Download Quarterly Bulletin - Winter 2002

Quarterly Bulletin Winter 2002
Bulletin
Winter 2002
 Central Bank of Ireland 2002
Quarterly Bulletin Winter 2002
Notes
1. The permission of the Government has been obtained for the use in this Bulletin of certain material compiled by the Central
Statistics Office and Government Departments. The Bulletin also contains material which has been made available by the courtesy
of licensed banks and other financial institutions.
2. Unless otherwise stated, statistics refer to the State, i.e., Ireland exclusive of Northern Ireland.
3. In some cases, owing to the rounding of figures, components do not add to the totals shown.
4. The method of seasonal adjustment used in the Bank is that of the US Bureau of the Census X-11 variant.
5. Annual rates of change are annual extrapolations of specific period-to-period percentage changes.
6. The following symbols are used:
e
estimated
n.a. not available
p
provisional
..
no figure to be expected
r
revised
—
nil or negligible
Q
quarter
f
forecast
7. As far as possible, data available at end-September 2002 are included in the Statistical Appendix (Section 3).
8. Updates of selected Tables from the Statistical Appendix, concerning monetary and financial-market developments, are provided
in Monthly Statistics. Data on euro exchange rates, Irish Government bond yields and on the Irish equity index are provided daily
on recorded telephone message (Telephone: 353 1 4344399).
Originated and Printed by:
Cahill Printers Ltd., East Wall Road, Dublin 3.
Designed by:
Keystrokes Ltd., Brunswick House, Brunswick Place, Dublin 2.
Paper: 100% Chlorine Free Product.
Enquiries relating to this Bulletin should be addressed to:
Central Bank of Ireland (Publications), P.O. Box No. 559, Dame Street, Dublin 2.
Telephone 4344000; Telex 31041; Fax 6716561; www.centralbank.ie
ISSN 0332-2645
Quarterly Bulletin Winter 2002
Contents
Page
SECTION 1
Comment
The Domestic Economy — Real and Financial Developments
Box: Monetary Policy Implementation by the Central Bank of Ireland
5
11
35
Domestic Prices, Costs and Competitiveness
37
An Timpeallacht Gheilleagrach
49
Developments in the International and Euro Area Economy
53
SECTION 2
Japan: A Case History in Deflation — Anne Marie McKiernan
An Overview of Monetary Policy in the US — Karl Whelan
SECTION 3
Statistical Appendix
69
103
Quarterly Bulletin Winter 2002
Comment
Broad indicators of economic growth this year are pointing in
somewhat different directions. The level of Gross Domestic
Product (GDP) in the first half of the year was 51⁄2 per cent higher
than in the corresponding period of 2001. On the other hand,
growth in Gross National Product (GNP) — a better measure of
the country’s output available for domestic residents since it
excludes net factor income outflows, i.e. that part of domestic
income accruing to foreigners net of overseas earnings of Irish
residents — was a much more modest 2 per cent, year to year,
in the first half of this year. This unusually large gap between
GDP and GNP growth rates is due to a substantial increase in
net factor income outflows in the early part of the year.
For 2002 as a whole, GNP growth is now unlikely to be more
than 21⁄2 per cent. If achieved, this would be a relatively good
performance against the background of a weak international
economy, with forecasts of growth in the major economies
having been revised downwards through the year. Recent official
estimates point to growth of less than 1 per cent in the euro
area, 21⁄4 per cent in the US and negative growth in Japan. Irish
growth has been reduced sharply from 10.7 per cent two years
ago. As unemployment was at a very low level in early 2001
and capacity constraints had become apparent, it was generally
accepted that growth would have to decelerate, although the
speed and extent of the deceleration has been greater than
expected.
Over the five years to 2000, GNP growth averaged almost 9 per
cent a year, supported by an annual average employment growth
of 53⁄4 per cent. The various adverse shocks that were
experienced last year — the major downturn in the information
technology sector, the foot-and-mouth disease and the 11th
September terrorist attacks in the US — combined with the much
weaker international economic environment and domestic
supply constraints to bring about the sharp reduction in
economic growth.
