Examples of economic analysis - the Generation ?uro Students' Award

Explaining Your Monetary Policy Decision
based on Economic and Monetary Analysis
SOME GUIDANCE
FOR WRITING YOUR ESSAY
FP Mongelli
20 September 2011

What you have to do
• You are in charge of price stability over the medium-term.
• Your objective is to to write an essay explaining the reasons for your interest rate decision
by referring to the underlying economic and monetary analysis.
• You also need to explain your inflation outlook as well as the various risk factors.
1 st , what is the medium term?
• It is a timeframe between the short-term – i.e., a period of one or at most two years - and the
long term which can last several more years – say the completion of a business cycle: not to
paraphrase JM Keynes (that in the LT we all passed away).
• Thus for all practical purposes your time-frame is of about 2-3-4 years.
2 nd, your mandate is to maintain inflation close but below 2% over the medium term:
– This is your price stability objective a year-on-year increase of HICPs < 2% over MT
– If there is no incompatibility, then you can consider also other objectives that are ancillary, like
economic growth and employment
– but let’s simplify this essay and only focus on price stability (that is difficult enough)
3 rd , why does the choice of timeframe in which you need to achieve your objective greatly matter?
• Because every month, or quarter, price dynamics are affected by a great variety of shocks, or
news, or self-reverting events (like a strike, some temporary disruption, or other short lived
blips)

What you have to do…
– These are often called “noise” by statisticians and economists
– Instead, you need to correctly interpret underlying price signals that emerge from the very
structure of the economic, monetary and financial systems
4 th , what is your geographic domain?
– It is the euro area as a whole: i.e., considering it as a single geographic entity
– Some comments on the concept of economic and financial integration.
– At the same time the analysis of heterogeneity and/or persistent imbalances has acquired
greater prominence in recent years (but is not going to be that relevant for your Essay)
5 th, now imagine that you were the President of the ECB and thus the Chair of the Governing
Council …
– you would be commanding one of the greatest professional and also intellectual armies in the
world
– basically all types of data, statistics, information, facts about the euro area economy would be
available to you as well as all other Governing Council members
– moreover, you would have at your disposal the best economic and monetary analysis possible
for the euro area.
– it is also important to note that this wealth of data and information is also available to all
beyond the Eurosystem, i.e., it is “publicly available information”

What you have to do…
6 th , Imagine that it’s the first Thursday of the month: the day of the “voting” Governing Council.
– Imagine that you have just met with your peers, the members of the Governing Council, and
conducted the economic and monetary analysis plus the cross checking
– You need now to explain your decision to a vast public that ranges from skilled “ECB
watchers”, other policy makers, the media, and the interested public at large.
– Explain in the Essay that the monetary policy decision that you have taken concerning the
appropriate interest rate level - is that of the Governing Council in its collegiality
– Moreover, as soon as you have finished reading out the essay, questions from the media that
is sitting in the Press Conference room will start flocking (there are about 2-300 journalists)
– Questions can range from something you said in your “essay”, or anything that you have
publicly discussed over recent days/weeks, or anything said by some other Board/Governing
Council members, or anything even indirectly related to the decision(s) you took.
Thus be prepared to explain anything you write in the essay.
7 th , how can you organise both your analysis, Governing Council discussion, deliberation and
explanation to the above vast public? Is there an organising device?
– Yes, it is shown in the picture in the next slide: we call it a Monetary Policy Strategy.
– It shows what is frequently called as “two-pillar analysis” plus the cross checking.

What you have to do…
7 th , now you have to explain your decision in an Essay of up to 2,000 words (roughly two-three A4
pages). You have to be concise and convincing. Thus remember that you have to:
– Explain also the pros and cons of your decisions,
– Lay out the various risks you see (both bad risks and positive risks), and,
– looking ahead, also present some possible scenarios
8 th , remember that your goal is to explain principally what has changed since your last Introductory
Statement/Essay.
It is about interpreting new information and whether it changes your broad picture and the various
risks to price stability and scenarios. Economists call this a “repeated game”
– In fact, you meet with your peers to discuss interest rates at least once a month (also there are
teleconferences and other Governing Council meetings).
– There is an underlying consensus that builds up over time and new evidence confirms it or
requires some adaptations.
– Thus your focus should be the new data/information or developments that have occurred over
recent weeks and that require changes in your baseline scenario.
9 th , unless there is a systemic crisis – like the ongoing financial crisis - which is a game changer…
– Then you need to assess the severity of the events unfolding
– Most backward data and information that you have collected loose partly in significance

