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The ECB’s Monetary Policy Strategy
and the Euro Area Enlargement
Massimo Rostagno
European 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
Comparison: The Fed
•
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]
Why Price Stability in the Medium Term?
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
 Evidence (Benati, 2007): 1% permanent increase in inflation
now would cut GDP level 10 years from now by
1.3%-2.3%
The Quantitative Definition of Price Stability
• 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
Comparison: The Fed
Quantitative Definition of Price Stability
Why not
Why
– Asymmetry within Dual Mandate
– Anchor for inflation expectations
– Price index measurement uncertainty
– Yardstick for accountability
– “Minimal incremental benefits” given
proven commitment to price stability
– Makes long-run commitment to price
stability binding in the short run
Average
Euro area
US
Break - even inflation rates 1)
(percentage per annum)
Long-term inflation expectations 2)
(percentage per annum)
Sensitivity of long-term inflation
forecasts to short-term inflation
forecasts
Standard deviation
Euro Area
US
2002-2007*
2.06
2.21
0.15
0.40
1990-1998
1999-2007*
2.80
1.86
3.49
2.47
0.44
0.08
0.47
0.14
1995-2002
0.075
0.216
Sources: Consensus Economics Forecast, Reuters and ECB internal calculations.
*Data refers to up to June 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).
The Quantitative Definition of Price Stability
 Was price stability conducive to macroeconomic stability?


Low inflation volatility …
… did not de-stabilize real activity
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
The Quantitative Definition of Price Stability
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
… 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
The Quantitative Definition of Price Stability
Inflation (and Growth) Differentials across Countries
… 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
The Quantitative Definition of Price Stability
Inflation Differentials across Euro Area Countries
Table: “Steady-state” inflation rates implied by Balassa-Samuelson effects according to
selected studies.
Sample
Alberola
and
Tyrväinen
HICP
proxy
IMF
(1999a)
Canconeri
et al.
De Grauwe &
Skudelny
Sinn &
Reutter
IMF
1960-96
73-97
1971-95
87-95
2.0
1.9
2.7
2.3
1.9
3.4
1.9
2.3
2.5
2.7
2.3
2.0
1.5
0.4
3.8
1.5
2.8
2.8
3.0
2.7
1.6
4.3
2.9
2.0
2.8
0.9
2.6
1.0
2.4
2.4
2.8
1.8
2.4
2.0
1.8
0.6
2.1
1.7
2.0
1.6
2.4
2.0
2.5
2.1
1.4
2.0
1.1
0.3
1.8
1.0
5.3
2.5
2.3
3.4
2.5
2.4
2.4
1.8
3.7
2.0
4.3
1.1
Average
of all
columns
Actual
average
HICP1995
-2002**
2.6
1.4
3.6
2.5
2.1
3.3
2.5
2.1
2.2
2.7
2.5
2.0
2.2
0.6
1.7
1.3
3.8*
3.0
1.5
3.1
2.8
2.5
1.5
3.0
1.6
1.9
2.5
0.8
1975-95
Belgium
Germany
Greece
Spain
France
Ireland
Italy
Netherlands
Austria
Portugal
Finland
Euro area
Max-min
Standard dev.
3.1
1.3
3.1
1.7
2.4
2.3
1.8
2.4
2.0
1.8
0.6
* = Greece since 1997.
** = average of monthly inflation rates.
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)
6
DE
5
FR
IT
4
ES
PT
3
NL
2
GR
U2
1
0
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
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
Benefits

Faster Real Convergence:Trade Expansion, Lower Interest Rates
ECB
and Transaction Costs

Credible Policy Environment : Protection Against External Crises
Euro Adoption: Individual Country Perspective
Benefits

Faster Real Convergence:Trade Expansion, Lower Interest Rates
ECB
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
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
ECB
Legal Convergence

Compatibility of National Legislation is Also Examined
Euro Adoption: ECB’s Convergence Assessment
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: Two Polar Options
annual percentage change, sa
Inflation Targeting Regimes

Achieve Real Appreciation through Low Domestic Inflation And
Nominal Appreciation