The objective of macroeconomic policy, looking forward, should
be to help the economy to revert to a sustainable growth path
as rapidly as possible. An improvement in the international
economy is an indispensable factor in achieving this, although a
significant recovery seems unlikely to happen now until well into
2003. Because of this, and in the light of the recent Budget, the
Bank has reduced the forecast for GNP growth in 2003 to less
than 3 per cent and even this depends on a recovery in the
international economy. In general, the risks to this forecast are
predominantly on the downside.
5
Quarterly Bulletin Winter 2002
There are a number of areas within our control which, when
oriented in the right direction, would facilitate the resumption
of stronger sustainable growth when the international economic
situation improves. One of the principal problem areas for the
Irish economy since 2000 has been the inflation rate and the
related problem of competitiveness. Prior to the year 2000,
Ireland’s inflation rate (the Consumer Price Index) was very
moderate, averaging 1.8 per cent a year, for example, over the
three-year period to 1999. Over the three years to 2002,
however, inflation has stepped up considerably to an average of
about 5 per cent a year, and the absolute Irish price level is now
above the EU average. Inflation next year is still forecast to be
rather high with the indirect tax increases in the Budget largely
offset by the recent reductions in mortgage rates. The CPI
increase now looks likely to be about 41⁄4 per cent in 2003, with
the increase in the Harmonised Index of Consumer Prices
(HICP), which excludes mortgage rates, being about 4 per cent.
Part of this deterioration can be attributed to imported inflation
as a consequence of a sharp depreciation of the euro in 2000.
However, the persistence of high inflation was strongly facilitated
by a very rapid growth rate and expansionary macro policies. An
accommodating monetary policy, at least from the perspective
of Ireland where high inflation meant that real interest rates at the
wholesale level continued to be negative, gave a large impetus to
domestic demand. With the stance of monetary policy set to deal
with conditions in the euro area as a whole, this puts the onus
on fiscal policy to act as a restraining influence on domestic
inflationary pressures. Fiscal policy was expansionary in both
2001 and 2002. The evidence that the economy was straining
against capacity constraints was clear from the remarkably low
unemployment rate of 3.7 per cent reached in the first quarter of
2001 and generalised pressure on infrastructure. As the economy
recorded double-digit growth rates for several years, the strong
demand for labour also gave rise to a substantial pick-up in
wages — from increases of 41⁄2 per cent in 1998 to over 9 per
cent in 2001.
As the Bank has frequently advised, an acceleration in inflation
is quite difficult to halt as higher inflation expectations become
embedded in the behaviour of wage- and price- setters. An
example of this persistence is the high increase in average
industrial earnings per hour in the year to last June — 8.8 per
cent — even though labour market conditions have eased
considerably over the past year. The recent Budget and Public
Services Estimates published in mid-November represent a
relatively balanced response to the more difficult economic
environment. The planned increase in total General Government
spending — 7 per cent in 2003 — has been aligned more closely
to the expected increase in resources available. On balance, the
budget is estimated to have a mildly restrictive effect on
economic growth which was already forecast to be relatively
6
Quarterly Bulletin Winter 2002
weak in 2003. Because of the pressures on infrastructure it would
have been preferable to have less of the spending restraint fall
on the capital side. On the other hand, with building sector
inflation still running at about 6 per cent per annum, a temporary
easing of demand pressures in the construction sector may be
helpful.
It will be important for the evolution of wages to be consistent
with a return to a sustained lower rate of inflation. In recent
years, strong demand has driven the exceptionally high rate of
inflation in the services sector. In the indigenous manufacturing
sector in particular, moderate increases in pay are necessary to
ensure sound performance and viability. The relatively weak euro
in recent years has provided short term protection from growing
competitive pressures. As the Bank has frequently stated, and this
has been confirmed by a recent IMF study, these labour-intensive
sectors are quite exposed to a sharp loss in competitiveness if the
euro were to appreciate further from what many commentators
regard as its currently undervalued level. Another element in
containing inflation must be a commitment to continuing price
transparency and enhanced competition, particularly in the
services sector which, for the most part, does not face
international competition. As mentioned in the last Bulletin,
continued consumer education and awareness are also
potentially important aspects of ensuring that price inflation
conforms to what is needed to ensure a culture of stability.
