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The two pillars – another compromise

Abandoning the so-called two pillars approach could lead to solving communication or even transparency problems in the ECB’s set-up.

Julian Callow

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 the second pillar was more ambiguous.