When assessing risks to price stability in the euro area, the Eurosystem relies on two pillars: economic analysis and monetary analysis. These two pillars, which constitute distinct, but complementary, perspectives on the inflation process, are used to organize and evaluate incoming data, structure deliberations and, ultimately, guide monetary policy decisions aimed at maintaining price stability. By including monetary analysis, the ECB’s strategy ensures that important information stemming from money and credit, typically neglected in conventional cyclical forecasting models of the economy, is considered in the formulation of monetary policy decisions, thus ensuring a “full-information approach.” In particular, monetary analysis provides important input for the assessment of risks to price stability from the medium to long-run perspective.
Monetary Analysis
Its role is founded on the well-documented link between trends in monetary growth and inflation. There is compelling empirical evidence that shows that over medium to longer-term horizons inflation exhibits a robust positive association with monetary growth. Over the medium to longer term, inflation is a monetary phenomenon. This well-established relationship, which is applicable across countries and monetary policy systems, provides monetary policy with a nominal anchor beyond the horizons conventionally adopted when constructing inflation forecasts.
Importantly, monetary growth is found to lead inflation at low frequencies, i.e. over medium to long-term horizons, although the closeness of this link may differ in intensity over time and according to circumstances. In particular, the low frequency link between monetary growth and inflation becomes most clearly visible in an environment of material low frequency movements in money and prices and is, conversely, less visible in the absence of such movements. These observations have two important implications for central banks. First, the low frequency component of monetary growth is instrumental in identifying longer-term inflation trends. Second, identifying the low frequency signal in monetary developments, which is relevant for longer-term risks to price stability, is more challenging than merely observing the trend of the growth rate of a specific monetary aggregate.
At the same time, analyzing higher frequency monetary developments in the context of a broad-based and comprehensive framework for monetary analysis helps policy-makers to assess and understand shorter-term macroeconomic and financial phenomena, which may give rise to risks to price stability over the longer-run if ignored. The detailed analysis of monetary dynamics provides useful information about financing conditions and the financial structure, as well as the condition and behavior of banks, which can be critical for understanding the transmission mechanism and, more broadly, the state of the business cycle. The insights gained from this dimension of monetary analysis have proved to be particularly valuable in tailoring the Eurosystem’s monetary policy response to the most recent financial crisis. Furthermore, the analysis of monetary dynamics helps policy-makers to put asset price developments into perspective and to form a view regarding the possible build-up of financial imbalances. In this respect, the Eurosystem’s monetary pillar can be seen as an appropriate approach to the challenges faced by all central banks in looking beyond standard forecasting horizons, notably when confronted by inflated asset prices and evolving financial imbalances. The empirical link between monetary developments and evolving imbalances in asset and credit markets implies that the two-pillar strategy, with the important role assigned to monetary analysis, may enable these imbalances to be detected at an early stage and ensure a timely, forward-looking response to the implied risks to financial, economic and price stability.
The Eurosystem’s monetary analysis combines a suite of econometric tools for model-based assessment and detailed institutional analysis. The former includes empirical money and credit demand models, statistical filters, and forecasting, as well as medium-scale structural models. The institutional analysis entails, inter alia, a comprehensive examination of bank balance sheet data, including the components and counterparts of and sectoral contributions to monetary aggregates.