Monetary analysis focuses on the longer term. In doing so, it employs one of the most remarkable empirical regularities in macroeconomics, namely the long-run relationship between the price level and the money stock, which reflects the fundamentally monetary origins of inflation over the medium to longer term. This relationship provides monetary policy with a nominal anchor beyond the horizons conventionally adopted when constructing inflation forecasts.
Monetary Analysis
Thus money, which is accorded a prominent role within the monetary policy strategy, is an instrument with which monetary policymakers support the medium-term orientation for monetary policy. When central banks base their monetary policy decisions – and evaluate the consequences thereof – not only on the short-term indications stemming from the analysis of economic and financial conditions but also on money and liquidity considerations, they may see beyond the transient impact of the various shocks and not be tempted to take a more activist course.
To provide a benchmark for the assessment of monetary developments, the ECB announced a reference value for the broad aggregate M3. This value refers to the annual growth rate of M3 that is considered to be consistent with the maintenance of price stability over the medium term. Hence, the reference value is a benchmark for analyzing the information content of monetary developments in the euro area.
Owing to the medium to long-term nature of the monetary perspective, however, there is no direct link between short-term monetary developments and monetary policy decisions. Therefore, monetary policy does not react mechanically to deviations of M3 growth from the reference value. This is partly the case because monetary developments may temporarily be influenced by "special" factors caused by institutional changes. These special factors can cause changes in money holdings, since individuals and firms will as a rule respond to changes in the attractiveness of bank deposits, which are included in the definition of M3, relative to alternative financial instruments, which are not included in M3, with portfolio shifts. However, monetary developments caused by these special factors may not be very informative about the outlook for price stability. Therefore, the monetary analysis of the Eurosystem attempts to focus on the underlying monetary trends in a detailed assessment of special factors and other shocks that influence money demand.
The analysis of monetary developments is not restricted to the assessment of M3 growth in relation to the reference value, though. Much rather, it comprises a comprehensive evaluation of liquidity conditions based on information about the development of the counterparts of M3 in the consolidated balance sheet of the MFI sector (above all loans to the private sector) and the composition of M3 growth. Such a detailed analysis of the counterparts and structures of M3 growth is helpful to extract signals about the outlook for price developments over the longer term from monetary developments. In this context, the most liquid components of M3– most notably M1 – receive particular attention, as they more closely reflect the transaction motives for holding money, and are thus the most tightly related to aggregate spending.
At the same time, gaining a thorough understanding of the interdependencies between M3 and its counterparts is instrumental in judging whether observed changes in money growth can be traced to portfolio shifts which, in turn, may or may not bear implications for price trends.
Finally, growth rates of money and credit in excess of those sufficient to sustain economic growth at a noninflationary pace may, under certain conditions, signal the emergence of financial imbalances. Such information is crucial for monetary policymaking, since the emergence of financial imbalances or speculative asset price bubbles may have a destabilizing effect on economic activity and on medium-term price developments.