After the European Central Bank's May rate cut debacle,
arguments resurfaced that communication or even transparency
problems were inherent to the bank's set-up, and could be avoided
by abandoning the so-called two-pillar approach.
The ECB bases its monetary policy on an inflation forecast, which
is determined by analyzing money growth figures (the first pillar)
and by analyzing real economy data (the second pillar). While
money-supply growth figures are used to predict inflation in the
longer term - about 18 months - the second pillar, inflation
targeting, focuses on a period shorter than this. The results from
these two assessments can point in different directions, as was the
case in April 1999 when rates were cut even though M3 growth
pointed to inflationary risks. But the second pillar suggested the
need to reduce interest rates. Conversely, in May 2001 a downward
revision in M3 led the ECB to lower the repo rate, even though the
justification for this from...
