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."
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