading volumes, high transaction costs and a reluctance to implement innovative financial instruments. This segmentation has been a function of exchange rate borders, tradition, differing practices and, of course, national regulations and tax regimes.

Following the elimination of the barriers implied by different currencies, it is now up to the European Commission and the relevant national authorities to further the integration process in the areas of regulation and taxation. Meanwhile, it is up to market participants to take advantage of the business opportunities implied by the increased scope for market integration.

The introduction of the euro brought about an almost immediate integration of the national money markets into a euro area-wide money market. This was made possible thanks to the establishment of pan-European payment systems, such as the TARGET system set up by the Eurosystem, which enables banks to access liquidity throughout the euro area in real time.

The cross-border integration of bond markets in the euro area is progressing at a slower pace, as is also true of equities and derivatives markets. This notwithstanding, we are also experiencing important developments in these segments of the financial markets. These developments are partly due to the general trends towards globalisation and technological refinement and partly related to the introduction of the euro. As a result of the introduction of the euro, market participants increasingly perceive similar instruments traded in the different national markets to be close substitutes. This holds true, in particular, for bonds issued by the euro area governments, where the establishment of common benchmarks, the narrowing of yield spreads and increased market liquidity seem to indicate that a high degree of cross-border substitutability has already been achieved.

The fact that euro area financial instruments are increasingly considered to be close substitutes increases the competitive pressures on national markets to attract issuers and investors wishing to benefit from increased cross-border competition and lower transaction costs. In this context, we have recently experienced several initiatives aimed at creating capital markets across national borders, such as the plans to establish common trading platforms linking the European stock exchanges. Similar initiatives have also been taken to establish links between national securities settlement systems, which would facilitate the cross-border mobilisation of securities. In the longer run, such developments will make it possible for investors to manage their investment portfolios more efficiently.

The Eurosystem welcomes such initiatives aimed at improving the cross- border integration of financial markets in the euro area, and globally, since they may result in a wider range of financial instruments on offer, and at a lower cost, than is currently the case in the national markets.
This could lead to a virtuous circle in which the increased issuance of instruments denominated in euro will draw the attention of international investors to the euro area capital markets, in turn making the euro an increasingly attractive currency for private as well as public issuers.

In fact, the experience of the first few months of the life of the euro seems to indicate that such a positive development may already be under way. In the first quarter of 1999, bonds denominated in euro accounted for around 50% of the bonds issued internationally. This share is considerably higher than the traditional aggregate share for bonds denominated in the constituent currencies, which had been in the range of
20% to 30% in recent years. We have also seen a considerable increase in the average size of bond issues denominated in euro, as compared with those of bonds denominated in the former currencies, which may indicate that the trade in euro-denominated issues is likely to become increasingly liquid.

Despite the recent developments in the euro area capital markets, euro area companies are still mainly dependent on financing through the banking system. Hence, there is still plenty of scope for further development in the area of corporate financing. For example, the amount of private bonds traded in the euro area is still very low compared with the
United States. The market capitalisation of equities is considerably lower in most euro area countries as compared with the United States and the
United Kingdom. Likewise, the venture capital business in the euro area is still in its infancy compared with the relatively mature venture capital markets in the United States and the United Kingdom. Personally, I am convinced that the introduction of the euro will also be helpful to the development of these segments of the financial markets.

In this context, I should like to say a few words on how the introduction of the euro may underpin the reshaping of the European banking sector. The increased scope for securitisation will put pressure on the
European banking sector to move away from traditional retail banking activities in favour of more advanced financial services. The European banking industry is still segmented into relatively small national markets.
The introduction of the euro is likely to add momentum to cross-border integration in the European banking sector. Although a considerable consolidation of the European banking sector has taken place over the last decade, this consolidation has so far been almost exclusively based on mergers and acquisitions within national borders. It is only recently that we have also started to see such deals taking place across national borders.

I welcome this trend towards an expansion beyond national borders with open arms, since the establishment of truly pan-European - and global
- banking groups will be instrumental in efforts to enhance competition in the provision of financial services.

5. The Eurosystem and the equity markets

I should like to conclude my presentation today by briefly discussing about the euro area equity markets as seen from the perspective of the
Eurosystem. It is clear that the Eurosystem has no direct control or influence over the development of equity markets. However, the Eurosystem acknowledges the importance of well-functioning and efficient equity markets for the economy as a means of mobilising savings into productive investment. Hence, efficient equity markets with transparent price formation, high market liquidity and low transaction costs are of great value in the capital formation process.

The existence of efficient equity markets should also reduce the risk of the emergence of asset price bubbles, which is desirable from a monetary policy perspective. Prior to the emergence of asset price bubbles in some industrialised countries in the early 1990s, few central banks paid much attention to the development of prices of equities or other assets in their monetary policy formulation.

