In the event, the January figure for German M3 growth turned out to be a stratospheric 21 per cent. Insiders report that on the day the news was released internally at the highest levels of the Bundesbank, the normally stern Mr Issing was almost apoplectic.
For 20 years the Bundesbank has waged an evangelical mission throughout an often sceptical world, preaching the gospel of M3 as the truest means of detecting the devils of inflation and casting them out. January's shocking M3 figure should have set alarm bells ringing. But instead the Bundesbank put on its most impassive central banker's face and cut its discount rate by half a percentage point, knowing full well that it had to act quickly before the M3 figure was made public. After that, it would be very difficult to justify easing interest rates.
The publication of the January M3 caused a bloodbath on the already nervous German financial markets, sending bond prices plummeting. Panicked traders spoke of the prospects of German interest rates being raised to contain the inflationary danger. The episode dramatically confirmed what some observers have suspected for a while - that the markets are taking the M3 indicator a great deal more seriously than the Bundesbank itself. After so many years of listening to its praises being sung, traders have come close to regarding the Bundesbank's monetary targeting as a science. However, the recent machinations, where the Bundesbank had to out- trick itself by slipping in a speedy rate cut, have exposed the high artistic content of the central bank's monetary policy. The pragmatism of the Bundesbank, which so likes to play the principled monetarist, has been forced into the open.
The timing is unfortunate. For it coincides with the initial skirmishes in a debate that will dominate European monetary circles for the coming years. What sort of monetary policy will European countries adopt in the final stage of economic union, and what instruments will be employed to pursue it? Hans Tietmeyer, the Bundesbank president, took the offensive from the outset, arguing that the German record on fighting inflation by means of intermediate monetary targeting was unrivalled, and so a similar approach should be adopted by a future European central bank. The employment of a monetary target and other instruments favoured by the Bundesbank would immediately wrap the new European institution in the mantle of German credibility, Mr Tietmeyer enthused.
Alexandre Lamfalussy, the president of the nascent European Monetary Institute, forerunner of a common central bank, is being extremely cautious about being seen to take sides in this debate, while making clear that the Bundesbank has a lot of convincing to do. Intermediate monetary targeting may have worked as an indicator of future inflation, and a means of controlling it, to the satisfaction of the German authorities, he said in a recent speech in Frankfurt.
But in other countries, such as Britain, this has not been the case. Trying to understand why this is so will be one of the main elements of the debate, Mr Lamfalussy said.
There is already one general explanation, related to the financial markets. In Germany, the universal banking tradition, and the relative absence of pension and insurance funds, mean that bank assets are predominant in the financial system.
This in turn means that the Bundesbank's M3 indicator, which is essentially a bank asset measure, comprising cash, sight deposits, time deposits with less than four years' maturity and savings deposits on statutory withdrawal notice, captures much more of the system than it would in Britain, for example, where pension and insurance funds are much bigger.
This is one reason why the Bundesbank is sceptical about developments, such as the growth of short-dated government paper, which weaken the banks' hold on the financial system.
But the overall trend is unmistakeably in the direction of greater financial deregulation, and ever more globalisation. As Mr Lamfalussy noted, it will not be theory but the way in which the European markets develop that will ultimately shape future common monetary policy.
The case for monetary targeting rests on two premises: first, that there exists a link between the speed of growth in the supply of money in the economy today and inflation two years or so hence.
Second, that this growth in the money supply can be steered, so as to control the medium-term inflationary risk. Since 1975, when it began using a monetary indicator, the Bundesbank has missed its target 10 times out of 19.
Undeterred, the central bank argues that the strength of its approach can be measured in terms of its anti-inflationary successes. M3 attained the status of the oracle in the Bundesbank's stability pantheon. The vital credibility image of the Bundesbank among international financial markets was increasingly based on a belief in the reliability of the M3 approach.
But since unification things have gone awry. M3's signalling value appears to have deteriorated significantly, forcing the Bundesbank to explain it away, or quite simply to ignore it, with unsettling frequency.
A number of reasons have contributed to this: heavy public borrowing to finance the massive transfers to eastern Germany; tax changes prompting huge flows in and out of the Euromarkets; and the currency upheavals in the ERM. M3 has demonstrated unusual volatility, around an average growth course well above what the Bundesbank had set as acceptable.
As long as two years ago, some economists were arguing that M3 had lost its way, and the inflationary potential it indicated was highly exaggerated. Interest rates could, and should, be brought down more quickly. But the Bundesbank was trapped by the credibility ethos surrounding M3. Confidence is everything in the markets, particularly in turbulent times, and maintaining it requires more art than science.
Interest rates were cut, therefore, with great caution, despite the deepening economic gloom in Germany. But as evidence has steadily mounted that the inflationary threat is receding, notwithstanding M3 surges, the Bundesbank has been tortuously giving ground to outside scepticism about its monetary indicator.
In effect, the Bundesbank for some while now has being paying greater attention to other indicators, such as producer prices, the wage round, bank lending, the gap between actual and potential output, and the exchange rate. These have suggested a rapidly weakening inflationary risk, which is why the Bundesbank cut rates in defiance of the doom-laden tones from the M3 oracle.
But this leaves the bank and the markets with a credibility problem, which is not about to go away. M3 is likely to to remain in double-digits in February and March, sharpening the agony of a Bundesbank increasingly keen to get rates down.
Belatedly, the central bank has to wriggle out of the corner it has got itself into over M3. How it tries to do so, while at the same time pursuing its campaign for German-style monetary targeting in a future European union, will test the Bundesbank's artistic skills, if not its scientific ones, to the full.Reuse content