The two pillars of the ECB’s monetary

policy strategy
The maintenance of price stability in the euro area is the primary objective of the ECB’s monetary
policy. Given the time-lags in the transmission of monetary policy impulses to the price level, the ECB
must be forward-looking. Therefore, the ECB must regularly assess the nature and magnitude of
economic shocks and the resulting risks to future price stability. In this respect, the ECB’s strategy
foresees, first, a prominent role for money (signalled by the announcement of a reference value for
monetary growth) and, second, an analysis of a wide range of other economic and financial indicators
in order to form a broadly based assessment of the risks to price stability. These two elements have
been called the two pillars of the ECB’s monetary policy strategy. Taken together, the two pillars form
a framework which is used to organise the analysis and the presentation of the information relevant
for monetary policy-making in order to maintain price stability.

The two-pillar presentation differs in some respects from the strategies pursued by other central
banks. It is, therefore, not surprising that the announcement and explanation of the ECB’s monetary
policy strategy (see the article entitled “The monetary policy strategy of the Eurosystem” in the
January 1999 issue of the ECB Monthly Bulletin) not only triggered an extensive debate, but was also
followed by occasional misunderstandings of the ECB’s policy framework. In the light of this discussion
and of experience gained with the strategy in practice, this article describes and reviews the two
pillars and the main arguments for the adoption of a two-pillar framework for the ECB’s strategy.

In the presence of considerable uncertainties surrounding the structure of the economy and the
transmission mechanism of monetary policy within this structure, when formulating monetary policy
central banks should not rely on any single indicator, single model or simple policy rule to take policy
decisions. Rather, a diversified approach to the analysis of the information underlying monetary policy
decisions is desirable. In accordance with standard economic thinking, the ECB’s strategy organises
the main approaches to assessing risks to price stability into two groups – on the one hand,
approaches which assign a central role to money and, on the other, a variety of other models of the
inflation process, predominantly those which focus on the interplay between supply and demand and
on cost pressures in the goods and labour markets. The diversified approach prompted by the two
pillars of the ECB’s strategy is consistent with an awareness of the uncertainties faced by the central
bank and stimulates cross-checking between analyses focusing on monetary developments and those
concentrating mainly on non-monetary indicators, thereby helping to ensure the robustness of
monetary policy decisions.

1 Introduction
In October 1998 the Governing Council of Moreover, the Governing Council announced
the ECB announced its monetary policy that its strategy would use two forms of
strategy (see Box 1). Most importantly, the analysis to support the assessment of risks to
ECB provided a quantitative definition of the price stability.
primary objective of monetary policy in the
euro area, namely price stability. Price First, in recognition of the fundamentally
stability was defined as an annual increase in monetary origins of inflation over the medium
the Harmonised Index of Consumer Prices term, the ECB assigned a prominent role to
(HICP) for the euro area of below 2%. It was money in the formulation of a monetary
emphasised that price stability is to be policy aimed at achieving its primary
maintained over the medium term. The ECB objective. This prominent role – the so-called
affirmed that, in line with its Treaty mandate, first pillar of the strategy – was signalled by
monetary policy decisions would focus on the announcement of a quantitative reference
this overriding objective. value for monetary growth. The first pillar
consists of a detailed analysis of potential

ECB Monthly Bulletin • November 2000 37

 Box I
The ECB’s monetary policy strategy
ECB press release entitled “A stability-oriented monetary policy strategy for the ESCB”, 13 October 1998.

“At its meeting on 13 October 1998 the Governing Council of the ECB agreed on the main elements of the
stability-oriented monetary policy strategy of the ESCB. These elements concern: the quantitative definition
of the primary objective of the single monetary policy, price stability; a prominent role for money with a
reference value for the growth of a monetary aggregate; and a broadly based assessment of the outlook for
future price developments.