However, the effects of the bubble economies in the early 1990s, notably in Japan, the United Kingdom and Scandinavia, led to an intense debate among economists on how monetary policy could have responded better to the situation. Some research was carried out in order to establish price indexes that would incorporate asset prices and which could be used as target variables or indicators within the monetary policy framework.
However, no central bank is explicitly making use of such asset price- weighted indexes in monetary policy formulation. Nevertheless, this development in the early 1990s made most central banks aware of the fact that large swings in asset prices can have important effects the price formation in the economy through its implications on real economic developments and, in particular, financial market stability.

However, in practice it is not easy to let monetary policy actions respond to asset price developments. Central banks have only one tool for the implementation of monetary policy - the short-term interest rate. They can therefore not effectively try to achieve several objectives at the same time. It is also difficult to judge how developments in asset prices actually feed into consumer prices, thereby making it tricky to assess the need for the appropriate monetary policy response to their changes. This difficulty is exacerbated by the rather high volatility of certain asset prices, such as equities, which could result in frequent changes in policy interest rates if the central bank were to incorporate them mechanistically into its reaction function.

In this respect, the present situation in the United States, as well as in several European countries, is interesting: equity prices have risen rapidly for an extended period but consumer prices remain very subdued and there are, so far, no signs that there is going to be a spill-over from asset price developments into consumer price inflation.

Against the background of the rather unclear relationship between asset price developments and consumer price inflation, the development of equity prices does not have a prominent role in the formulation of the
Eurosystem's monetary policy. This notwithstanding, the Eurosystem closely monitors the prices of equities and other assets within its broadly based assessment of economic developments in the euro area, which forms the second pillar of its monetary policy strategy. The Eurosystem will therefore remain vigilant in order to detect any influence from asset prices, through their impact on real economic developments and financial market stability, on the formation of consumer prices.

***

THE MONETARY POLICY OF THE EUROPEAN CENTRAL BANK

Speech by Eugenio Domingo Solans

Member of the Executive Board of the European Central Bank during the "Working Breakfast" at the Permanent Seminar on 4 December 1998 in Madrid

Introduction

It was with immense pleasure that I accepted the invitation to take part in this event, organised by Euroforum. In view of the prestigious nature of Euroforum, the professional standing of its MESTER PROGRAM OF
MARKETING WEEK AT.DOCl[pic][?]- -#President, Eduardo Bueno, Professor at the Universidad Autуnoma de Madrid and consultant to the Banco de Espaсa
(there is a great deal of similarity between our respective professional histories) and, above all, the value I have attached to his friendship over the past thirty years, there was no question as to whether to agree to join you for this working breakfast.

I have been asked to keep my presentation brief in order to allow as much time as possible for discussion. Therefore I will try to put forward a few ideas on the monetary policy of the European Central Bank (ECB) which I can develop during subsequent discussions. During the discussion period please feel free to raise any questions on other aspects of the ECB's operations.

The three fundamental principles underlying the monetary policy

As in the case of any other central bank, the ECB's monetary policy is based on three fundamental principles: setting the objectives to be achieved, establishing the most appropriate strategy for accomplishing these objectives and, finally, selecting the best instruments for implementing its chosen strategy.

While the Governing Council of the ECB is responsible for formulating its monetary policy, both the Executive Board of the ECB and the national central banks are involved in its application and therefore this constitutes one of the tasks allotted to the European System of Central
Banks (ESCB) as a whole.

Objectives, strategies and instruments therefore form the three main elements which enable us to establish the precise point within the range of monetary policy possibilities which should constitute the ECB's policy: its precise altitude, longitude and depth.

The ECB's monetary policy objectives

We did not have to think long and hard to define the ECB's monetary policy objectives and, generally speaking, those of the ESCB. This had been done for us by the Treaty on European Union in which, under Article 105, it is stated that "the primary objective of the ESCB shall be to maintain price stability" which, on a more practical level, the ECB has defined as a year-on-year increase in the harmonised index of consumer prices (HICP) for the euro area of below 2%, which it seeks to maintain in the medium term.
"Without prejudice to the objective of price stability", continues the aforementioned Article 105 of the Treaty, "the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article
2".

If you refer to the aforementioned Article 2 of the so-called Treaty of Maastricht, you will find that sustainable and non-inflationary growth, together with a high level of employment and social protection, are among its aims.

The ECB, then, must prioritise those of its activities which promote the objective of stability and, without prejudice to this approach, it will contribute, indirectly and to the extent possible, to economic growth and increased employment.