Another area of concern is the continuing strong growth in
private sector credit in Ireland. Growth in the housing credit
segment of the market has been particularly robust, with the
pace of growth strengthening sharply between the first quarter
of this year, when it was running at a rate of 15.6 per cent, and
the third quarter when it was running at 23.5 per cent. This is
paralleled by a rapid acceleration in residential property prices
which, according to the latest data, show house prices rising by
10.4 per cent in the year to October. This occurred in the wake
of a fairly modest rebound in prices in the earlier part of the year.
There are a number of factors which may currently be impacting
on house prices — easy credit conditions along with the
expectations of a further easing, which has now been confirmed,
as well as the reversal, in the 2002 Budget, of some earlier tax
measures designed to discourage investors from the residential
property market. While there are a number of fairly strong
fundamental factors underlying demand such as demographics
and employment growth, the Bank is nonetheless concerned
about the recent re-acceleration in house prices. The concern is
heightened all the more because the increases are coming on the
back of house price levels that are already high by international
standards. The Governor has written to the chairpersons of credit
institutions about these concerns. The Bank will carefully monitor
the responses.
7
Quarterly Bulletin Winter 2002
International and euro area economy
The global economic recovery in 2002 has been weaker and
more uneven than expected. After a strong inventory-led upturn
in the first quarter, the recovery has lost momentum, even in
the US, where strong third quarter growth has been followed
by evidence of renewed weakness in more recent months. The
disappointing growth performance reflects the persistently high
degree of uncertainty which has prevailed from around the
middle of the year. This uncertainty has been driven by a number
of factors, the most important of which have been the
deterioration of equity and financial markets and the rise in
geopolitical tensions and their impact on oil markets. More
fundamentally, however, the recovery has been held back by the
fact that many of the significant economic and financial
imbalances which were generated in the preceding boom are
still in the process of being corrected. As a result of the scale of
the earlier investment boom, there is still an excess of production
capacity. Moreover, uncertainty over equity market valuations
remains a cause for concern.
Reflecting all of these developments, concerns about the strength
and sustainability of the recovery have grown. Financial market
developments have played a key role in this regard, with equity
market weakness a major factor in driving the deterioration in
business and consumer confidence in the second half of the year.
The evidence suggests that the fall in equity markets since the
Spring has offset the impact of earlier policy stimulus, even in
countries where fiscal easing has reinforced monetary policy
support for demand. This has occurred through two channels
— first, through the negative impact of the stock market fall on
household wealth and, second, through an adverse impact on
investment. While the strength of the housing market in some
countries, and the extent to which it has facilitated equity
extraction to support consumer spending, has mitigated some of
the weakness emanating from stock market developments,
wealth effects have been strongly negative in net terms.
Uncertainty about the growth outlook has also had a dampening
influence on labour markets, with unemployment rising in the
major economies. Allied to the negative wealth effect arising
from financial market developments, this has further undermined
consumer spending. In turn investment spending has been
constrained by the existing excess capacity and the uncertainty
about growth prospects. Against this background, domestic
demand in the major economies has remained subdued and the
recovery has stalled.
Turning to the Euro area, developments in recent months have
followed a broadly similar pattern. As the downside risks to
growth intensified over the course of 2002, the euro area
8
Quarterly Bulletin Winter 2002
recovery lost momentum. Consequently, the euro area economy
has now grown at a below trend rate for the past six quarters.
Moreover, the outlook suggests that a return to trend growth
is unlikely until the second-half of 2003. The subdued growth
performance and prospects reflect a number of developments.
First, with the initial impetus to recovery predicated on an upturn
in the global economy, the rise in uncertainty with regard to the
international economic outlook has had a dampening influence.
Second, the fall in euro area stock markets, which has been as
sharp as that in the U.S, has undermined both consumer
spending and investment. Even though euro area households and
firms have more limited exposure to equity markets than their
U.S counterparts, equity indices still act as a barometer of
economic performance. Against this background, recent months
have seen sharp falls in consumer and business confidence
across most euro area countries, reinforcing the prospect that
growth will remain subdued in coming quarters.
