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The ECB’s Monetary Policy Strategy
and the Euro Area EnlargementMassimo RostagnoEuropean Central Bank
The views expressed in this presentation are those of the speaker and do not necessarily represent those of the
European Central Bank or the Eurosystem
Skopje 30 May 2008
Overview
• The ECB’s Mandate
• The Quantitative Definition of Price Stability
• The Safety Margin
• Euro Adoption: The Perspective of the ECB and New Members
• Paths to Euro Adoption: Two Polar Options
• Are There Patterns?
• Conclusions
• Dual Mandate“To furnish an elastic currency [and] to afford means of re-discounting commercial paper” [Federal Reserve Act, 1913]
* * *“Maintain the growth of monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates” [Full Employment and Balanced Growth Act, 1978]
• Primary Objective“The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the objectives of the Community” [The Treaty, Article 105]
* * *Community Objectives include: “sustainable non-inflationary growth”, “high level of employment”, “raising the standards of living” [The Treaty, Article 2]
Comparison: The Fed
Price stability boosts Potential in the long term Reduces uncertainty regarding the level of future
prices and encourages the formation of productive capital
Minimizes noise by which high inflation erodes price signals
Reduces the distortion of the fiscal system (fiscal drag)
Minimizes the inflation tax on small savings
Why Price Stability in the Medium Term?
Evidence (Benati, 2007): 1% permanent increase in inflation now would cut GDP level 10 years from now by 1.3%-2.3%
• Year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2% over the medium term
Clarification of the Strategy (8 May 2003)
• The Governing Council will aim to maintain inflation rates close to 2% over the medium term
The Quantitative Definition of Price Stability
Quantitative Definition of Price Stability
Why not – Asymmetry within Dual Mandate
– Price index measurement uncertainty
– “Minimal incremental benefits” given proven commitment to price stability
Why – Anchor for inflation
expectations
– Yardstick for accountability
– Makes long-run commitment to price stability binding in the short run
Comparison: The Fed
Euro area US Euro Area US
2002-2007* 2.06 2.21 0.15 0.40
1990-1998 2.80 3.49 0.44 0.471999-2007* 1.86 2.47 0.08 0.14
1995-2002 0.075 0.216
Sensitivity of long-term inflation forecasts to short-term inflation forecasts
Long-term inflation expectations 2) (percentage per annum)
Sources: Consensus Economics Forecast, Reuters and ECB internal calculations. *Data refers to up to J une 2007 1) Refer to 10-year rates. 2) Long-term inflation expectations are extracted from Consensus Economics Forecast. Data are collected on a semi-annual basis and refer to a horizon of 6-10 years. 3) Reported coefficient measures co-movement of survey-based 10-year and 1-year ahead inflation expectations. Source: Castelnuovo, E., Nicoletti-Altimari, S., and Rodriguez-Palenzuela, D. (2003).
Average Standard deviation
Break - even inflation rates 1) (percentage per annum)
The Quantitative Definition of Price Stability
Source: ECB calculations. See J.C. Trichet (2007): “The euro and is Monetary Policy” (speech delivered at the Conference “The ECB and its Watchers”, Frankfurt, 7 September) UPDATED 20.5.2008
Was price stability conducive to macroeconomic stability? Low inflation volatility … … did not de-stabilize real activity
Why “inflation below but close to 2%”?
... Below 2% The costs of inflation are minimised at below 2%
... Close to 2% Measurement Bias in HICP Zero inflation restricts Central Bank room for manoeuvre
in case of negative demand shocks (Zero Lower Bound problem)
Inflation Differentials across countries: if average inflation is too low it brings zero or negative inflation to richer countries
The Quantitative Definition of Price Stability
Inflation (and Growth) Differentials across Countries
The Quantitative Definition of Price Stability
… can be temporary Local adjustment to asymmetric shocks
Differences in Fiscal Policies and Structural Policies
…. but can be more persistent: catching-up processes Less productive countries catch up to higher
productivity levels …
… wages increase in the tradable (catching up) sector …
… wages increase in the non-tradable sector as well …
… where, however, productivity does not increase so much.