…and why is it difficult?
The exercise that you are about to engage in, is rendered more challenging by the following
difficulties (but there are others):
1 st , the most complex of all difficulties is that you will be acting “in real time”
• i.e., the data you are using has some lag with respect to what is happening now.
• You don’t know precisely the current state of the economy right now.
• an analogy would be that you know your body temperature of last week (and not today) and
yet you need to decide whether you stay home and take medicines (and/or go to the doctor)
• You may have to undertake some guessing work and some projecting/forecasting is involved.
• You will also need to use some coincidental and leading indicators.
2 nd , there is also what we call “model uncertainty”
• i.e. our analytical tools only provide an interpretation of reality…
… while the economy may be changing over time
• An increase in oil prices today may be reverted soon or be the start of a trend
• Similarly if you misjudge the pace of innovation, you may unduly keep monetary policy too
tight.

…and why is it difficult?
3 rd , there is also the policy debate, interaction among policy makers and voting outcome
– Most times Governing Council decisions are by consensus and for a long time this has
been the main outcome
– More recently some dissent has emerged: some public and some latent
– For the purpose of your essay we only look at “consensual decisions”: i.e., your team
agrees on one decision which it then explains.
The rest of this presentation is about some key elements for the Essay

The Introductory Statement (IS) preceding the ECB’s
Press Conferences is a “model” essay …
• See http://www.ecb.europa.eu/press/pressconf/2011/html/index.en.html
• Introductory paragraph
• Monetary policy decisions
• Key monetary policy messages / intentions / signals
• Economic analysis
• Growth and employment developments
• Price developments
• Once a quarter, summary of staff projections
• Monetary analysis
• Money growth
• Credit growth
• Cross-checking / summing-up

… but the IS is also a highly policy-intense and
politically dense statement
• From time to time the IS also contains fiscal and structural policy messages
• Yet, the desire of the organisers of the Generation €uro Students Award is not to receive a
“copy and paste” with some editing exercise from the IS.
• This happened to some extent in the pilot exercise.
• Hence, while it is OK to seek some inspirations from the IS and also some ECB Monthly
Bulletin articles or text, you should attempt to provide your own thoughts
• In the rest of this presentation we show some examples of recent time series that have a
bearing on your essay and present the main features of the economic and monetary analysis

Here are key interest rate facts:
what decision do you recommend next?
• It currently stands at 1.50%
• It is reviewed monthly but only changed occasionally (31 changes since 1999)
• It is changed in discrete steps of 25, 50 and sometimes 75 basis points
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

3.0
2.8
2.6
2.4
2.2
2.0
1.8
Example: Long-term inflation expectations from surveys
and break-even inflation rates (role of credibility)
5-year forward 5 years ahead BEIR
5-year I/L swap rate 5 years ahead
ECB Survey of Professional Forecasters (long-term)
3.0
2.8
2.6
2.4
2.2
2.0
1.8
1.6
1.6
Jan-08
Apr-08
Jul-08
Oct-08
Jan-09
Apr-09
Jul-09
Oct-09
Jan-10
Apr-10
Jul-10
Oct-10
Jan-11
Apr-11
Jul-11
Sources: ECB and Reuters.
Latest observation: BEIR and I/L swaps – 8 September 2011 and 2011Q3 SPF – July 2011.

THE “TWO-PILLAR APPROACH”
The two Pillar Approach shown in the previous picture consists of two complementary
perspectives:
– The economic analysis (EA) that is aimed at assessing short to medium-term risks to
price stability. Its focus is on real activity and financial conditions in the economy.
– The monetary analysis (MA) focuses on a longer-term horizon, exploiting the long-run
link between money and prices.
MA also serves as a means of cross-checking, from a medium to long-term
perspective, the short to medium-term indications from the economic analysis.
• This dual approach secures robustness and works as an “insurance mechanism”
• It allows a close mapping between the Monetary Policy Strategy and the Communication
policy.