As mandated by the Treaty establishing the European Community, the maintenance of price stability will be
the primary objective of the ESCB. Therefore, the ESCB’s monetary policy strategy will focus strictly on this
objective. In this context, the Governing Council of the ECB has adopted the following definition: ‘Price
stability shall be defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for
the euro area of below 2%’. Price stability is to be maintained over the medium term. (…)

Three features of this definition should be highlighted. (1) The HICP is the most appropriate price measure for
the ESCB’s definition of price stability. It is the only price index that will be sufficiently harmonised across
the euro area at the start of Stage Three. (2) By focusing on the HICP ‘for the euro area’, the Governing
Council of the ECB makes it clear that it will base its decisions on monetary, economic and financial
developments in the euro area as a whole. The single monetary policy will adopt a euro area-wide perspective;
it will not react to specific regional or national developments. (3) An ‘increase (...) of below 2%’ is very much
in line with most current definitions adopted by national central banks in the euro area.

Furthermore, the statement that ‘price stability is to be maintained over the medium term’ reflects the need for
monetary policy to have a forward-looking, medium-term orientation. It also acknowledges the existence of
short-term volatility in prices which cannot be controlled by monetary policy.

In order to maintain price stability, the Governing Council of the ECB agreed to adopt a monetary policy
strategy which will consist of two key elements. (1) Money will be assigned a prominent role. This role will be
signalled by the announcement of a quantitative reference value for the growth of a broad monetary aggregate.
(…) (2) In parallel with the analysis of monetary growth in relation to the reference value, a broadly based
assessment of the outlook for price developments and the risks to price stability in the euro area will play a
major role in the ESCB’s strategy. This assessment will be made using a wide range of economic and financial
variables as indicators for future price developments.

This strategy underlines the strong commitment of the Governing Council of the ECB to its primary objective
and should facilitate the achievement of this overriding goal. It will also ensure the transparency of the
ESCB’s decision-making and its accountability. Based on its strategy, the Governing Council of the ECB will
inform the public regularly and in detail about its assessment of the monetary, economic and financial
situation in the euro area and the reasoning behind its specific policy decisions.”

deviations of monetary growth from Second, recognising the important

the reference value, supported and information relevant for monetary policy
complemented by an examination of the decisions contained in other indicators, the
information content of monetary aggregates ECB announced that, in addition to a
and their components and counterparts (in thorough analysis of monetary developments,
particular, credit) for future price a broadly based assessment of a wide
developments. range of other indicator variables (including

38 ECB Monthly Bulletin • November 2000

macroeconomic projections and forecasts) decisions. This broadly based assessment has
would also be carried out and would been labelled the second pillar.
constitute a further basis for monetary policy

2 A description of the two pillars and their role in the strategy

The two pillars of the ECB’s strategy are implying multiple targets for monetary policy,
embedded in a broader strategic framework, with the two pillars representing competing
which is described schematically in the chart and potentially conflicting objectives. This
below. As is illustrated in the chart, the role interpretation fails to recognise that the
of the two pillars is to provide a framework maintenance of price stability in the euro
for organising, analysing and cross-checking area is the only “target” (more formally, it is
the large amount of economic information the “primary objective”) of the ECB’s
available to policy-makers in a manner that monetary policy strategy. Both pillars of
helps the Governing Council to take policy the strategy should be understood as
decisions which serve the maintenance of instrumental in conducting the analysis
price stability in accordance with the ECB’s needed to guide monetary policy decisions in
published definition. order to achieve this ultimate objective,
rather than as distinct targets in themselves.
The ECB’s strategy is sometimes Therefore, it has been clearly stated from
misunderstood by external observers as the outset that the first pillar is not a

Chart
Schematic presentation of the ECB’s monetary policy strategy

Primary objective of price stability

Governing Council
systematically combines all
information in order to take
monetary policy decisions

Analysis
First assigning a prominent cross- Analysis focused on a Second
pillar role to money checking wide range of other pillar
(signalled by the reference economic and financial
value for M3 growth) indicators

