The European Central Bank (ECB) Governing Council on 29 March 2001
confirmed its position of "wait and see" with regard to its monetary policy
stance. Is this policy too cautious? This is one of the questions answered in the
forthcoming release of the Economic Survey of Europe 2001, No. 1 which will be
issued on 10 May 2001 by the United Nations Economic Commission for Europe (UNECE).
"The ECB is now the only central bank among the G-7 not to lower
interest rates in the wake of the cuts made by the Federal Reserve" stresses Paul
Rayment, Acting Deputy Executive Secretary of the United Nations Economic Commission for
Europe (UNECE) "There can be little doubt that a lowering of interest rates would be
a help for economic growth."
No serious inflation threat
The reason for the Bank’s policy is the assumption that the
balance of risks facing the euro area, between higher inflation and lower growth, are
"evenly balanced", even though the economic environment is now very different
from when it first set its key interest rate at 4.75 per cent in October 2000. Since then
activity has slowed sharply, especially in Germany, where the prospective stimulus of tax
cuts has been somewhat offset by the weakness of net exports and construction activity.
Forecasts for 2001 have been generally lowered and business confidence has fallen. Most
observers and forecasters are unable to see any serious inflation threat. The prospect of
the large rise in oil prices triggering an upturn in inflation was dismissed by most
forecasters and their prediction that the risk in oil prices would be temporary proved to
be correct. Indeed the impact of higher oil prices in lowering effective demand seems to
have been more important than its effect on the underlying inflation rate.
Neither of the two pillars of the ECB’s monetary policy strategy
stand in the way of a reduction in the interest rates. Money supply growth has been
slowing down and was approaching the reference value of 4.5 per cent in the first quarter
of 2001. In any case, it can be argued that the derivation of the reference value is based
on rather cautious estimates of potential output growth and the trend decline in money
velocity. Inflationary expectations are, moreover, quite moderate. The ECB’s own
Survey of Professional Forecasters shows that inflation is expected to average 2 per cent
in 2001 declining to 1.7 per cent by December 2001 and remaining at an average of 1.7 per
cent in 2002. Long-term inflationary expectations are even lower. Thus, the inflation rate
implied by the difference between yields on French nominal and real (i.e. price index
linked) bonds which mature in 2009 was only 1.4 per cent at the end of February 2001. It
is true that the actual inflation rate was about half a percentage point above the
ECB’s target rate of 2 per cent in February 2001, but the underlying, core rate of
inflation is well below that and there is no sign of any acceleration in prices or in
average wages.
Not sufficiently forward looking
"It may be argued that the current situation constitutes a dilemma
for monetary policy because a lowering of interest rates when inflation is above target
could compromise the ECB’s efforts to establish its credibility," says Paul
Rayment. "On the other hand, there is general awareness that this overshooting of the
inflation target reflects specific circumstances, mainly the sharp rise in oil prices, the
effects of which have already started to diminish. And in view of the deteriorating
external environment, the risks to both output and inflation are tilted to the
downside."
In any case, given the long and variable lags with which monetary
policy affects inflation, the actual inflation rate is not the appropriate focus for
monetary policy. The objective is to maintain price stability in the medium term and this
implies the need for a forward-looking, medium-term orientation of monetary policy, which
the ECB itself correctly emphasized in its first monthly report at the beginning of 1999.
This provides at the same time a degree of discretion for the conduct of monetary policy
to react to specific shocks in the short term without losing sight of the general
objective of price stability. It goes without saying that this also requires the provision
of clear explanations to the public as to why certain actions are taken or not. "But,
in practice, the bank’s actions appear to many observers not sufficiently forward
looking, and too sensitive to fluctuations in monthly price changes" adds Paul
Rayment.
The apparent deflationary bias of the ECB arises not only from its
actions but also from its terms of reference. Its target of 2 per cent inflation is
asymmetric in that it is not required to take any action when the actual rate is below it
for a sustained period of time (unlike the Bank of England, for example). Secondly, it has
no formal responsibility for other policy objectives such as growth or employment (unlike
the Federal Reserve, for example). Thirdly, there is no political influence on the setting
of the inflation target, which could provide such a broader view of policy. Finally, the
bank’s target rate of 2 per cent inflation is very low, especially when the
upward bias due to quality improvements and the effects of fixed base weights are taken
into account.
Lower interest rates for stronger growth
The ECB gives the impression that it believes nothing much has changed
in the past two decades as regards inflationary expectations and wage-setting behaviour.
At the end of January the bank’s focus was said to be "on avoiding possible
second-round effects of the temporary increase in inflation". These fears would
appear to discount heavily the many structural changes which have occurred in the world
and European economies in the last two decades. As a result disinflationary pressures are
now greater than at any time since the 1930s and there is no sign of the struggle over
functional income shares that triggered the wage-price spirals of the 1970s. In Europe
wage indexing has disappeared, union membership and strength have fallen drastically, and
all economies are vulnerable to the intense competitive pressures from the global economy.
The relation between inflation and the labour markets now appears to have returned to that
prevailing before the oil crises of the 1970s, or even earlier given that perceptions of
job insecurity in Europe seem to be greater than in the 1950s and 1960s. The examples of
the United States and the United Kingdom, as well as a number of smaller European
economies, suggest that expansionary policies can reduce unemployment now without setting
off a new inflation. But the key appears to be the need to have a coherent mix of policies
for employment and growth, not just a one-dimensional monetary policy.
"There would now appear to be a strong case for a sharp reduction
in euro area interest rates in order to tip the balance towards stronger growth in Europe
and offset the effects of weaker net exports to the rest of the world" stresses Paul
Rayment. The behaviour of the euro exchange rate against the dollar over the last two
years seems to be largely explained by capital flows responding to relative growth
prospects in Europe and the United States and, hence, to expectations of relative stock
prices. A large cut in euro interest rates is therefore likely to lead to an appreciation
of the euro, encourage investment and growth, and dampen further any residual inflationary
pressures in the system. (This goes against the view that it is the weakness of the euro
that is inhibiting the willingness of the ECB to lower interest rates.) "One of the
key lessons to be learned from the performance of the United States economy over the last
decade," concludes Paul Rayment, "is for policy to recognize the dynamic
interactions between growth expectations, fixed investment, rising productivity and
employment – and mild or falling inflation rates. This is not the new economy, but an
older one that was lost sight of during the crises of the 1970s and the disinflation of
the 1980s."
For further information please contact:
Economic Analysis Division
United Nations Economic Commission for Europe (UNECE)
Palais des Nations
CH - 1211 Geneva 10, Switzerland
Tel: (+41 22) 917 27 78
Fax: (+41 22) 917 03 09
E-mail: [email protected]
Website: http://www.unece.org/ead/ead_h.htm
Ref: ECE/GEN/01/06