ECONOMIC ANALYSIS (I)
• The Economic Analysis takes account of the fact that price developments over the short and
medium term are influenced largely by the interplay of supply and demand in the goods,
services and factor markets (see next picture)
• To conduct the economic analysis, the ECB regularly reviews amongst others various
hardcore macro indicators such as:
– developments in overall output,
– demand and labour market conditions,
– a broad range of price and cost indicators,
– fiscal policy, and
– the balance of payments for the euro area.

ECONOMIC ANALYSIS (II)
• Asset prices and financial yields
– Financial variables are analysed to derive information about the expectations of financial
markets, including expected future price developments.
– Using a variety of techniques, financial prices permit to “extract” the markets’ implicit
expectations about future developments.
• Macroeconomic projections
– Projections, a synonym of forecasts, are produced under the responsibility of the ECB
and the Eurosystem staff using analytical tools and empirical models.
– The projections help to structure and synthesise a large amount of economic data. They
ensure consistency across different sources of economic evidence.
– Permit to sharpen the assessment of economic prospects and the short to medium-term
fluctuations of inflation around its trend.

Examples of economic analysis
• Changes in inflation (year-on-year)
5
4
3
2
1
0
-1
Latest observation: August 2011
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Examples of economic analysis
• Changes in real GDP (percentage changes)
5.0
4.0
3.0
2.0
1.0
0.0
-1.0
-2.0
-3.0
-4.0
-5.0
annual percentage changes (LHS)
quarter on quarter percentage changes (RHS)
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
-2.0
-2.5
-6.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
-3.0
Latest observation: 2011Q2

Examples of economic analysis
• Changes in unemployment
5.0
10.5
4.0
unemployment rate (RHS)
10.0
3.0
9.5
2.0
9.0
1.0
8.5
0.0
8.0
-1.0
annual change in millions (LHS)
-2.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
7.5
7.0
Latest observation: July 2011

Examples of economic analysis
• Staff projections
• Latest figures released in early September 2011
• Next release at the December 2011 Press Conference (thus every 3 months)
• Important to check how the numbers have changed compared with the last release
• How do they compare with the definition of price stability?
2010 2011 2012
HICP-September 2011 1.6 2.5-2.7 1.2-2.2
HICP-June 2011 1.6 2.5-2.7 1.1-2.3
GDP-September 2011 1.7 1.4-1.8 0.4-2.2
GDP-June 2011 1.7 1.5-2.3 0.6-2.8

A remark: what type of data should you look at?
• You will quickly notice an enormous number of data series and charts like the one below
• Look in fact at the relevance of seasonality: e.g., in euro area industrial production
• By necessity, the data we look at are not “pure” but they are filtered somehow: here is one useful
example, while another example of filtering comes along with the monetary analysis.
120.0
110.0
100.0
90.0
80.0
70.0
60.0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Monetary Analysis
The ECB is almost unique among the leading central banks in assigning a high importance to
monetary aggregates.
Why does the ECB do that?
– Reason 1: in the medium to long run monetary growth and inflation are closely related.
– Reason 2: the analysis of credit and liquidity conditions enables the ECB to see beyond
the transient impact of the various shocks.
• Which monetary aggregates?
– M1 has been defined as currency in circulation plus overnight deposits.
– M2 comprises M1 plus deposits with an agreed maturity of up to and including two years
and deposits redeemable at notice of up to and including three months.
– M3 comprises M2 plus repurchase agreements, money market fund shares and units as
well as debt securities with a maturity of up to and including two years.

Monetary Analysis
• Beyond assessing the growth of the broad monetary aggregate M3, diverse other monetary
and financial variables are also informative, including:
– developments in the components of M3 (e.g. cash in circulation and time deposits) as
they can offer an insight into the overall changes in M3; and
– narrower aggregates such as M1 may contain some information about real activity.
• Similarly, changes in credit extended to the private sector can also be informative about
financial conditions and, through the monetary financial institutions (MFI) balance sheet, can
provide additional information about money.
• Moreover, the analysis of money and credit may provide early information on developing
financial instability. This is of relevance for SMP because over time the emergence of
financial imbalances or asset price bubbles could have a destabilising effect on activity and,
ultimately, prices.