Economic information

ECB Monthly Bulletin • November 2000 39

 “monetary target” and the second pillar is The first pillar
not an “inflation target”. Taken together, the
two pillars of the strategy form a framework Taking the experience of other central banks
which organises the analysis and the into account, the ECB chose to assign a
presentation of the information relevant for prominent role to money as the first pillar
monetary policy-making, in order to guide of its monetary policy strategy, in reflection
decisions which aim to maintain price stability. of the fundamentally monetary origins of
inflation over the medium to longer term.
The distinction between the two pillars of One of the most remarkable empirical
the strategy is mainly a distinction between regularities in macroeconomics is the
economic models or approaches to the ubiquitous long-run relationship between the
analysis of the inflation process. The first price level and the money stock. The
pillar can be seen as representing approaches monetary origins of inflation are the subject
which assign a prominent role to money in of widespread consensus in the economics
explaining the future evolution of price profession.
developments. The second pillar comprises
analyses of a broad range of factors and Unlike other countries where monetary
captures models of inflation which focus developments have been rather erratic during
mainly on real economic variables, such as recent decades, available evidence for the
the interplay of supply and demand in the euro area continues to point to the existence
goods and labour markets. Against this of a stable relationship between broad
background, in practice, the strategy implies monetary aggregates – in particular, M3 –
focusing on monetary indicators under the and price developments at horizons relevant
first pillar, while concentrating on conjunctural to monetary policy-making. Moreover, M3
and mainly non-monetary indicators under and other monetary and credit aggregates
the second pillar. appear to possess good leading indicator
properties for future price developments,
However, as is also indicated in the chart, especially in the medium term. On the basis
the strategy does not imply a partition of the of these results, the analysis under the first
information used for the analysis under the pillar offers particularly useful guidance over
two pillars. For example, since the demand a medium-term horizon.
for money depends on price developments,
real GDP and interest rates, the analysis of Furthermore, compared with alternative
monetary developments must always take indicators of future price developments,
place in the context of developments in these money has a number of desirable features.
non-monetary variables. Similarly, the analysis Monetary data are measured relatively more
of some monetary variables, e.g. sectoral accurately than many other economic
credit developments, can be of assistance in indicators and are typically available in a more
the assessment of real consumption and timely fashion.
investment demand. Thus, analysis under both
pillars aims at examining the available The prominent role of money has been
information in the best possible manner. The signalled by the announcement of a reference
difference in emphasis placed on specific value for the broad monetary aggregate M3
variables reflects their role in the framework (see Box 2). The announcement of the
for the analysis or economic interpretation reference value represents a visible public
underlying each pillar and is, therefore, one commitment on the part of the Governing
of degree. Council to analyse and explain monetary
developments and their implications for
the risks to price stability in detail. This
explanation appears regularly in the
President’s introductory statement at the

40 ECB Monthly Bulletin • November 2000

ECB’s monthly press conference and in the liquidity conditions in the economy and their
editorial and commentary of the ECB Monthly consequences with regard to the risks to
Bulletin. price stability.

However, as noted above, the reference value This broader analysis of monetary and credit
for M3 is not an intermediate monetary developments is particularly important when
target. The ECB does not attempt to control evaluating the magnitude of monetary
monetary growth so as to reach the reference impulses in the economy and assessing their
value at a specific point in time. Rather, the potential impact on future economic
reference value acts as an analytical and developments. In addition, such analysis may
presentational tool which constitutes an help to assess the possible existence and the
important benchmark for assessing risks to potential effects of bubbles in financial
price stability. markets. Historically, booms and busts in
asset markets have been closely associated
Moreover, analysis under the first pillar goes with large movements in monetary and,
beyond the evaluation of deviations of M3 especially, credit aggregates, and their
growth from the reference value. The first implications for the economy may depend on
pillar involves an analysis of the components the strength of the balance sheet position of
and counterparts of M3, in particular credit, the financial sector. This is another reason
and other key aspects of the balance sheet for the ECB to give a special status within its
position of financial intermediaries. Such strategy to the analysis of monetary and
analysis helps to provide both a better insight credit aggregates and financial intermediaries’
into the behaviour of M3 in relation to the balance sheets.
reference value and a broad picture of the

Box 2
The reference value for monetary growth
In December 1998 the Governing Council of the ECB announced the first reference value for monetary
growth, namely an annual growth rate of 4½% for the broad monetary aggregate M3. This reference value was
confirmed in December 1999. It was also announced then that the reference value would henceforth be
reviewed on an annual basis.

