Speech by Jens Weidmann at the New Year Reception of Deutsche Börse ©Thorsten Jansen

Weidmann: Make monetary policy easier to understand

Bundesbank President Jens Weidmann says that monetary policy needs to be easier to understand. Speaking at Deutsche Börse’s New Year’s reception in Eschborn, he explained that while financial market agents have a good understanding of monetary policy, research suggests that monetary policy communication does relatively little to affect the expectations of households and firms. And yet it is precisely these inflation expectations that matter when households make decisions about their purchases, when companies set the prices of their products, or employers and trade unions negotiate wages.

An “understandable, forward-looking and realistic” monetary policy aim

Mr Weidmann said that the review of the monetary policy strategy also needs to consider how the policy aim is formulated. “I believe we should word our monetary policy aim to make it understandable, forward-looking and realistic,” he told his audience. For the Bundesbank President, ‘understandable’ means that people are able to grasp how the aim is defined and that it makes sense to them. ‘Forward-looking’ means ensuring price stability in the medium term and going forward, because it is quite difficult for monetary policy to affect current price developments. “Our measures only really take full effect after a time lag,” he explained, given that economic adjustment processes frequently extend over a longer period of time. ‘Realistic’ means that the wording of the policy aim should not lead people to develop any illusions. “We should counter the impression and claims that we could fine-tune inflation right down to the decimal, because we can’t!” Mr Weidmann reasoned. Rather, a realistic and forward-looking aim allows monetary policy to wait if there are good reasons to do so, and not just to react frenetically to every change in the data.

Mr Weidmann also used his speech in Eschborn to speak out against sharply raising the target inflation rate, offering three reasons to back up his opinion. First, the increase in monetary policy’s room for manoeuvre might not be as large as hoped, as it is likely that companies would adjust their price setting. Second, a strong increase in the target rate could raise the risk of inflation expectations becoming unanchored. People could begin to doubt the credibility of the central bank and think that the target rate of inflation might be increased still further. And third, there are costs to inflation, which affect people. Inflation scrambles the signals emitted by prices and therefore distorts decisions on, say, investment or consumption. “Inflation hits the weakest members of society especially hard,” Mr Weidmann observed, “for they are less able to protect themselves from inflation.”

Remeasuring inflation

Another topic to consider, Mr Weidmann continued, is whether the rate of inflation is currently being measured correctly. The existing monetary policy aim is based on the Harmonised Index of Consumer Prices (HICP) for the euro area. “In principle, it best meets the requirements of a measure for price stability within the euro area,” said Mr Weidmann, adding that while the HICP contains rents, for example, owner-occupied housing is absent from its basket of goods. “It is undisputed that the HICP should really include this component,” he noted, explaining that the reasons for its absence are of a methodological nature. “I personally would be willing to accept some methodological shortcomings if that meant that we were able to better reflect people’s real-life situations”, Mr Weidmann remarked. “This would allow us to better fulfil our mandate of securing price stability within the euro area.”

Clear hierarchy for deploying monetary policy instruments

In order to secure price stability within the euro area, Mr Weidmann believes central bankers need the right tools. Recent years have demonstrated that traditional interest rate policy may reach its limits. Monetary policymakers therefore need other tools to deal with such exceptional circumstances. First and foremost, these tools need to be effective in terms of safeguarding price stability, but they must also achieve this objective with as few side effects as possible. This, he reasoned, is why a clear hierarchy should be observed. Turning his attention to forward guidance, the Bundesbank President said: “If our key interest rates are already very low, we should initially consider such communication, say, before upping the ante.” Mr Weidmann continues to take a critical view of the large-scale purchases of government bonds in the euro area. “In my opinion, they should be used only in emergencies.”