ECB demotes money supply in inflation forecasts


By Ralph Atkins
Financial Times, London
Friday, July 13, 2007

FRANKFURT, Germany -- The European Central Bank is taking a more pragmatic approach to its analysis of monetary data -- a move that highlights the evolution of a tradition inherited from Germany’s conservative Bundesbank.

On Thursday the Frankfurt-based bank downgraded its attempts to forecast inflation by using money supply data, saying that such projections should be referred to as indicators rather than forecasts.

The change follows an analysis that had shown the performance of such measures was "no different from a broad variety of other economic and financial indicators," the ECB said.

The subtle but significant demotion highlights the evolution in the ECB's use of money supply and credit data -- which distinguishes it from other central banks.

Since the launch of the euro in 1999, the ECB has used a "two-pillar" strategy that looks at the implications of money and credit growth separately from more conventional economic data. Adopting a strategy similar to that of the Bundesbank helped it establish credibility as an institution.

But the effectiveness of the so-called "monetary pillar" has been called into question within the ECB as well as by academics at a time of rapidly changing financial markets.

Fast growth in M3, the broad money supply, has seemingly borne little relationship to eurozone inflation, which at 1.9 per cent remains exactly within the ECB's target of an annual rate "below but close" to 2 per cent. Lucas Papademos, ECB vice-president, has suggested that eventually the two "pillars" -- monetary and more conventional data -- could be merged.

Money-based inflation forecasts, which sometimes overestimated inflation trends, have been published only occasionally by the ECB, most recently in June last year.

The ECB has also broadened its approach to money and credit data, with several governing council members stressing the fast growth in eurozone lending, especially to business, rather than M3 data. Thursday's bulletin acknowledged that the annual growth rate of M3 might "overstate the dynamism of the underlying rate of monetary expansion."

Jürgen Stark, ECB executive board member and former Bundesbank vice-president, said that the bank wanted to include house prices and wealth indicators in its economic models. He said the ECB's approach was based "on the well-established empirical relationship between the underlying trends in monetary growth and inflation, which has been found to be robust across time, across countries, and across different monetary policy regimes."

-- The eurozone economy grew faster in the first three months of this year than originally reported, according to official data on Thursday. Gross domestic product rose by 0.7 per cent in the 13-country region, according to Eurostat, the European Union’s statistical unit. It had previously reported 0.6 per cent growth.

With the data suggesting the underlying eurozone growth trend remains robust, the ECB is expected to keep raising interest rates, with another quarter- point rise to 4.25 per cent likely in September.

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