Member of the Executive Board, European Central Bank
My remarks focus on the challenges facing monetary policy in a rapidly changing world. I start by examining the nature of economic change confronting monetary policy in its daily execution. In the absence of an unambiguous mandate to maintain price stability and of a clear strategy to sustain it, the ongoing task of identifying the latest economic shocks may easily distract the central bank from the need to maintain a firm sense of direction in the longer run. Next, I advance an interpretation of why the transition to European monetary union-involving, by all standards, a state of acute uncertainty--could be accomplished in the smooth manner in which it proceeded. In this context, I highlight the role of two complementary policy perspectives. These two principles of good policy are conducive to flexible and timely responses to unfolding events and, at the same time, ensure policy against myopia and short-termism and keep it solidly anchored to its medium-term objective.
Cyclical and structural change
Economic change-and the uncertainty that it brings about-has three dimensions. At the ground level we have cyclical that is transitory and/or nonstructural economic shocks coming along continuously. The theory of economic policy normally assumes that such shocks are "additive" in nature, in that they do not pose a controllability problem for policy. Nevertheless, they have to be properly identified in real time. Econometric theory has spent decades devising sophisticated identifying restrictions to isolate different types of shocks from the tangle that appears in the data. The purpose of these exercises is to trace the propagation profile of exogenous impulses through the economic system. But nothing close to a consensus view has emerged. In fact, inference is often nonrobust across various identification schemes.1
As a consequence, central bankers are given little guidance as to the nature of the stochastic disturbances that drive the business cycle on average. Of course, model selection itself is at stake here, as competing modelling paradigms can only be put to a test-and discriminated-by matching their quantitative implications with the dynamic shock responses seen in the data. If the latter can only be generated on the basis of controversial identification restrictions, the empirical benchmark becomes elusive. For all these reasons, central bankers must exercise judgment when they encounter perturbations, and they cannot rely on any single approach to reasoning through the implications of such shocks.
At a higher level, and a lower frequency, we have structural change. This induces parameter-i.e., multiplicative-uncertainty, as innovations tend not only to persist, but become embedded in the coefficients through which key variables respond to exogenous forces. Monetary policymakers, again, find themselves at a crossroads. For one thing, it is extremely difficult for them to decompose in real time what is due to structural change and what stems from normal cyclical sources of fluctuation, as these events tend to come together. But, more fundamentally, central bankers perceive the uncertainty surrounding structural variation as of a higher order of magnitude-and of a different nature-compared with the way parametric risk is treated in much of the literature. I believe this type of our measure of uncertainty is closer, in this case, to a Knightian concept, wherein probability distributions for model coefficients cannot be articulated.2
A further source of uncertainty, of a strategic sort, stems from the endogenous-at times unpredictable-process whereby agents form their expectations. This process has a strategic, game-theoretic flavor, as the central bank and its way to respond to the events is very much part of the picture, and in some way it is driving the formation of views about the future.
Incidentally, the identification of the disturbances stemming from cyclical, structural or expectational disturbances is further complicated by the ex post statistical revisions, which may at times overturn the empirical platform on which central bankers have to make their decisions in real time. …