Where money matters more ? Fed or ECB?

I came across this excellent paper (and very readable) from Kansas Fed Economists – George A. Kahn and Scott Benolkin. In this paper they compare the monetary policy strategies of Fed and ECB. They show money plays a much important role in ECB as money is more linked to inflation in Euroarea than US economy.

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.

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 no longer specifies targets or monitoring ranges for the monetary aggregates, and committee members seldom mention the aggregates in their deliberations. In contrast, the ECB regularly examines the implications of money growth for the inflation outlook over the medium term to long term. What accounts for these differences of views, and why do the Federal Reserve and ECB see things so differently?

Kahn and Benolkin examine why the Federal Reserve and ECB differ in their approach to the monetary aggregates and find 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.

In a post I had mentioned, it will be interesting to look whether institutional structures of central banks are converging or diverging while achieving the same objective of price stability. I found some useful stuff which tells me there is substantial divergence in the structures-  divergence in Fed and ECB monetary policy in the recent crisis from ECB member, divergence between policies in US and EU from Fed member and this paper which looks at 17 central banks and shows wide divergence. In another speech, Lorenzo Bini Smaghi points to the differences between Euroarea and US institutions.

Coming to the paper, there are actually lot of questions on the role money plays in monetary policy. This is quite surprising as it has been a well-known fact that inflation is always and anywhere a monetary phenomenon (given by Milton Friedman). However, economists disagree. This research was first started by Michael Woodford who argued that money had no role to play in monetary policy (read his 2007 paper; he made this point in a 1996 conference). This view has led to a lot of criticism as ECB has made monetary policy as one of its 2 pillars (defended ferventlyby Otmar Issing). An entire ECB conference was devoted to this topic – The role of money: money and monetary policy in the 21st century.

This is the main idea Kahn et al use in the paper- where does money matter more? in US or Euroarea? Not surprisingly, money shows correlation with money in Euroarea and not in US. Apart from this ECB has this Bundesbank legacy to follow which had made monetary targeting (and role of money supply in inflation( very popular (see this). Hence, ECB’s focus on money supply.

Apart from this paper has an excellent explanation (in English) of the two approaches to monetary policy – one with role of money (as explained by Friedman) and one explained by Woodforde (interest rate approach).

Excellent paper!

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