This causes systematically higher inflation in catching up countries
Inflation (and Growth) Differentials across Countries
The Quantitative Definition of Price Stability
… can be temporary Local adjustment to asymmetric shocks
Differences in Fiscal Policies and Structural Policies
…. but can be more persistent: catching-up processes Less productive countries catch up to higher
productivity levels …
… wages increase in the tradable (catching up) sector …
… wages increase in the non-tradable sector as well …
… where, however, productivity does not increase so much.
This causes systematically higher inflation in catching up countries
Inflation in productive countries steadily lower than average
Table: “Steady-state” inflation rates implied by Balassa-Samuelson effects according to
selected studies.
Sample Alberolaand
Tyrväinen
1975-95
HICPproxy
IMF
IMF(1999a)
1960-96
Canconeriet al.
73-97
De Grauwe &Skudelny
1971-95
Sinn &Reutter
87-95
Averageof all
columns
Actualaverage
HICP1995-2002**
Belgium 3.1 2.0 3.8 2.6 2.1 1.8 2.6 1.7
Germany 1.3 1.9 1.5 1.0 1.7 1.0 1.4 1.3
Greece - 2.7 2.8 - - 5.3 3.6 3.8*
Spain 3.1 2.3 - 2.4 2.0 2.5 2.5 3.0
France 1.7 1.9 2.8 2.4 1.6 2.3 2.1 1.5
Ireland - 3.4 3.0 - - 3.4 3.3 3.1
Italy 2.4 1.9 2.7 2.8 2.4 2.5 2.5 2.8
Netherlands 2.3 2.3 1.6 - 2.0 2.4 2.1 2.5
Austria 1.8 2.5 - 1.8 2.5 2.4 2.2 1.5
Portugal - 2.7 4.3 - 2.1 1.8 2.7 3.0
Finland 2.4 2.3 2.9 2.4 1.4 3.7 2.5 1.6
Euro area 2.0 2.0 2.0 2.0 2.0 2.0 2.0 1.9
Max-min 1.8 1.5 2.8 1.8 1.1 4.3 2.2 2.5
Standard dev. 0.6 0.4 0.9 0.6 0.3 1.1 0.6 0.8* = Greece since 1997.
** = average of monthly inflation rates.
Inflation Differentials across Euro Area Countries
The Quantitative Definition of Price Stability
The Safety Margin“The Governing Council agreed that in the pursuit of price stability it will aim to maintain inflation rates close to 2% over the medium term. This clarification underlines the ECB's commitment to provide a sufficient safety margin to guard against the risks of deflation. It also addresses the issue of the possible presence of a measurement bias in the HICP and
the implications of inflation differentials within the euro area.”
The Safety Margin“The Governing Council agreed that in the pursuit of price stability it will aim to maintain inflation rates close to 2% over the medium term. This clarification underlines the ECB's commitment to provide a sufficient safety margin to guard against the risks of deflation. It also addresses the issue of the possible presence of a measurement bias in the HICP and
the implications of inflation differentials within the euro area.”HICP inflation in selected euro area countries(y-o-y; non-seasonally adjusted)
0
1
2
3
4
5
6
Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07
DE
FR
IT
ES
PT
NL
GR
U2
The Safety Margin“The Governing Council agreed that in the pursuit of price stability it will aim to maintain inflation rates close to 2% over the medium term. This clarification underlines the ECB's commitment to provide a sufficient safety margin to guard against the risks of deflation. It also addresses the issue of the possible presence of a measurement bias in the HICP and
the implications of inflation differentials within the euro area.”
The Safety Margin“The Governing Council agreed that in the pursuit of price stability it will aim to maintain inflation rates close to 2% over the medium term. This clarification underlines the ECB's commitment to provide a sufficient safety margin to guard against the risks of deflation. It also addresses the issue of the possible presence of a measurement bias in the HICP and
the implications of inflation differentials within the euro area.”
