Jens Weidmann, do you remember the second pillar?

Today the ECB is very eager to stress it’s 2% inflation target. However, a couple of years ago the ECB in fact had two targets – the so-called two pillars of monetary policy. The one was the inflation target and the other was a money supply target – the so-called reference value for the growth rate of M3.

The second pillar in many ways made a lot of sense – at least as a instrument for monetary analysis. The second pillar was put into the ECB tool box by the Bundesbank which insisted that monetary analysis was as important as a pure inflation target. Read for example former ECB chief economist and Bundesbanker Otmar Issing’s defense of the two-pillar set-up here.

The starting point for calculating the reference value for M3 was the equation of exchange:

(1) MV=PY

or in growth rates:

(2) m+v=p+y

(2) of course can be re-written to:

(2)’ m=p+y-v

If we assume trend real GDP growth (y) is 2% you can calculate the reference value for m that will ensure 2% inflation over the medium term. You of course also have to make an assumption about velocity. ECB used to think that trend growth in v was -0.5 to -1%.

This give us the following reference growth rate for M3 (m-target):

(3) m-target=2+2-(-1)=5% (4.5% if you assume velocity growth of -0.5%)

Said in another way if the ECB keeps M3 growing at 5% year-in and year-out then inflation should be around 2% in the medium term. An yes, this is of course exactly what Milton Friedman recommend long ago.

2.5% M3 growth is hardly inflationary

Today we got the latest M3 numbers for the euro zone. The calvinists should be happy – M3 decelerated sharply to 2.5% y/y in April. Half of what should be the reference growth rate for M3 – and that is ignoring the fact that velocity has collapsed.

What does that tells us about the inflationary risks in the euro zone? Well, there are no inflationary risks – there are only deflationary risks.

Using the assumptions above we can calculate the long-term inflation if M3 keeps growing by 2.5% – from (2)’ we get the following:

(4) p=m-y+v

(4)’ p=2.5-2+(-1)=-0.5%

So it is official! Monetary analysis as it used to be conducted in the Bundesbank is telling you that we are going to have deflation in the euro zone in the medium term! And don’t tell me about monetary overhang – the ECB is in the business of letting bygones be bygones (otherwise the ECB would target the NGDP LEVEL or the price LEVEL) and by the way the ECB spend lots of time in 2004-7 to explain why money supply growth overshot the target.

Jens Weidmann – monetarist or calvinist?

The Bundesbank brought in monetary analysis and a money supply focus to the ECB so I think it is only fair to ask whether Bundesbank chief Jens Weidmann still believe in monetary analysis? If he is true to the strong monetarist traditions at the Bundesbank then he should come out forcefully in favour of monetary easing to ensure M3 growth of at least 5% – in fact it should be much higher as velocity has collapsed, but at least to bring M3 back to 5% would be a start.

I hope the Bundesbank will soon refind it’s monetarist traditions…please make Milton Friedman and Karl Brunner proud!

PS I of course still want the ECB to introduce a NGDP level target, but less would make me happy – a 5-10% target range for M3 (the range prior to the crisis) and a minimum price on European inflation linked bonds would would clearly be enough to at least avoid collapse.

Leave a comment


  1. I have been trying to understand the fear of inflation that is leading to self-defeating policies for the euro zone as a whole. I don’t know enough about the trade dynamics across the zone, or with outside trading partners, to rationalize where the Germans, in particular but not necessarily exclusive, might be coming from in objecting to allowing the ECB to take advantage of the elasticity of currency to help alleviate the crisis, and perhaps you could help with that.

    It’s seems implausible that the German economy could be running on all cylinders with economic depression all around it, which would be the case that using currency measures to fight the crisis would cause excess inflationary pressures. It is possible, however, if there are protectionist policies that cause a supply imbalance across the euro zone as whole, or some other combination of policies that might be preventing supply from expanding naturally in order to offset inflation. It’s a rather peculiar problem, if there is any rationality to the fear of inflation, that is likely contributed to by all parties, with some countries having rather hostile supply side policies, and perhaps a bit a activism on the part of northern industry in the EU parliament that would put them in a predicament to not be able to provide more supply for the offset.

    My thoughts are that there are things that can be done to avoid excess inflationary pressures if the ECB were to adopt a more appropriate policy stance for the entire euro zone; and it’s be beyond all reasonable explanation to hold down demand across the entire currency block with tight money due to lack of ability to expand supply, when if markets and trade were more free, it would do so naturally.

  2. dwb

     /  May 31, 2012

    Does not sound like Weidmann is likely to change.

    Very depressing. Does not sound like Rajoy wants a disastrous bailout either. I wouldn’t. With 25% unemployment, whats the downside of leaving the Euro? at least there is a possibility for growth in 3 years if they leave.

  3. dwb

     /  June 6, 2012

    i came across this it made me nostalgic for the good old days, and thought of this post:

    “The ECB announced a reference value for M3 growth of 4.5% calculated as the sum of an inflation target and a foretasted trend growth rate of real output of 2.5%”

    Click to access 1191022.PDF

    Did I hear Draghi right on the ECB conference this morning M3 growth is sub 3%?? doomed.

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