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Inflation is a monetary phenomenon. When the rate at which the money supply grows is greater than the nominal potential rate of growth of an economy, in the medium term this will generate inflation. In other words, the medium-term inflation rate is indicative of excessive monetary expansion in relation to economic growth. Growth in the money supply therefore provides the best early warning of inflation and monetary control is the best monetary policy strategy. The virtues of the first component of the ECB monetary strategy are, when all is said and done, well known. If it worked, this alone would be sufficient.

In practice, however, things are never so simple. Inflation forecasting and control cannot rely solely on a monetary aggregate because of doubts as to whether or not this monetary aggregate can be controlled and is stable and meaningful. If a narrow definition of money, such as M1, is adopted, controllability can be achieved in that, through the monetary policy instrument, it is possible to have a greater impact on its evolution, but this is offset by the loss of stability and significance. If it is decided to opt for a broad monetary aggregate, such as M3 or M4, the money demand function becomes more stable and clearly more significant, in that a greater correlation can be achieved between exchange rates, providing a better explanation of changes in nominal costs and inflation, in return for some loss of control. Despite this, doubts persist. In practice, these will, of course, increase when national currencies are replaced with the euro; then the need for the second part of the monetary policy strategy will become obvious.

The ESCB monetary policy tool

The wide range of instruments available to the ESCB for the implementation of the euro area monetary policy has been established with reference to two fundamental criteria: efficiency and neutrality. These instruments can be separated into three categories, related to open market operations, standing facilities and minimum reserves.

The ESCB's instruments and procedures do not differ significantly from those traditionally used by the Banco de Espaсa and with which you are all familiar. This means that I only need to highlight a few differences.
In addition, I should add that over recent weeks the Banco de Espaсa has introduced changes aimed at facilitating a smooth transition.

With regard to open market operations, the frequency and maturity of the main re-financing operation has become that of a weekly auction of loans with a maturity of two weeks, and an interest rate which is either announced in advance (fixed rate auction) or announced later as the result of offers received (variable rate auction). There will also be monthly auctions for three-month loans which will always be of the variable rate type in order to avoid sending signals to the market. Fine-tuning will be carried out in exceptional circumstances between two regular auctions and, finally, the structural liquidity demand can be influenced by means of open market transactions which consist in the direct purchase and sale of securities or the issuance of debt certificates.

Standing credit and deposit facilities will supply or absorb overnight liquidity, without the imposition of any other restrictions on their use by institutions other than the provision of guarantees or collateral. Both types of interest on standing facilities constitute a strip or corridor which will contain short-term market interest rate swings and provide a structure for monetary policy trends. This means that they will play an important role in terms of providing signals, a role also fulfilled by the Banco de Espaсa but in a less predetermined and formalised manner.

As far as guarantees for all these transactions are concerned, it should be stated that acceptable collateral may take the form of either a public instrument or a private instrument, provided that these are of a suitable nature, according to the neutrality principle applied to the public sector and to the private sector.

The minimum reserves will be equal to 2% of book liabilities calculated on the basis of a monthly average, will be subject to a minimum exempt level of EUR 100,000 and - this being the most important point underlining the main difference compared with the current position in Spain
- will be remunerated in line with market rates. The averaging provision will allow us to absorb liquidity shocks without recourse to standing facilities. Such a minimum reserves will constitute a useful tool for restricting the volatile nature of monetary market interests rates, for reducing the need for fine-tuning and for tightening up the system's liquidity, thereby enhancing the effectiveness of the monetary policy. Its remuneration in line with the market will not only reduce money demand elasticity with regard to interest rates but also offer neutrality to euro area banks as compared with those in other countries which do not use such a tool.

Conclusion

Although inevitably in a simplified form, I hope that this statement on the aims, strategy and instruments of the euro area monetary policy has provided some basic information on the central core of the ECB's operations and that it can be used as a starting-point for our discussions.

Thank you for listening; during the discussion period, I shall be pleased to elaborate on the issues raised or examine any others which you think may be of interest.

The monetary policy of the Eurosystem

Main remarks of the speech delivered by Eugenio Domingo Solans

Member of the Governing Council and the Executive Board of the

European Central Bank at the SOCIETAT CATALANA D'ECONOMIA

(Institut d'Estudis Catalans)

Barcelona, 2 July 1999

The text will be available in Catalan at a later stage.

* The primary objective of the Eurosystem and, therefore, the touchstone to measure its success is the achievement of price stability. In the medium term the best contribution that the Eurosystem can make in favour of sustained growth is, precisely, to create an environment of stability.
There is clearly no greater fertiliser for economic growth than price stability, and nothing is more refractory to economic growth than inflation. Provided that stability is achieved and that there is no risk for stability in the future, the Eurosystem has to create the best monetary conditions for exploiting the considerable growth potential of the euro area. This should be done in a passive way, without any activism: like the air we breathe, not like the air from an oxygen tank.