Euro Adoption: The Euro Area Perspective
Benefits One Currency, One Europe
Improvements in production efficiency
Completion of Internal Market for Goods, Services, Labor, Capital
Euro Adoption: The Euro Area Perspective
Benefits One Currency, One Europe
Improvements in production efficiency
Completion of Internal Market for Goods, Services, Labor, Capital
Challenges Lack of Convergence Could Mean Lasting Divergences
in EMU
Persistent Divergences Mean Persistent Negative Spill-Overs
Euro Adoption: Individual Country Perspective
ECB
Benefits Faster Real Convergence: Trade Expansion, Lower
Interest Rates and Transaction Costs
Credible Policy Environment : Protection Against External Crises
Euro Adoption: Individual Country Perspective
ECB
Benefits Faster Real Convergence: Trade Expansion, Lower
Interest Rates and Transaction Costs
Credible Policy Environment : Protection Against External Crises
Challenges Suboptimal Policies if Business Cycles are Misaligned
Risk of Asymmetric Shocks
Loss of Monetary Autonomy and the Exchange Rate as Policy Tools: New Adjustment Channels
Euro Adoption: Convergence Criteria
ECB
Maastricht Criteria Price Stability
Fiscal Position: General Government Deficit and Debt
Exchange Rate
Long-Term Interest Rate
Other Factors: Market Integration and Current Account Positions
Legal Convergence Compatibility of National Legislation is Also Examined
Every Second Year (May 2008), ECB-EC Report on State of Convergence
Strict Interpretation and Application
No Hierarchy
To Be Met on Actual Data
Consistent, Transparent, Simple Application
To Be Achieved on a Lasting Basis
Euro Adoption: ECB’s Convergence Assessment
Euro Adoption: Two Polar Options
Source: ECB.
annual percentage change, sa
Inflation Targeting Regimes Achieve Real Appreciation through Low Domestic
Inflation And Nominal Appreciation
Czech Republic, Hungary, Poland, Romania, Slovakia
Euro Adoption: Two Polar Options
Source: ECB.
annual percentage change, sa
Inflation Targeting Regimes Achieve Real Appreciation through Low Domestic
Inflation And Nominal Appreciation
Czech Republic, Hungary, Poland, Romania, Slovakia
Hard Pegs Achieve Real Appreciation through Exchange Rate
Stability And High Domestic Inflation
Bulgaria, Estonia, Latvia, Lithuania
Euro Adoption: Two Polar Options
Source: ECB.
annual percentage change, sa
Inflation Targeting Regimes Achieve Real Appreciation through Low Domestic
Inflation And Nominal Appreciation
Czech Republic, Hungary, Poland, Romania, Slovakia
Hard Pegs Achieve Real Appreciation through Exchange Rate
Stability And High Domestic Inflation
Bulgaria, Estonia, Latvia, Lithuania
Is There a Better Way?
Hard Pegs Performed Better But Starting GDP-per-Capita Was Lower
Real GDP Growth
HARD PEGS FLOATERS
Lines: unweighted average. Shaded areas: maximum-minimum.
Real GDP growth (in %)
-10
-5
0
5
10
15
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-10
-5
0
5
10
15
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
GDP per capita(PPP, % of euro area)
Hard pegs Floaters
1997 30.8 44.0
2006 49.3 54.3
Substantial Reduction and Less Dispersion in Hard-Pegs
Unemployment
HARD PEGS FLOATERS
Bulgaria included from 2000 onwards. Latvia, Lithuania, Czech Republic and Slovakia excluded in 1997.
Unemployment (% of labour force)
0
2
4
6
8
10
12
14
16
18
20
1997 1998 1999 2000 2001 2002 2003 2004 2005 20060
2
4
6
8
10
12
14
16
18
20
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Disciplinary Effect of Exchange Rate Regimes
Fiscal Performance
HARD PEGS FLOATERS
Romania excluded in 1997.
General government balance (% of GDP)
-12
-10
-8
-6
-4
-2
0
2
4
6
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-12
-10
-8
-6
-4
-2
0
2
4
6
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Initially, Lower in Hard Pegs … But on a Rise
Inflation
HARD PEGS FLOATERS
Bulgaria excluded in 1997.
Annual HICP inflation (in %)
0
5
10
15
20
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 20060
5
10
15
20
25
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Hard Pegs Experience Easing of Monetary Conditions
Real Interest Rates
HARD PEGS FLOATERS
Bulgaria, Latvia, Lithuania and Romania excluded in 1997
1) Defined as nominal 3-month interest rates minus actual HICP inflation.