Despite the sluggishness of economic growth, however, euro
area inflation has been rather persistent. While this persistence
has partly reflected a series of transitory developments, such as
earlier oil and food price increases, structural rigidities in labour
markets have also played a role, as evidenced by wage
developments. As a result, inflation has remained above 2 per
cent for most of 2002. Base effects and the impact of indirect
tax increases are likely to prevent inflation falling below 2 per
cent in coming months. However, beyond the short-term, both
growth prospects and exchange rate developments should
contribute towards reducing inflationary pressure, and forecasts
suggest that inflation will fall below 2 per cent in 2003 and ease
further the following year.
With evidence growing that inflationary pressures have eased,
and with downside risks to growth still present, the ECB
Governing Council lowered interest rates by 50 basis points in
early December. By providing a counterweight to some of the
existing downside risks to economic growth, and supporting
confidence, this decision should help to improve the outlook for
the euro area economy. At present, the most likely scenario is
that, supported by the low level of interest rates, rising disposable
incomes and some improvements in the external environment,
economic growth will gradually recover in the course of 2003
towards rates more in line with potential.
9
Quarterly Bulletin Winter 2002
The Domestic Economy —
Real and Financial
Developments1
Overview
Following the sharp slowdown experienced by the domestic
economy during 2001, output growth strengthened in the early
part of this year. Industrial production and export volumes grew
quite strongly. Much of this recovery was, however, driven by
the chemicals sector and the impact on domestic incomes was
limited by the fact that the sector is not labour intensive and is
largely foreign-owned. By the middle of the year, industrial
production and export volumes were beginning to register
modest declines again, with relatively sluggish growth in external
markets and weaker foreign direct investment preventing a more
broadly based and sustained recovery. Domestic demand growth
also eased back this year reflecting a slowdown in income
growth combined with much weaker consumer confidence. The
broad services sector of the economy seems to have continued
to expand through the year, however, assisted by strong public
sector employment growth in the first part of the year. Overall,
the volume of GNP is estimated to have grown by about 21⁄2 per
cent this year, down from a figure of 4.6 per cent last year,
although, if net factor outflows remained strong in the latter part
of the year, a lower outcome is likely.
The international environment is expected to improve during the
course of next year after a quite tepid recent performance. The
effects of the sharp falls in stock prices which have occurred this
year should begin to fade and the cumulative effects of the
easing in the stance of economic policies should become more
evident. Assuming that the competitiveness of the domestic
economy is not adversely affected by, for example, a
combination of high wage inflation and an appreciating
exchange rate, this should promote a gradual but more
widespread and sustained recovery in export volumes. This
should, in turn, support domestic income growth and bolster
sentiment leading to a limited increase in private sector domestic
demand growth. Any pick-up in overall output growth seems set
to be modest, however, with the growth in real GNP volumes
unlikely to exceed 31⁄2 per cent in 2003.
1 The forecasts contained in this and the following chapter are based on the Central Bank of
Ireland’s contribution to the Eurosystem’s Broad Macroeconomic Projections. They were
produced in a manner consistent with the agreed assumptions for this exercise and with
the projection results for the euro area as a whole. The cut-off date for revisions to the
forecasts was in mid-November, although the text may refer to information available up to
the end of November. The forecasts do not take into account the impact of changes in
spending and taxation announced in the recent Budget or in the Public Expenditure
Estimates.
11
Quarterly Bulletin Winter 2002
Domestic demand helped to support overall output growth
during the external slowdown last year but it lost much of its
momentum this year. Consumer sentiment, which had recovered
from its sharp fall in the aftermath of the events of 11 September,
was eroded by high-profile job losses and rising, if still limited, in
unemployment. The ongoing deterioration in the public finances
may also have added to households’ uncertainty over their future
disposable incomes. The household savings rate appears to have
risen sharply this year, although consumer spending, excluding
cars sales, is still recording reasonably steady if modest growth.