* The 5.2% increase in the three-month moving average of the 12-month growth rates of M3 covering the period from March PROGRAM
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аto May 1999 is in line with the 4 Ѕ reference value for money growth, which is the basis of the first pillar of the ECB's monetary policy.
Neither the slight increase in the moving average compared to its value last month (5.1%) nor the non-substantial and almost constant difference from the reference value signal a risk for price stability.

* The results of the broadly based assessment of the outlook for price developments, which constitutes the second pillar of the ECB's strategy, confirm that there is no risk to price stability in the euro area.

* The second pillar of the ECB's monetary policy strategy includes, among other indicators, the exchange rate developments of the euro. The ECB's assessment on the evolution of the exchange rate of the euro should, therefore, be linked to the risk for price stability of a depreciation of the euro. Taking into account that the euro area economy is a rather closed one, no significant inflationary impact should be expected from the recent exchange rate developments of the euro.

* One main feature of the instruments and procedures of the Eurosystem's monetary policy is their high level of flexibility, in the sense that without discretionary changes the instruments can accommodate a wide range of different market situations. On the other hand, there is flexibility in the sense that the Eurosystem has at its disposal a wide set of monetary policy instruments and has, therefore, the possibility to move from one to the other if and when it is deemed appropriate, taking into account their advantages and disadvantages. In the first stage of the ECB's monetary policy, the fixed rate tender with a discretionary allotment is the best choice for the main refinancing operation owing to its advantages in terms of signalling effects and controlling both the liquidity allotted and the volatility of overnight rates. On the contrary, in the case of longer-term refinancing operations, the Eurosystem as a rule does not intend to send signals to the market and the effects on the liquidity and on the overnight rates are weaker. Therefore, for longer-term refinancing operations, the market-oriented variable rate tender has a clear advantage.

* The activities and the monetary policy decisions of the ECB should be interpreted from a euro area perspective as a whole. To interpret them from a national standpoint would be a mistake.

***

THE ROLE OF THE CENTRAL BANK IN THE UNITED EUROPE

Speech by Dr. Willem F. Duisenberg,

President of the European Central Bank,

National Bank of Poland,

Warsaw, Poland on 4 May 1999

1. Introduction

First and foremost, I should like to congratulate the National Bank of Poland (the NBP) on its 75th anniversary. The age of the NBP already suggests that as the President of the European Central Bank (ECB), an institution that is even less than one year old and has only been conducting monetary policy since January this year, I should be modest. I am aware that the role of the NBP has not been constant over these 75 years and that in the past decade, in particular, the NBP has gone through a remarkable restructuring process. My previous central bank, de
Nederlandsche Bank, has, together with the International Monetary Fund and many national central banks, been involved in assisting the NBP in its efforts to adapt to the role of a central bank in a market economy. Of course, the real work had to be done by you yourselves and I believe you can be proud of what has been achieved over the past decade.

Today in my speech I should like to focus on the role of the ECB, as a truly European institution. First of all, I shall explain the background against which the introduction of the euro and the establishment of the ECB should be considered. Thereafter, I shall discuss the main features of the institutional structure that determines monetary policy-making. I shall then turn to our monetary policy strategy and the role of accountability and transparency in this strategy. I shall conclude by briefly addressing the issue of EU enlargement.

2. The process of European integration

On 1 January of this year the euro was introduced in 11 countries with a combined population of almost 300 million. The ECB started to conduct a single monetary policy for the so-called euro area. Former national currencies, such as the French franc and the German Mark are no longer autonomous currencies, but subdivisions of the euro. Euro banknotes and coins will only be introduced in 2002.

The voluntary transfer of monetary sovereignty from the national to the European level is unique in history. However, it should not be seen as a single, isolated event. The introduction of the euro is part of the process of European integration. This process started shortly after the second World War and has now been under way for more than half a century.
The aims of European integration are not only, or even primarily, economic.
Indeed, this process has been driven and continues to be driven by the political conviction that an integrated Europe will be safer, more stable and more prosperous than a fragmented Europe. It is true that economic integration has been the main engine of this process and that, although it has had its ups and downs, integration has delivered important economic benefits. On balance it has been successful.

The introduction of the euro and the establishment of the ECB are important new steps in this process of European integration. They are not the completion of this process, for at least two reasons. First, the launch of the euro can be compared to the launch of a rocket. A good launch is crucial, but only the beginning of the mission. The euro has been launched successfully. The challenge now is to make it a success. This will not happen automatically, but will require effort on the part of many authorities, institutions and people. Second, four EU Member States have not (yet) introduced the euro. I hope that this will happen in the future.
Moreover, as you are aware, the EU itself is likely to increase its membership over time, also to include Poland. Ultimately, this is bound to extend the euro area. This process, too, is already requiring and will continue to require great efforts: no pain, no gain, as is often the case.

3. The institutional framework of the single monetary policy

Let me now turn to the institutional framework for the conduct of the single monetary policy. This was laid down in the Treaty establishing the
European Community, the so-called Maastricht Treaty, and the Statute of the
ESCB, which is an integral part of this Treaty. According to the Treaty the
ECB has the primary objective of maintaining price stability. Without prejudice to this objective, it is to support the general economic policies in the Community, with objectives such as economic growth and high employment.