Czech Republic, Hungary, Poland, Romania, Slovakia
Source: ECB.
Euro Adoption: Two Polar Options
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
Source: ECB.
Euro Adoption: Two Polar Options
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?
Source: ECB.
Real GDP Growth
Real GDP growth (in %)
HARD PEGS
FLOATERS
15
15
10
10
5
5
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-5
-10
-5
-10
Lines: unweighted average. Shaded areas: maximum-minimum.
 Hard Pegs Performed Better
 But Starting GDP-per-Capita Was Lower
GDP per capita
(PPP, % of euro area)
Hard pegs
1997
30.8
2006
49.3
Floaters
44.0
54.3
Unemployment
Unemployment (% of labour force)
HARD PEGS
FLOATERS
20
20
18
18
16
16
14
14
12
12
10
10
8
8
6
6
4
4
2
2
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Bulgaria included from 2000 onwards. Latvia, Lithuania, Czech Republic and Slovakia excluded in 1997.
 Substantial Reduction and Less Dispersion in Hard-Pegs
Fiscal Performance
General government balance (% of GDP)
HARD PEGS
FLOATERS
6
6
4
4
2
2
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-2
-2
-4
-4
-6
-6
-8
-8
-10
-10
-12
-12
Romania excluded in 1997.
 Disciplinary Effect of Exchange Rate Regimes
Inflation
Annual HICP inflation (in %)
HARD PEGS
FLOATERS
25
25
20
20
15
15
10
10
5
5
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Bulgaria excluded in 1997.
 Initially, Lower in Hard Pegs
 … But on a Rise
Real Interest Rates
Real short-term interest rates (in %)1)
HARD PEGS
FLOATERS
30
30
25
25
20
20
15
15
10
10
5
5
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-5
-5
-10
-10
Bulgaria, Latvia, Lithuania and Romania excluded in 1997
1) Defined as nominal 3-month interest rates minus actual HICP inflation.
 Hard Pegs Experience Easing of Monetary Conditions
Credit Conditions
Annual credit growth (to the private sector, in %)
HARD PEGS
FLOATERS
70
70
60
60
Stocks of credit
50
50
40
40
30
30
20
20
10
10
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
(% of GDP)
2005
Hard pegs
Floaters
54.8
33.8
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Czech Republic, Romania and Slovakia included from 2003, 2005 and 2000 onwards, respectively. Hungary and Latvia excluded in 1997.
 Accelerating Growth in Hard Pegs
External Imbalances
Current account balance (in % of GDP)
HARD PEGS
FLOATERS
5
5
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
-5
-5
-10
-10
-15
-15
-20
-20
-25
-25
 Widening Deficits for Hard Pegs
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 Metropolitan
Statistical Areas (MSAs) and the 4 US census regions
(unweighted standard deviation in percentage points)
7.0
Stage II
of EMU
Stage I
of EMU
6.0
Stage III
of EMU
Euro area (15 countries,
incl. Cyprus and Malta)
Euro area
(12 countries)
5.0
Euro area
(13 countries, incl. Slovenia)
4.0
3.0
United States
(4 census regions)
2.0
1.0
United States
(14 MSAs)
0.0
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
19
00
20
01
20
02
20
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.
03
20
04
20
05
20
06
20
07
20
08
20
Productivity Growth Differentials
Labour productivity (GDP per person employed), average annual rates in percent.
Balassa-Samuelson for New Member States
External Imbalances: Hard Pegs
Investment, saving and current account, 2006
(in percentages of GDP)
Investment
Current account balance
(in % of GDP)
2005
Bulgaria
-11.9
Estonia
-10.2
Latvia
-13.1
Lithuania
-7.7
40
38.2
2007 Q1
-17.3
-15.7
-23.5
-11.5
20
Current account
38.0
31.9
27.0
26.7
30
2006
-15.8
-14.7
-21.1
-10.8
Saving
17.0
16.2
16.2
21.6 21.3
10
-0.2
0
-10
-20
-15.6
-11.5
-14.8
-20.9
-30
Bulgaria
 High Investment and Low Savings
Estonia
Latvia
Lithuania
euro area
Exposure to Exchange Rate Risk: Hard Pegs
Selected New EU Member States: Foreign currency loans, 2004-06
2004
Foreign currency loans to private sector
2005
2006
(share in total loans, percent)
Floaters
Czech Republic
Hungary
Poland
Slovakia
Romania
Average (unweighted)
11.2
39.0
25.3
21.5
58.2
31.0
10.0
45.9
25.9
22.5
58.9
32.6
10.4
49.5
27.0
20.0
48.2
31.0
46.1
80.0
60.6
57.2
61.0
48.4
79.3
69.8
65.0
65.6
45.7
77.6
76.8
52.2
63.1
Hard pegs
Bulgaria
Estonia
Latvia
Lithuania
Average (unweighted)
 High Level of Exposure
The state of economic convergence
HICP inflat ion
(average annual percentage change)
December 2006 CR
May 2008 CR
Reference value May 2008 (3.2%)
14
12.3
12
12
9.4
10
10
8.3
7.5
7.4
8
6.7
5.5
6
4.4
4.3
3.5
3.2
4
2
14
1.5
2.0
2.2
2.2
8
6
4.3
4
2.7
1.2
2
0
0
Sweden
Slovakia
Poland
Czech Rep. Romania
Lithuania
Hungary
Estonia
Bulgaria
Latvia
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)
December 2006 CR
4
2
3.0
3.5
3.4
2.3
May 2008 CR
Reference value (-3%)
4
2.8
2
0.1 0.0
0
-2
0
-0.5
-1.2
-4
-1.6
-3.6
-2
-2.0
-2.5
-2.2
-3.1
-2.5
-6
-8
-4
-5.5
-7.8
-10
Sweden
Bulgaria
Estonia
Latvia
Lithuania Czech Rep.
Poland
Slovakia
Romania
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.
-6
-8
-10
Hungary
The state of economic convergence
General government gross debt
(percentage of GDP)
80
December 2006 CR
May 2008 CR
80
Reference value (60%)
66.0
61.7
70
60
70
60
50.4
50
40.6
40
30.4
28.7
30
18.7
17.3
20
10
12.1
9.7
45.2
42.0
50
40
34.5
29.4
30
18.2
20
13.0
10
4.5 3.4
0
0
Estonia
Latvia
Romania
Lithuania
Bulgaria
Czech Rep.
Slovakia
Sweden
Poland
Hungary
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-t erm int erest rat es
(in percentages, annual average)
December 2006 CR
8
May 2008 CR
Reference value May 2008 (6.5%)
7.1
7
5.4
6
5
4
4.2
3.7
4.5
4.6
4.3 4.5
3.8
5.2
6.9
7.1
7
5.7
6
4.7
5
3.9
3.7
8
4
3
3
2
2
1
1
0
0
Sweden
Czech Rep.
Slovakia
Lithuania
Bulgaria
Latvia
Poland
Hungary
Romania
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.