The reference value is an analytical and presentational tool which facilitates the formulation and explanation
of monetary policy decisions aimed at the maintenance of price stability. To this end, the concept of a
reference value has two key features. First, the reference value must be consistent with – and serve the
achievement and maintenance of – price stability. This means that the monetary aggregate used to define the
reference value should exhibit a stable relationship with the price level over the medium term. Second,
substantial or prolonged deviations of monetary growth from the reference value would, under normal
circumstances, signal risks to price stability. This means that the monetary aggregate used to define the
reference value should possess leading indicator properties for future inflation.

The derivation of the reference value was based on the standard relationship between money, prices, real
activity and the velocity of circulation. Using the Eurosystem’s definition of price stability (annual increases
in the HICP for the euro area of below 2%) and assumptions for trend real GDP growth (2% to 2½% per
annum) and the development of M3 income velocity (a trend decline of between ½% and 1% per annum), a
reference value of 4½% was derived. By using the Eurosystem’s definition of price stability and assumptions
for trend real GDP and velocity, the derivation of the reference value emphasises the medium-term orientation
of monetary policy. The next review of the reference value will take place in December 2000.

ECB Monthly Bulletin • November 2000 41

 The second pillar gradual and quite persistent impact on
consumer prices.
As noted, inflation is ultimately a monetary
phenomenon. This notwithstanding, monetary In line with standard models of the business
developments cannot be the only guide cycle, this analysis is often centred on the effects
for assessing risks to price stability. In order of the interplay between supply and demand
to be able to take appropriate decisions, and/or cost pressures on pricing behaviour
the Governing Council needs to have in the goods, services and labour markets. In
a comprehensive understanding of the this respect, developments in overall output,
prevailing economic situation and be aware demand and labour market conditions, in a
of the specific nature and magnitude of the broad range of price and cost indicators as well
economic disturbances which threaten price as in the exchange rate and the balance of
stability. For example, in order to assess risks payments for the euro area are regularly
to price stability it is important to know reviewed by the ECB (see also the articles
whether shocks originate on the supply or entitled “The role of short-term economic
the demand side, have an external or indicators in the analysis of price developments
domestic origin or are temporary or in the euro area” in the April 1999 issue of the
permanent. This information is not revealed ECB Monthly Bulletin and “Price and cost
in the analysis conducted under the first pillar indicators for the euro area: An overview” in
alone. Therefore, in parallel with the analysis the August 2000 issue of the ECB Monthly
of monetary developments, the ECB also Bulletin).
evaluates a wide range of other economic
and financial indicators within its broadly Moreover, developments in financial market
based assessment of the risks to price stability indicators and asset prices are also closely
in the euro area. monitored. Movements in asset prices may affect
price developments via income and wealth
The analysis conducted under the second effects. Furthermore, asset prices and financial
pillar focuses on revealing the influence of a yields can be used to derive information on the
host of factors, some of which influence price expectations of financial markets, including
developments in the shorter term. Such information on expected future price
short-term developments are nevertheless developments (see the article entitled “The
relevant for monetary policy since their information content of interest rates and their
effects may become entrenched and may, derivatives for monetary policy” published in
therefore, jeopardise prospects for price the May 2000 issue of the ECB Monthly Bulletin).
stability in the medium run. Other indicators
considered under the second pillar can also Under the second pillar, macroeconomic
signal threats to price stability in the medium projections based on conventional models
term in a more direct manner. For example, and economic experts’ knowledge produced
growing shortages in the labour market tend both inside and outside the Eurosystem also
to result in upward pressure on labour costs play an important role as a tool for
which may in turn, with a time-lag, have a summarising existing information (see Box 3).

42 ECB Monthly Bulletin • November 2000

Box 3
The role of macroeconomic forecasts and projections under the second pillar

By contrast with the forecasts produced by international organisations and other institutions, the Eurosystem
itself does not produce “forecasts” in the sense of best predictions of future developments. Rather, it produces
a “projection” for future developments based on the assumption of unchanged interest rates (and exchange
rates). In order to understand the role of the Eurosystem’s projections in the ECB’s strategy, this distinction
must be borne in mind.