Residential construction has also held up well, but spending on
non-residential construction, especially offices and industrial
property, has suffered from the emergence of over-capacity in
this sector. Public infrastructural expenditure did much to sustain
construction activity this year but this spending is likely to be
curtailed as a consequence of the deterioration in the public
finances. Machinery and equipment investment was badly
affected by the downturn in the international environment last
year and, although it picked up somewhat in the early part of this
year, it will probably not stage a more significant and sustained
recovery until the external environment becomes more positive
again.
As already noted, export growth recovered sharply at the
beginning of the year but much of this reflected a surge in output
by the broad chemicals sector. Most other exporting sectors did
not experience significant growth in the early part of the year. In
fact, export volumes began to drift downwards again from the
middle of the year reflecting the absence of a sustained recovery
in external demand. For the purpose of these forecasts, it is
assumed that there is a general improvement in the international
environment next year which brings about a broadly based
recovery in export growth. There are, however, a number of
downward risks to this outlook. It is unclear, for example,
precisely when demand growth in our main trading partners is
likely to strengthen. It is also possible that competitiveness
developments may be unfavourable. The euro could appreciate
further while domestic costs might rise at a more rapid rate than
currently projected. This would make it difficult to reap the
benefits of any improvement in the external environment.
The impact of the slowdown on the labour market has been
relatively muted. Unemployment has risen but the increase has
been smaller than might have been expected. There are a
number of possible reasons for this. Public sector employment
grew rapidly in the latter part of last year and the early part of
this year, helping to ease the impact on the labour market. Some
firms affected by a decline in output may also have held on to
workers in the expectation that conditions would improve in the
near future. This interpretation is supported by the fact that
average hours worked have fallen significantly. The private
12
Quarterly Bulletin Winter 2002
Table 1. Expenditure on Gross National Product 2001, 2002e and 2003f
2001
Personal Consumption Expenditure
Public Net Current Expenditure
Gross Domestic Fixed Capital Formation
of which:
• Building and construction
• Machinery and equipment
Value of physical changes in stocks
Statistical Discrepancy
% change in
2002e
% change in
2003f
\ million
Volume
Price
\ million
Volume
Price
\ million
55,144
15,288
26,670
3
8 1 ⁄4
2 1 ⁄4
5 1 ⁄4
6 3 ⁄4
4 1 ⁄4
59,798
17,673
28,492
33⁄4
11⁄2
23⁄4
33⁄4
51⁄2
33⁄4
64,372
18,924
30,346
18,050
8,620
279
221
2
3
6
1
19,516
8,976
200
221
2
4
51⁄2
−1⁄4
21,031
9,315
220
221
Gross Domestic Expenditure
Exports of goods and services
97,602
112,368
31⁄2
3 1 ⁄2
51⁄4
1 1 ⁄2
106,384
118,163
31⁄4
7
4
−1⁄4
114,083
126,256
Final Demand
Imports of goods and services
209,970
−95,491
31⁄2
2 1 ⁄2
31⁄4
3⁄
4
224,547
−98,554
51⁄4
61⁄2
13⁄4
3⁄
4
240,339
−105,587
Gross Domestic Product
Net factor income from rest of the world
114,479
−17,677
41⁄2
51⁄4
125,993
−20,585
41⁄4
21⁄2
134,752
−22,112
96,802
21⁄2
61⁄4
105,408
31⁄2
31⁄4
112,640
Gross National Product
services sector also seems to have maintained modest growth
through the year, which may have helped to absorb workers who
lost their jobs in the manufacturing sector. Some decline in
labour force participation may be another factor. Overall,
employment is estimated to have grown by about 11⁄4 per cent
this year with an average unemployment rate of 41⁄2 per cent.
Further employment growth is expected next year, but this is
unlikely to be enough to prevent the unemployment rate rising
to an average of about 5 per cent.
Domestic Demand
Personal Consumer Spending
Disposable incomes continued to grow quite strongly this year.
The total number of persons in employment increased in spite
of some high-profile job losses in certain sectors. Wage growth
moderated but remained quite high by international standards
and there were further tax reductions in the 2002 Budget.