A remark: what type of data should you look at? Monetary Analysis,
annualised quarter-on-quarter changes, deviations from mean
8
8
6
6
6
6
6
6
4
4
3
3
3
3
3
3
0
0
0
0
0
0
0
0
-4
-4
-3
-3
-3
-3
-3
-3
-8
-8
1974 1981 1988 1995 2002 2009
M3 =
-6
-6
-6
-6
1974 1981 1988 1995 2002 2009
1974 1981 1988 1995 2002 2009
Low
Business cycle
frequency
+
frequency
component
component
-6
1974 1981 1988 1995 2002 2009
High
+
frequency
component
-6
e.g. inflation
(expectations)
e.g. economic
activity
e.g. bank
behaviour

MONEY GROWTH AND INFLATION IN THE EURO AREA
High frequency
Low frequency
9
9
8
8
6
3
M3
6
3
4
4
0
0
0
M3
0
-3
-6
HICP
-3
-6
-4
HICP
-4
-9
1974 1982 1990 1998 2006
-9
-8
1974 1982 1990 1998 2006
-8
Source: ECB. Chart shows annual percentage changes as deviations from the mean.

Example of monetary analysis
• Changes in M3 (annual percentage changes, adjusted for seasonal and calendar
effects)
14
12
10
8
6
4
2
0
-2
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Latest observation: September 2011

Example of monetary analysis
• Loans to households and non-financial corporations (annual percentage changes;
seasonally adjusted)
16
14
12
10
8
6
4
2
0
-2
-4
non-financial corporations
households
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Latest observation: 2011 Q2

Cross-checking
• Are the messages from the economic analysis and the
monetary analysis consistent?
• October 2010: “A cross-check of the outcome of our
economic analysis with that of the monetary analysis
confirms that inflationary pressures over the medium
term remain contained, as suggested by weak money
and credit growth.”

The importance of expectations for the economy
• Many points in the Introductory Statement refer to expectations and
are forward-looking in nature, e.g.:
• “Statistical releases and survey evidence generally confirm our
expectation of a moderation in the second half of this year in the
euro area and elsewhere.”
• “The global recovery is expected to go on.”
• This is due to the fact that monetary policy takes quite some time to
have an effect on the economy (via the transmission mechanism).

The importance of expectations …
• Of course, we cannot be certain about the future
• “The risks to this economic outlook are slightly tilted to the downside…”
• “… with uncertainty still prevailing”
• “Risks to the outlook for price developments are slightly tilted to the upside”
probability /
likelihood
less uncertainty
probability /
likelihood
more uncertainty
downside
risks
Modal
view
inflation
Modal
view
inflation

Example: Distribution of Euro Area Barometer
2010 HICP Forecasts
2.5
Value of density function
2
1.5
1
Jun09, Mar10
1.1
Sep09,
Dec09
1.2
Apr10
1.2
Averages
Forecast from Jun 09
Forecast from Sep 09
Forecast from Dec 09
Forecast from Mar 10
Forecast from Apr 10
0.5
0.0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 2.2 2.4 2.6 2.8 3 3.2 3.4
HICP annual growth rate
Source: EZB.
Latest observation: April 2010

Careful consideration is needed
• Central banks, and the GC in particular, look at a very large amount
of data information and analysis very carefully
• The discussion and deliberation plays an important role.
• Everything is considered very carefully: in fact, in the presence of
doubts modern central bankers prefer to be cautious and move little
steps at a time.
• They also need to be forward-looking
• Unfortunately, there is no easy procedure that generates a correct
monetary policy decision: in fact it may take some time – months or
even years – to gauge the correctness of a MP decision today
• Thus, do your best and remember that you have to upload your
essay to the competition website by 8 p.m. CET

The latest data releases
• Eurostat: Latest news releases http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/
• ECB
• Statistics, latest data http://www.ecb.europa.eu/stats/html/index.en.html
• Monthly Bulletin http://www.ecb.europa.eu/pub/mb/html/index.en.html
• Monetary developments http://www.ecb.europa.eu/press/pr/stats/md/html/index.en.html
• Bank lending survey http://www.ecb.europa.eu/stats/money/surveys/lend/html/index.en.html
• Newspaper and analysts’ reports: it’s important to get a feeling for the “news component” in the
releases

The ECB has over the last 12-18 months also worked on two educational games
See http://www.ecb.europa.eu/education
€CONOMIA
The monetary policy game
INFLATION ISLAND
How inflation affects the
economy
Looks at deflation, low
inflation, high inflation, and
even hyperinflation