Real short-term interest rates (in %)1)
-10
-5
0
5
10
15
20
25
30
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-10
-5
0
5
10
15
20
25
30
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Accelerating Growth in Hard Pegs
Credit Conditions
HARD PEGS FLOATERS
Czech Republic, Romania and Slovakia included from 2003, 2005 and 2000 onwards, respectively. Hungary and Latvia excluded in 1997.
Annual credit growth (to the private sector, in %)
0
10
20
30
40
50
60
70
1997 1998 1999 2000 2001 2002 2003 2004 2005 20060
10
20
30
40
50
60
70
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Stocks of credit(% of GDP)
Hard pegs Floaters
2005 54.8 33.8
Widening Deficits for Hard Pegs
External Imbalances
HARD PEGS FLOATERS
Current account balance (in % of GDP)
-25
-20
-15
-10
-5
0
5
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-25
-20
-15
-10
-5
0
5
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
General Patterns
• Situation Differs from Country to Country
General Patterns
• Situation Differs from Country to Country
• But There Is a Pattern
General Patterns
• Situation Differs from Country to Country
• But There Is a Pattern Hard Pegs Catch Up Rapidly And Enjoy Fiscal
Sustainability
Monetary policy has more room to maneuver in floating regimes: nominal appreciation and lower inflation
Both strategies can lead to euro adoption: Slovenia (2007) and Slovakia (2009)
Free capital mobility within the EU constraints domestic policy options to address evolving instabilities
General Patterns
• Situation Differs from Country to Country
• But There Is a Pattern Hard Pegs Catch Up Rapidly And Enjoy Fiscal
Sustainability
Monetary policy has more room to maneuver in floating regimes: nominal appreciation and lower inflation
Both strategies can lead to euro adoption: Slovenia (2007) and Slovakia (2009)
Free capital mobility within the EU constraints domestic policy options to address evolving instabilities
• Reinforcing Policies Seem Necessary Fiscal
Structural
Supervision
Conclusions
• Price Stability is The Primary Objective of Monetary Union
• Current Definition Builds In Sufficient Margin To Account for Lasting Differentials
• But There Are Sizeable Risks If Convergence Is Insufficient
Conclusions
• Price Stability is The Primary Objective of Monetary Union
• Current Definition Builds In Sufficient Margin To Account for Lasting Differentials
• But There Are Sizeable Risks If Convergence Is Insufficient
• Convergence Has to Be Achieved Against High Capital Mobility
• This Is a Blessing But Can Become a Challenge If It Means Loss of Domestic Macroeconomic Control
• Reinforcing Policies Are Essential To Ensure Domestic Stability
Thank You
Inflation Differentials
Dispersion of annual inflation across euro area countries, the 14 US MetropolitanStatistical Areas (MSAs) and the 4 US census regions(unweighted standard deviation in percentage points)
Sources: Eurostat and US Bureau of Labor Statistics.
Euro area data up to Mar 2008. US 4 regions up to Feb 2008 and US 14 MSAs up to Dec 2007.
0.0
1.0
2.0
3.0
4.0
5.0
6.0
7.0
19901991
19921993
19941995
19961997
19981999
20002001
20022003
20042005
20062007
2008
Stage Iof EMU
Stage IIof EMU
Stage IIIof EMU
Euro area (12 countries)
United States(14 MSAs)
United States (4 census regions)
Euro area(13 countries, incl. Slovenia)
Euro area (15 countries, incl. Cyprus and Malta)
Productivity Growth Differentials
Labour productivity (GDP per person employed), average annual rates in percent.