Households were cautious about spending, however, and the
proportion of income that was saved rather than spent would
seem to have risen significantly. Surveys of consumer sentiment
indicate that confidence recovered towards the end of last year,
after falling sharply in the immediate aftermath of the events of
11 September, but declined again over the course of this year.
This reflected concerns over the prospects for disposable income
growth in the face of rising unemployment, general uncertainty
and the deterioration in the public finances.
In spite of the increase in the savings rate, consumer spending
still managed to record modest year-on-year growth this year.
Some categories of spending were more affected than others by
the deterioration in sentiment. Car sales were down 5.5 per cent
13
Quarterly Bulletin Winter 2002
Chart 1
Index of Volume of
Retail Sales
Year-On-Year % Change (SA)
16
14
12
10
8
in the first ten months of the year. The headline retail sales index
recorded growth of only 1.1 per cent in the first nine months but
the equivalent figure, excluding car sales, was considerably
higher at 2.9 per cent. Expenditure seems to have been
particularly weak in the second quarter, but the retail sales index
suggests that it strengthened again in the third quarter. The
pattern of indirect tax receipts also suggests that overall
consumer expenditure remained reasonably strong for the year
as a whole. Spending on services is likely to have been less
affected by changes in sentiment than items covered by the retail
sales index. Nevertheless, it seems unlikely that consumer
expenditure in national accounts terms will record growth of
more than 3 per cent for the year as a whole.
6
4
2
0
-2
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
'99
'00
'01
'02
All Businesses
Core (excluding Motor Trades)
Disposable income growth next year is likely to be more modest
than in recent years. Employment growth will probably not
strengthen in the short-term, even if external demand improves,
as some firms have probably held on to workers in the
expectation of an upturn. Wage growth is likely to be more
modest than this year, although still high by international
standards. The details of tax and social welfare changes in the
Budget have not been included in this forecast, as they were not
available at the time of writing, but it is assumed that, at a
minimum, no further reduction in direct taxes will occur. These
developments would tend to suggest that nominal disposable
income growth is likely to decelerate next year, although lower
inflation will ease the impact on real incomes somewhat.
The key development affecting consumer spending will,
however, be the evolution of the savings rate. It seems unlikely
that the increase in the savings rate that has occurred this year
will be repeated next year. The savings rate has already risen
sharply and sentiment has fallen to low levels. It would seem to
require another adverse shock to hit the economy for a similar
rise to occur again next year. If, on the other hand, there is some
improvement in the international environment, this will help to
bolster confidence. Developments in the public finances could
also play a role if there is a general perception that expenditure
growth is under control and the public finances have stabilised.
These developments could facilitate consumer spending growth
of about 33⁄4 per cent. On the other hand, if confidence remains
poor and households are uncertain about the future growth in
their real disposable income, a much weaker outcome would be
likely.
Government Consumption
The recently published national accounts for the second quarter
incorporated a very substantial upward revision to the year-onyear growth rate in the volume of government consumption in
the first quarter of this year. Taking this into account, along with
14
Quarterly Bulletin Winter 2002
the strong second quarter figure, would suggest an increase in
the estimated rate of growth for the year as a whole to about 81⁄4
per cent. This strong rate of growth mainly reflects increases in
public sector employment in the early part of this year. This
expansion is likely to have eased off as the year progressed and
the prospects are for a much lower rate of increase next year.
(These forecasts were compiled in advance of the Budget and
the projected increase of about 11⁄2 per cent for next year has to
be seen as highly tentative).
Investment
Investment demand growth has been negative, year-on-year,
every quarter since the second quarter of 2001. In the first half
of 2002, the volume of gross domestic fixed capital formation
was down 3 per cent, year-on-year. This was mainly due to a
sharp drop in equipment investment, which fell by around 61⁄2
per cent between the first half of 2001 and the first half of this
year. Construction investment, on the other hand, has held up
reasonably well so far and was up by around 1⁄2 per cent, yearon-year, in the first six months of 2002.
