Academic journal article Economic Review (Kansas City, MO)

The Role of Money in Monetary Policy: Why Do the Fed and ECB See It So Differently?

Academic journal article Economic Review (Kansas City, MO)

The Role of Money in Monetary Policy: Why Do the Fed and ECB See It So Differently?

Article excerpt

Monetary policymakers and central banks universally recognize that, in the long run, inflation is strictly determined by monetary policy. However, they disagree sharply about the role of monetary aggregates in the conduct of monetary policy. For example, former Federal Reserve Governor Lawrence Meyer has said that "money plays no role in today's consensus macro model.... and virtually no role in the conduct of monetary policy, at least in the United States." In contrast, Otmar Issing, former member of the Executive Board of the European Central Bank (ECB) has said that, "money should never be ignored--neither in monetary policy nor in research."

These differences in views are reflected in the way the Federal Reserve and the ECB conduct monetary policy and communicate with the public. At the Federal Reserve, the Federal Open Market Committee (FOMC) no longer specifies targets or monitoring ranges for the monetary aggregates, and committee members seldom mention the aggregates in their deliberations. For example, a search of the most recently published transcript of an FOMC meeting (for December 2001) reveals that the money supply was mentioned only twice--in the same sentence. In contrast, at the ECB, money growth represents one of two "pillars" of monetary policy. As such, the ECB regularly examines the implications of money growth for the inflation outlook over the medium term to long term.

While the role of money currently differs sharply in the Federal Reserve's and ECB's conduct of policy, there is ongoing debate within both institutions about what role, if any, money should play. For example, Federal Reserve Bank of St. Louis President William Poole has said he is "uneasy that money plays practically no role in policy discussions in the Federal Reserve today.... if and when [warning signs from money growth] appear, I will not be the only [member of the Federal Open Market Committee] talking about them." More recently, in contrast, some members of the ECB's policy committee have suggested the role of money should be somewhat redefined. For example, Christian Noyer, governor of the Bank of France and a member of the ECB's governing council, has questioned the reliability of recent money growth as an indicator of future inflation given ongoing financial market developments such as the growth in hedge fund assets (The Wall Street Journal).

What accounts for these differences of views, and why do the Federal Reserve and ECB see things so differently? This article concludes that the Federal Reserve and ECB differ in their approach to the monetary aggregates for two main reasons. First, their institutional histories are different. And, second, in the United States and the Euro area, there are differences in the usefulness of monetary aggregates as indicators of future economic conditions over the medium to long run. The first section of the article examines the way monetary aggregates are currently used by the Federal Reserve and ECB. The second section explores explanations for the different approaches at the Federal Reserve and ECB. The appendix describes the theoretical basis for the view that money is important in monetary policy as well as the alternative view that money is more of a sideshow.

I. THE CURRENT ROLE OF MONEY IN FEDERAL RESERVE AND ECB MONETARY POLICY

The Federal Reserve and ECB currently view the role of money in monetary policy very differently. For the Federal Reserve, the monetary aggregates are indicator variables like a myriad of others that are monitored for clues about the outlook for economic activity and inflation. For the ECB, the monetary aggregates have special status and their behavior is given considerable weight in policy deliberations.

Federal Reserve

The goal of Federal Reserve monetary policy is maximum sustainable growth with price stability. The Federal Reserve seeks to achieve this goal through its influence over the federal funds rate--the overnight rate that banks charge each other for loans of reserves held at the Federal Reserve. …

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