Since macroeconomic projections produced within the Eurosystem and the forecasts of other institutions are
typically produced on the basis of models of the inflation process which do not accord a prominent role to
money, they form part of the second pillar of the ECB’s strategy. Given that the range of relevant indicators
under the second pillar is potentially very broad, there is a need to structure and summarise this information so
as to facilitate the analysis of risks to price stability. Forecasts and projections offer a convenient analytical
tool for organising a large amount of information and help to create a consistent picture of possible future
developments.

Within the Eurosystem two macroeconomic projection exercises for the euro area are performed every year
which bring together experts from both the ECB and the national central banks (NCBs). These are not the only
projections produced within the Eurosystem, but they are the projections which involve the greatest interaction
between ECB and NCB staff experts.

The Eurosystem’s main macroeconomic projections aim to deliver a coherent and consistent assessment of the
outlook for short and medium-term economic prospects in the euro area. The projections are constructed by
combining econometric model-based projections with non-model-based judgemental assessments. A number
of different econometric models are used by both ECB and NCB staff experts in the projection exercises,
including a variety of national and euro area-wide structural macroeconometric models. These tools have the
advantage of being able to provide a detailed global structure. Based on this structure, the final projections
seek to be coherent both with past experience and with economic theory, as well as being consistent with the
national accounts identities. Judgemental assessments based upon recent conjunctural information and leading
indicators constitute another key input into the Eurosystem projections. Such assessments are produced by
sectoral and national experts who have a thorough knowledge of both recent economic developments and the
institutional context.

Despite the considerable care taken in producing the projections, it is important to realise that it is not possible
to incorporate the entire analysis conducted under the second pillar into these projections. This is because
macroeconomic forecasts and projections are inevitably subject to a number of conceptual and practical
limitations which need to be taken into account when assessing their information content. First, projections
and forecasts can vary significantly, depending on the underlying conceptual framework or the set of
techniques employed. For this reason, it is not appropriate to rely solely on any single projection. Any forecast
or projection needs to be cross-checked with information derived on the basis of other techniques and/or
market expectations of future developments. Second, forecasts and projections are always based on assumptions
for the path of some exogenous variables which may be volatile and the future path of which is difficult to
predict. Such variables include, for example, exchange rates and commodity price developments. The forecast
or projection for future inflation may depend significantly on the assumptions chosen for such variables. In
addition, as discussed in the opening paragraph of this box, forecasts and projections need to be made
conditional on an assumed path for monetary policy. Within central banks, such assumptions are typically
represented as unchanged short-term interest rates in order to allow the projection to be meaningful when
assessing the risks to price stability which might arise from current (and unchanged) monetary policy interest
rates. In practice, these monetary policy assumptions may often lead to problems of internal consistency, since

ECB Monthly Bulletin • November 2000 43

 the expectations and decisions of forward-looking investors, firms and consumers may incorporate different
expectations of future monetary policy actions. Third, the production of detailed forecasts or projections is
inevitably time-consuming. This implies that forecasts and projections are only produced periodically and,
therefore, may not always include all the latest information. Fourth, by their very nature, econometric models
provide only a summary description of the economy, consisting of the main relationships governing economic
developments and thus do not include all relevant information. Finally, whichever techniques are used,
forecasts and projections always need to be adjusted on the basis of informed judgement and practical
experience. However, the impact of judgemental adjustments may not be easy to make explicit. Consequently,
such judgemental adjustments can complicate the interpretation of the results. This means that a discussion of
the developments in indicators underlying the forecasts or projections needs to be made transparent.