Is this approach in any way contradictory? Absolutely not. The best contribution the ECB can make to promoting investment and thus to generating economic growth and increased employment is precisely by providing a framework for price stabilisation. The worst path that the ECB could follow would be to implement a lax economic policy which claimed to be directly creating jobs.

In fact, in the medium term price stability will encourage efficient investment, sustainable growth and employment. This is because stability prevents price distortions, that is to say any distortion of the mechanism which guides decision-makers in the markets, and thus favours an improved allocation of resources. When stability is achieved, prices are more transparent, which promotes competition and therefore efficiency.

Moreover, if economic agents have positive expectations with regard to stability, the risk premium element of long-term of interest rates will fall, promoting investment and lasting consumption. In this respect, it should be remembered that one of the clearest inflation forecast indicators is an increasingly steep maturity-related asset yield curve.

Finally, stability promotes growth and employment insofar as it allows resources to be channelled into productive activity. Inflation, on the other hand, merely encourages speculative investment with the aim of safeguarding funds against monetary deterioration.

As we saw earlier, the aims set out in Article 2 of the Maastricht
Treaty also include social safeguards. In this context, therefore, it can be said that inflation is the most unjust of all taxes, because it attacks personal income and assets while distorting certain public redistribution mechanisms such as, for instance, progressive taxation scales.

In other words, stability is not just important for economic efficiency but also for social justice, since it provides economic conditions which benefit the weakest and most vulnerable members of society.

An appropriate ECB monetary policy is a necessary condition but will not, in itself, enable us to achieve stability. National taxation policies geared to satisfying the objectives of the Stability and Growth Pact, together with several supply-side policies leaning towards liberalisation and flexibility, are also necessary to enable us to avoid the persistent need for measures to combat inflation.

We must avoid the temptation to reinterpret the Stability and Growth
Pact by introducing "golden rules" of dubious legality, based on the false theoretical foundations of the so-called "ultra-rationality hypothesis" which, in the past, claimed to justify increased taxation pressure and which now calls for increased public spending in terms of investment. Let's not beat about the bush: taxation policy has only one golden rule, which consists in maintaining a long-term budgetary balance on the economic horizon.

In connection with the ECB's objectives, it should also be noted that it is difficult or even impossible to meet two separate targets simultaneously using only a single monetary policy. This applies when dealing with the concept of fixing fluctuation bands for the rate of exchange between the euro and the US dollar. In this case, the exchange rate objective could conflict with the price stability concept and the ECB would then fail in its primary objective. We must not forget, with regard to this issue, that combining linked exchange rates, the free circulation of capital and monetary autonomy is not, to be quite blunt, sustainable. It is precisely this which is the raison d'кtre of the ECB as the single monetary authority in an economic area which has irrevocably fixed exchange rates (a single currency) and freely circulating capital (a single market).

To conclude this section, let me stress that it is essential for the
ECB to make it absolutely clear that its main objective is stability. If, as some would suggest (for instance in the Modigliani manifesto), the ECB were to directly target employment, this would adversely affect the credibility of its monetary policy and thus have an impact not only on inflation but also, paradoxically, on employment. The direct targeting of employment objectives by a central bank is counterproductive.

The ECB's monetary policy strategy

A strategy is a combination of criteria and procedures which allow decisions to be taken in order to achieve a monetary policy objective. This decision-making process can be based on inflation forecasts which depend on the behaviour of a relevant monetary variable or, more simply, on the
"pegging" of exchange rates to a stable currency. This last strategy is ideal for more open economies, encompassed by a specific monetary zone, such as, for instance, the Netherlands and Germany. However, this would not be suitable for a much larger but relatively closed economic space such as the euro area.

I believe that it is a mistake to try to exaggerate the polarity of the inflation strategy and the monetary strategy. These are quite clearly separate strategies but they are not in any way opposed, incompatible or irreconcilable. Certainly, some aspects of each of these strategies should be combined, resulting in another, completely separate and valid strategy.
This is what the ECB has done and it now needs to give the end product a name which does not merely describe the desired objective ("the stability- orientated monetary policy strategy").

There are two components to the ECB's monetary policy strategy. The first, more practical and visible component consists in a quantitative reference to the growth of the money supply as defined by the broad M3 aggregate. Taking into account the quantitative definition of stability, economic growth and realistic hypotheses on money circulation rates, this monetary reference has initially been set at 4 1/2%.

The second component of the ECB's monetary strategy, a more general and enveloping one, is the estimation of inflation forecasts and risks for price stability in view of changes in a group of significant variables, all of which are related to the euro area as a whole. Some examples of these significant variables are credit, long-term interest rates, prices of raw materials, import prices, wages and public spending deficits.

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