The downturn in economic activity has had a negative impact on
certain parts of the construction sector, most notably private nonresidential construction investment. New investment in office
and industrial premises has declined sharply and is unlikely to
recover significantly within the current forecast horizon. A more
serious slowdown in the construction industry has been
prevented by continued strong residential investment demand.
The most recent housing output data show that total completions
in the first half of 2002 were up 5.2 per cent on the first half of
last year, including an increase of 4.3 per cent in private housing
output. Government investment expenditure has also increased
strongly this year, including significant growth in social housing
and roads.
The prospects for the construction sector remain reasonably
favourable, although any significant cutbacks in public capital
growth could have a negative impact on the sector. As already
indicated, the non-residential private component of construction
demand is expected to remain quite subdued. On the other
hand, housing output continues to increase strongly. HomeBond
registrations, which give some indication of housing starts and
consequently serve as a leading indicator of housing output,
show an increase of 60 per cent, year-on-year, in the first 10
months of the year, albeit from a very low base figure for 2001.
It is estimated that the volume of construction investment
increased by around 2 per cent in 2002 and a similar rate of
growth is expected in 2003. The current forecast was, however,
finalised in mid-November. Given the decrease in capital
expenditure announced in the Public Expenditure Estimates, the
15
Quarterly Bulletin Winter 2002
risk to the current forecast for the construction sector for next
year must be on the downside.
There is considerable uncertainty regarding the prospects for
equipment investment. This component of aggregate demand
has traditionally been extremely volatile and difficult to predict.
The available data show a significant decline in equipment
investment since the start of the more general economic
slowdown during the second quarter of last year. Some recovery
was evident in the first quarter of 2002 but this has not been
maintained since then. Capital imports in the first eight months
are down just over 6 per cent, year-on-year. Figures published by
the Society of the Irish Motor Industry (SIMI) show that new
registrations of light commercial vehicles were down 11.8 per
cent and registrations of heavy commercial vehicles down 15.7
per cent, year-on-year, in the first ten months of 2002. It is
possible that some slight increase in total equipment investment
will be recorded for the year as a whole, although if this happens
it would be a reflection of the extremely weak second half of last
year rather than an indication of any significant resumption of
inward foreign investment growth. The weakness in the external
environment makes it unlikely that there will be any strong
rebound in equipment investment in the early part of 2003,
though the slight recovery in the information technology sector
provides some cause for optimism.
It is expected that investment in machinery and equipment might
increase by around 3 per cent this year with an increase in the
growth rate to around 4 per cent in 2003. Given the forecasts for
construction investment outlined above, this would imply total
investment growth of around 21⁄4 per cent in 2002 and 23⁄4 per
cent in 2003.
Stock Changes
According to the latest national accounts data, inventory
investment made a small negative contribution to growth last
year. This outcome is a little surprising in the light of the sharp
slowdown in output growth during the year but may reflect the
ability of the most affected sectors to avoid involuntary
accumulations of stocks. There was, however, evidence of
significant stock increases during the second quarter of this year.
Some of these may have been involuntary with both relatively
weak consumer demand domestically and on external markets.
It is likely that any involuntary stock accumulation was
subsequently unwound, however, and as a result, stock changes
are not expected to make much of a contribution to growth for
the year as a whole. Some modest voluntary accumulation of
stocks may occur next year, assuming that growth picks up but,
at this point, there would not seem to be a likelihood of any
major contribution to growth from stock accumulation.
16
Quarterly Bulletin Winter 2002
Merchandise Trade and the Balance of Payments
Merchandise Trade
Merchandise export volumes have exhibited a good deal of
volatility over the last two years. They bore the brunt of the
international downturn last year and ended the year down
significantly, year-on-year, in volume terms. There was a sharp
rebound in the first part of this year but this essentially reflected
a surge in output from the chemicals sector. The value of exports
from this broad sector was 21.5 per cent higher in the first eight
months of this year compared with the same months last year.
This increase was greater than the overall increase in the value
of exports. One of the main contributors to the year-on-year
decline in the value of the remainder of exports was the
downturn in the information technology sector.