For all these reasons, the analysis under the second pillar of the strategy is not limited to the Eurosystem’s own
macroeconomic projections. The second pillar encompasses a broader set of analyses, which range from the
monitoring of timely indicators and more sectoral and structural analyses to the use of small-scale econometric
models embodying a different view, estimated with different methodologies or focused on revealing information
at specific horizons. Furthermore, these projections are always cross-checked against forecasts produced
elsewhere and against forward-looking information derived from financial market prices. Such analyses allow
timely information, which is not easily fed into formal forecasting and projection exercises, to be used in the
policy discussion, reveal the information in individual indicators and sectors on threats to price stability and
help to provide an insight into how developments in specific variables influence the overall inflation outlook.

It should be emphasised that the macroeconomic projections of the Eurosystem are based on the staff’s
technical expertise. These macroeconomic projections do not embody the view or judgement of the Governing
Council of the ECB. The Governing Council itself has to make an overall assessment of the economic
situation and of the risks to price stability using all the information available, including, in particular, the
information derived from the analysis under the first pillar of the strategy, but also information other than the
Eurosystem’s projection under the second pillar. Any publication of macroeconomic projections by the ECB
would have to reflect the (limited) role that forecasts play in the monetary policy decision-making process.

3 Rationales for the two pillar approach

The need for robustness in a world of leads to policy decisions which take the
uncertainty prevailing uncertainty into account in an
appropriate manner.
Central banks operate in an environment of
considerable uncertainty. This uncertainty takes Given the considerable uncertainties faced
on many forms. One form of uncertainty is by monetary policy – exacerbated in the case
related to the partial predictability of economic of the ECB by the potential for behavioural
outcomes. This becomes manifest in the form and institutional changes associated with the
of so-called shocks to individual variables introduction of the euro – monetary policy
which cannot be predicted in advance. Other, would be unwise to rely on one specific
arguably more profound, forms of uncertainty model, indicator or forecast to the exclusion
include the inevitably imperfect measurement, of alternatives. Furthermore, the possibility
interpretation and understanding of the available of imperfections in the data and the
information, of economic behaviour and, in uncertainty associated with the reliability of
particular, of the way in which the economy the economic information available to central
functions. A monetary policy strategy will be banks also call for a continuous cross-
successful in such an environment only if it checking of information and analyses. By

44 ECB Monthly Bulletin • November 2000

implication, it would be unwise for central chosen to organise its analysis under two
banks mechanistically to use simple “policy pillars. In this respect, the ECB took account
rules” which link interest rate changes to of the fact that it has proven extremely
developments in a small number of indicators difficult to integrate an active role for money
and/or forecasts. On the contrary, central into conventional real economy models, such
banks should cross-check and compare the as those normally used in macroeconomic
signals given by different indicators and forecasting exercises, despite the general
evaluate the available information and the consensus that inflation is ultimately a
consequences of their actions in the light of a monetary phenomenon. Therefore, the first
range of plausible models of the economy. pillar can be seen as representing a group of
In this context, a policy that performs models which embody a view of price level
reasonably well under many plausible models determination that accords an important role
and in a range of possible circumstances is to money. The second pillar encompasses a
often the best choice over the medium term. range of alternative models of the inflation
process, predominantly those which
The ECB’s strategy embodies a “full emphasise the interplay between supply and
information” approach in a broad sense, demand and/or cost pressures.
i.e. it is a framework that not only
encompasses all relevant information, but also Of course, neither pillar in itself represents a
takes into account various, possibly different single monolithic approach. Within both
interpretations of this information. Against pillars – and especially under the second – a
this background, the strategy adopted by the variety of models and specifications exist.
ECB represents a framework that reduces Moreover, these sets of models are
the risks of policy errors caused by over- undergoing continuous evolution as new
reliance on a single indicator or model. Since empirical and analytical tools are developed.
it adopts a diversified approach to the
interpretation of economic conditions, the Quite naturally, occasions may arise when
ECB’s strategy may be regarded as facilitating the indications emerging from the two
the adoption of a robust monetary policy in pillars give conflicting signals for monetary
an uncertain environment. policy-making. This potential tension should
not be seen as a limitation of the strategy.
On the contrary, it actually constitutes the
Competing paradigms of the inflation essence of a robust strategy, in the sense
process explained above. It is only by revealing and
confronting such tension between the
A reflection of the uncertainties about, and information revealed under the two pillars
the imperfect understanding of, the economy that a robust monetary policy response can
is the large range of models of the inflation be formulated. In general, the need to
process proposed in economics literature, reconcile the potentially conflicting signals
which incorporates a multiplicity of views on represents, in itself, an important source of
the structure of monetary economies and insight and an additional stimulus for achieving
the transmission mechanism of monetary a deeper understanding of the economic
policy within them. Many of these models situation.
capture important elements of reality, but
none of them appear to be able to describe
reality in its entirety. Therefore, any single Problems involved when relying entirely
model is necessarily incomplete. on either the first or the second pillar

