ECB Monetary Policy

[HenryTo]

A very interesting October 10, 2005 speech by Mr. Lorenzo Bini Smaghi, Member of the Executive Board at the European Central Bank. This basically outlines the beliefs of the ECB - as well as what they believe is the best way to promote growth in the face of an oil shock similar to the one we're having now. This is a must-read, IMHO:

http://www.ecb.int/press/key/date/2005/html/sp051010_1.en.html

Going through the speech, it is obvious that the next move in rates will be up, not down. Readers should continue to watch energy and metal prices here and look for any signs of pricing power or strong demand for higher wages. A few notable quotes:

The first conclusion that I would draw to your attention is that if monetary policy aims primarily at stabilizing income in the face of a permanent supply shock, it will produce the opposite result, i.e. unstable output and inflation.

To sum up, any output loss produced by an oil shock is minimised if the central bank focuses primarily on price stability rather than trying to stabilize income and employment and if economic agents fully believe that the central bank will behave accordingly. In other words, monetary policy can better support growth if the primary target is price stability and if the central bank is credible in pursuing its commitment.

And finally, hidden in footnote number 2: See in particular Leduc and Sill (2004), who evaluate the performance of different policy rules following a rise in oil prices in a calibrated stochastic dynamic general equilibrium model of the US economy. Leduc and Sill find that interest rate rules that place a high weight on inflation lead to a smaller loss in output, a lower inflation rate, and a lower nominal interest rate than rules placing a larger weight on output stabilization. Indeed, the authors also find that the recessionary consequences of oil price shocks are smallest when the central bank targets the price level.