Decisions on monetary policy are made by the Governing Council of the
ECB. This body comprises the six executive directors of the ECB and the 11 governors of the national central banks (NCBs) of the Member States which have introduced the euro. These 17 people meet every fortnight at the ECB, in Frankfurt am Main. Decision-making on monetary policy is fully centralised. All members of the Governing Council have one vote, whether they come from Germany or Luxembourg. This is because of an important principle. They are not representing their country, but are obliged to take decisions on the basis of euro area-wide considerations. Regional or national monetary policy does not and cannot exist in the euro area. There is only one, single monetary policy for the euro area as a whole.
Therefore, the ECB should develop into a truly European institution. This is a process that will inevitably take some time, but my feeling is that we are already making good progress.

The execution of monetary policy is to a great extent decentralised.
It is in large part carried out by the NCBs. The ECB and the 11 NCBs together are referred to as the Eurosystem. If we refer to the ECB and the
15 NCBs of all EU Member States, we speak of the European System of Central
Banks (ESCB). The General Council of the ECB meets quarterly and comprises the President and Vice-President of the ECB and the 15 governors of the
NCBs of all the EU Member States. This body does not make decisions on monetary policy, but discusses issues concerning the relationship between the "ins" and the countries I prefer to call "pre-ins", such as exchange rate issues. The third decision-making body of the ECB is the Executive
Board of the ECB, comprising the six executive directors of the ECB. The
Executive Board is responsible for current business and the implementation of monetary policy as decided by the Governing Council. The staff of the
ECB will, in the course of this year, reach a level of between 750 and 800 and is likely to grow further in the years ahead.

The ECB is one of the most, if not the most, independent central bank in the world. Its independence and that of the participating national central banks are firmly enshrined in the Maastricht Treaty. Members of the
Governing Council are not allowed to take or seek instructions from anybody, politicians included. Politicians are not allowed to give such instructions. Members of the Governing Council have a term of office of at least five years. The ECB is financially independent.

The independent status of the ECB fits into the recent world-wide trend of granting independence to central banks. This tendency is evidenced by both practical experience and academic research. By shielding monetary policy decisions from political interference, price stability can be maintained without having to give up economic growth. Indeed, in that sense having an independent central bank is a good thing for all concerned. The reason for central bank independence is that monetary policy-making under the influence of politicians tends to focus too much on short-term considerations. This can easily lead to temporary, non-sustainable increases in growth, but inevitably results in lasting increases in inflation with no lasting gains in growth and employment at all.
Politicians all over the world have come to realise this and have decided to remove the temptation to pursue short-term gains and to make their central bank independent. It should be underlined that granting this independence is, as it should be, a political decision. An independent central bank needs a clear legal mandate.

4. The monetary policy strategy

The ECB has, as I mentioned earlier, such a mandate. However, the
Treaty does not specify how the ECB should pursue its primary objective of maintaining price stability; in other words: it is silent on what is called the monetary policy strategy. The ECB therefore formulated its strategy in the second half of last year. That was no easy task. The introduction of the euro constitutes a structural break, which may change the behaviour of firms and individuals and make it less predictable. To a certain extent it is comparable to what Poland experienced when it embarked on its reform process. The rules of the game change and this makes policy-making more complicated. Our monetary policy strategy has taken these specific circumstances into account. It is tailored to this unique period of the introduction of the euro, although it has elements of both monetary targeting and inflation targeting.

In the context of this strategy the ECB has provided a quantitative definition of price stability. Price stability is defined as a year-on-year increase in the harmonised index of consumer prices (HICP) of below 2% for the euro area as a whole. Price stability is to be maintained in the medium term.

The strategy consists of two pillars. The first pillar is a prominent role for money. Ultimately, inflation is a monetary phenomenon. It is in the end result of too much money chasing too few goods. Therefore, we have formulated a reference value for the growth of a broad monetary aggregate,
M3, of 4 Ѕ% on an annual basis. Growth of the money stock at this pace would provide the economy with sufficient liquidity for growth in activity in line with trend growth, without inflation. At the end of this year this figure will be reviewed. It should be emphasised that we did not define a target for money growth. The reason for this is the structural break that the introduction of the euro creates. By calling this a reference value, it is made clear that money is one variable which we look at very carefully in order to examine whether inflationary or deflationary pressures are tending to emerge. We do not, however, react mechanistically to changes in money growth.

The formulation of the second pillar is also prompted by the potential changes in economic behaviour on account of the introduction of the euro. It is a broadly based assessment of the outlook for price developments on the basis of an analysis of monetary, financial and economic developments. In this context interest rates, the yield curve, wage developments, public finance, the output gap, surveys of economic sentiment and many other indicators are analysed. Use is also made of forecasts produced by other bodies and internally for inflation and other economic variables.

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