As the set of plausible models is very broad, There are two main arguments against relying
any policy analysis needs to be organised solely on the first pillar for the analysis
within a simplifying framework. The ECB has underlying monetary policy decisions. First,

ECB Monthly Bulletin • November 2000 45

 owing to the volatility in the velocity of pillar projections and forecasts in the context
circulation of money, it may, on occasion, be of a medium-term oriented monetary policy.
difficult to interpret monetary developments
in the shorter term and extract the signals In addition, the fundamentally monetary
which they contain regarding risks to price nature of inflation – as shown in many studies
stability. Distortions to the information – implies that relying entirely on the second
content of M3 (and its components and pillar is misguided. Furthermore, risks to
counterparts) may be caused by special medium-term price stability identified by
factors, such as changes in the taxation of analysis under the second pillar may be
interest income on deposits, regulatory deemed to be of limited importance for
changes, etc. Financial innovation, in particular monetary policy decisions if – at the same
if not anticipated, can also cause difficulty in time – analysis under the first pillar indicates
understanding the indicator properties of that these inflationary pressures will not be
money for future price developments. accommodated by more rapid monetary
growth. One purpose of the first pillar is to
Second, relying solely on the first pillar entails ensure and signal a commitment to the
the danger that insufficient attention is paid thorough analysis of monetary developments.
to risks to medium-term price stability that
arise from developments in variables other
than money. For example, excessive increases Problems of combining the two pillars in a
in nominal wages or other costs may become single analytical approach in a transparent
entrenched and self-perpetuating, and may, manner
therefore, have implications for medium-term
developments in the price level. Such threats While the above discussion has made it clear
to price stability are not necessarily signalled that analysis should always be conducted
immediately by the monetary data. Although under both pillars, it should also be apparent
sustained inflation is ultimately associated that it is not practically feasible to combine
with more rapid monetary growth, threats to these two forms of analysis in a transparent
price stability of this kind can be identified manner in a single analytical approach. In
more promptly by conducting an analysis of practice, monetary policy-making is too
wage and cost data and undertaking a complex and the environment in which
thorough assessment of developments in central banks operate too uncertain to rely
labour and other markets. on a single model or approach.

At the same time, relying solely on the second Although the internal procedures of central
pillar would be equally ill-advised. Insofar as banks pursuing a stability-oriented policy may
the second pillar focuses on indicators of not, therefore, differ fundamentally in this
shorter-term price dynamics, the danger respect, differences between central bank
exists of a short-term bias being imparted to strategies arise in the presentation of the
monetary policy, which would conflict with analysis underlying monetary policy decisions
the medium-term orientation. to the public. In this context, some trade-off
between simplicity and openness may exist.
The fact that the second pillar also includes Adopting a simple form of presentation may,
projections and forecasts with a horizon of at first sight, help to make the description of
longer than one year does not change this monetary policy easier to comprehend, but it
interpretation. Conventional macroeconomic will not honestly convey the complexity of
projections and forecasts are always the analysis which central banks have to
surrounded by considerable uncertainty and conduct.
this uncertainty becomes greater the longer
the horizon of the forecast. This creates The ECB’s two-pillar approach represents a
difficulties in relying solely on such second balance between the requirements of clarity

46 ECB Monthly Bulletin • November 2000

and simplicity, on the one hand, and openness The two-pillar framework within which
and honesty, on the other. The two-pillar policy decisions are presented to the
structure recognises the need for central public corresponds closely to the framework
banks to organise the presentation of a wide used to organise the analysis underlying
range of information and an array of models monetary policy decisions within the ECB.
and analytical tools in a clear manner within a If one defines transparency as the extent
consistent framework. At the same time, the to which explanations of policy decisions
two pillars of the ECB’s strategy represent presented to the public correspond to the
the diverse modes of analysis conducted actual internal procedures on which these
within the ECB and the need to cross-check decisions are based, then the ECB’s approach
the results of these analyses in order to make to the presentation of monetary policy can
an overall assessment upon which monetary only be rated as one of the most transparent
policy decisions aimed at price stability are in the world.
based.