Balassa-Samuelson for New Member States
High Investment and Low Savings
Current account balance(in % of GDP)
2005 2006 2007 Q1Bulgaria -11.9 -15.8 -17.3Estonia -10.2 -14.7 -15.7Latvia -13.1 -21.1 -23.5Lithuania -7.7 -10.8 -11.5
Investment, saving and current account, 2006(in percentages of GDP)
31.938.2 38.0
27.026.7
-15.6 -14.8-20.9
-11.5
-0.2
21.617.016.2 16.2
21.3
-30
-20
-10
0
10
20
30
40
Bulgaria Estonia Latvia Lithuania euro area
Investment Saving Current account
External Imbalances: Hard Pegs
High Level of Exposure
Exposure to Exchange Rate Risk: Hard Pegs
Selected New EU Member States: Foreign currency loans, 2004-06
2004 2005 2006
Foreign currency loans to private sector (share in total loans, percent)
Floaters
Czech Republic 11.2 10.0 10.4
Hungary 39.0 45.9 49.5
Poland 25.3 25.9 27.0
Slovakia 21.5 22.5 20.0
Romania 58.2 58.9 48.2Average (unweighted) 31.0 32.6 31.0
Hard pegs
Bulgaria 46.1 48.4 45.7
Estonia 80.0 79.3 77.6
Latvia 60.6 69.8 76.8
Lithuania 57.2 65.0 52.2Average (unweighted) 61.0 65.6 63.1
The state of economic convergence
HICP inflation(average annual percentage change)
1.5
4.3
1.22.2
2.73.5
4.3
6.77.4 7.5
8.39.4
12.3
5.54.4
2.23.2
2.0
0
2
4
6
8
10
12
14
Sweden Slovakia Poland Czech Rep. Romania Lithuania Hungary Estonia Bulgaria Latvia
0
2
4
6
8
10
12
14December 2006 CR May 2008 CR Reference value May 2008 (3.2%)
Source: Eurostat. For Lithuania the first observation is from the May 2006 Convergence Report. The reference value was 2.6% in May 2006 and 2.8% in December 2006.
The state of economic convergence
General government surplus (+) or deficit (-)(percentage of GDP)
3.02.3
-0.5
-3.6-2.5
-3.1
-7.8
3.5 3.4
-1.6 -2.0 -2.2 -2.5
-5.5
0.1
2.8
0.0
-1.2
-10
-8
-6
-4
-2
0
2
4
Sweden Bulgaria Estonia Latvia Lithuania Czech Rep. Poland Slovakia Romania Hungary
-10
-8
-6
-4
-2
0
2
4
December 2006 CR May 2008 CR Reference value (-3%)
Source: Eurostat. The reference year in the 2006 Convergence Reports was 2005; in the May 2008 CR it was 2007. For Lithuania the first observation is from the May 2006 Convergence Report.
The state of economic convergence
General government gross debt(percentage of GDP)
4.5
12.1
34.5
50.4
42.0
61.7
3.4
9.713.0
17.3 18.2
28.7 29.4
45.2
66.0
18.7
30.4
40.6
0
10
20
30
40
50
60
70
80
Estonia Latvia Romania Lithuania Bulgaria Czech Rep. Slovakia Sweden Poland Hungary
0
10
20
30
40
50
60
70
80December 2006 CR May 2008 CR Reference value (60%)
Source: Eurostat. The reference year in the 2006 Convergence Reports was 2005; in the May 2008 CR it was 2007. For Lithuania the first observation is from the May 2006 Convergence Report.
The state of economic convergence
Participation in ERM II with effect from
Bulgaria -
Czech Republic -
Estonia 28 June 2004
Latvia 2 May 2005
Lithuania 28 June 2004
Hungary -
Poland -
Romania -
Slovakia 25 November 2005, revaluation on 19 March 2007
Sweden -
The state of economic convergence
Long-term interest rates(in percentages, annual average)
3.7 3.84.3
3.7 3.9
5.2
7.1
4.24.5 4.5 4.6 4.7
5.4
7.1
5.7
6.9
0
1
2
3
4
5
6
7
8
Sweden Czech Rep. Slovakia Lithuania Bulgaria Latvia Poland Hungary Romania0
1
2
3
4
5
6
7
8December 2006 CR May 2008 CR Reference value May 2008 (6.5%)
Sources: Eurostat and ECB. Estonia does not have a harmonised long-term interest rate. For Lithuania the first observation is from the May 2006 Convergence Report. The reference value was 5.9% in May 2006 and 6.2% in December 2006.
Cross-country overview - key challenges
Further fiscal policy efforts are needed, in particular the implementation of credible fiscal consolidation paths.
Wage increases should not exceed labour productivity growth and should take into account labour market conditions and developments in competitor countries.
Continued efforts to reform product and labour markets are needed to increase flexibility and maintain favourable conditions for economic expansion and employment growth.
The conduct of a stability-oriented monetary policy is crucial to the achievement of lasting convergence towards price stability.