4 Concluding remarks
The maintenance of price stability in the In this context, relying on any single indicator
euro area is the primary objective of the or on a single framework of analysis would
single monetary policy. All aspects of the entail too high a risk. A well-designed
ECB’s monetary policy strategy serve the monetary policy must be capable of
achievement of this primary objective. maintaining price stability across a range of
plausible interpretations of the economy. By
The centre of the ECB’s strategy is the diversifying across different indicators and
announcement of a quantitative definition of analytical frameworks rather than relying on
its primary objective, price stability. By virtue a single, inevitably incomplete approach, the
of this announcement, the ECB provides a risk of policy errors is reduced.
clear yardstick against which the public can
judge the performance of monetary policy. The strategy adopted by the ECB constitutes
The two pillars are instruments which a framework which provides for such a
facilitate the achievement of this primary diversified approach. The prominent role
objective – they do not represent assigned to money in the ECB’s strategy
independent policy objectives which have a (the first pillar) ensures that monetary
value in their own right. The two pillars developments are thoroughly analysed, taking
constitute a framework within which to into account the ultimately monetary nature
organise and structure the diverse and of inflation. At the same time, the second
extensive analyses underlying monetary policy pillar of the strategy ensures that other forms
decisions. of analysis, such as investigations of the
interplay between supply and demand or cost
Given the time-lags in the transmission pressures, are also incorporated into the
process of monetary policy, central banks policy process. In this way, shorter-term
need to be forward-looking and have a developments and risks to price stability are
medium-term orientation. At the same time, also taken into account, given the fact that
the ECB faces considerable uncertainties with such short-term price dynamics may spill over
regard to, inter alia, the reliability of available to medium-term price developments. The
economic indicators, the structure of the two-pillar structure of the strategy helps
euro area economy and the transmission to ensure that information and analyses
mechanism of the single monetary policy. produced on the basis of one methodological
Monetary policy decisions must take these perspective are always cross-checked against
uncertainties into account. information and analyses produced on the

ECB Monthly Bulletin • November 2000 47

 basis of the other perspective. This discipline issues on an ongoing basis has, together with
is imposed not only on the internal analysis, the clear overriding focus on the primary
but also on external communication, objective, imposed a strict discipline on
highlighting the transparency of the ECB’s the ECB’s decisions, while eschewing any
approach. mechanistic application of simplistic, textbook
policy rules.
The experience of using the ECB’s monetary
policy strategy since January 1999 has In its public presentation, the ECB’s strategy
illustrated how these elements have appears to be more complex than some
disciplined the implementation of the single alternatives. However, this complexity
monetary policy. In particular, in presenting reflects the environment in which policy
and explaining its monetary policy decisions decisions are made. Furthermore, the ECB
to the public over almost two years, the ECB has adopted a new – and therefore
has always had: (i) to justify how a decision unfamiliar – strategy, which differs from
has served the prospects for the maintenance those pursued by other central banks
of price stability; (ii) to explain the role of prior to the introduction of the single
monetary developments in the decision; monetary policy. A process of learning
(iii) to explain the role of developments in and familiarisation with the new regime
other indicators, projections and forecasts in has, therefore, been required. There are
the decision; and (iv) to account, whenever indications that understanding of the ECB’s
potential discrepancies have emerged, for the strategy is improving. This article is a
different signals emerging from the two pillars contribution towards consolidating this
and explain how these have been reconciled process.
in the final decision. Having to address these

48 ECB Monthly Bulletin • November 2000