Chart 2
Value of
External Trade
Year-On-Year % Change (SA)
30
25
20
15
10
By the middle of the year, export volumes were beginning to
show signs of weakness and appear to have drifted downwards
again. There are some positive indicators, however, in terms of
sectoral developments. In particular, the information technology
sector seems to be experiencing something of a recovery.
According to seasonally-adjusted industrial production data, the
output of office and data processing machinery was 18.8 per
cent higher in the third quarter compared with the previous
quarter, although some related sectors continued to decline. The
broad chemicals sector is still recording strong growth in yearon-year terms, but output seems to be declining again, following
its sharp rise in the early part of the year. The impact on domestic
incomes may be limited, however, by the sector’s low labour
intensity and the fact that it is largely foreign owned. Overall, it
seems likely that merchandise export volumes may grow by
about 21⁄4 per cent for the year as a whole, given the strength of
the initial recovery in the earlier part of the year. This modest
growth compares to a figure of 5 per cent in 2001 and over 19
per cent in 2000.
5
0
-5
-10
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
'99
'00
'01
'02
Exports
Imports
Considerable uncertainty remains over the timing and strength
of the international recovery. For the purposes of the forecast, it
is assumed that a gradual improvement takes place in external
demand through the course of next year. The prospects for a
recovery in export growth also depend critically on
competitiveness developments. If these are unfavourable, it will
not only inhibit any growth in exports by existing firms but also
limit the recovery in inward investment required to sustain export
growth in the longer-term. These forecasts assume an unchanged
euro exchange rate, although there is a risk that there could be
a significant and sustained appreciation of the euro against the
dollar or sterling that would impinge on the competitiveness of
the economy, especially if it took place against a background of
continuing high wage inflation. If these risks do not materialise
and the international economy recovers through next year, it
17
Quarterly Bulletin Winter 2002
Table 2. Merchandise Trade 2001, 2002e and 2003f
2001
\ million
Volume
Merchandise Exports (adjusted)
88,551
2 1 ⁄4
Merchandise Imports (adjusted)
−54,294
Trade Balance (adjusted)
34,257
2002e
% change in
3
% change in
2003f
Price
\ million
Volume
Price
\ million
⁄2
91,046
71⁄2
−11⁄4
96,532
−23⁄4
−54,402
5
−13⁄4
−56,137
1
36,644
40,395
should be possible to foresee a gradual pick-up in export
volumes to about 71⁄2 per cent, particularly if the information
technology sector experiences some improvement in demand
conditions internationally.
Merchandise import volumes displayed a rather similar pattern
to exports during the year. They recovered significantly from a
very low point at the end of last year but this rebound
subsequently ran out of momentum by about the middle of the
year and there are some indications of subsequent volume
declines. This mainly reflects the varying demand for inputs by
the exporting sectors, rather than developments in domestic
demand, although private consumption did ease back somewhat
in the second quarter. Merchandise trade prices remained rather
flat in the early part of this year but came under downward
pressure around mid-year reflecting the appreciation of the euro.
On the assumption of an unchanged exchange rate, they should
remain under downward pressure next year. A somewhat
surprising development has been the emergence of a significant
terms-of-trade gain, i.e. an increase in export prices relative to
import prices, towards the end of last year that was sustained
into this year. This may reflect compositional factors which may
not persist so that a repeat of this gain is unlikely next year.
Taking these volume and price trends into account, this would
suggest an increase in the merchandise trade surplus from \34.3
billion to about \36.6 billion this year and a further rise to \40.4
billion next year.
Services, Factor Incomes and International Transfers
Tourism earnings were affected this year by the impact on US
visitor numbers of the events of 11 September, although CSO
data for the first half of the year suggest a better than expected
performance, with an actual increase in overall earnings in yearon-year terms. Since expenditure by Irish residents abroad
showed very little change in year-on-year terms, the net balance
for tourism earnings also increased somewhat in the first half of
this year compared with the first half of 2001. The overall services
balance also looks set to put in a much better performance than
in recent years with a decline in the overall deficit in year-on-year
terms in the first half of the year. This reflects rather slow growth
in service imports, possibly related to the weak export
performance of some sectors. A more striking factor, however, is
18
Quarterly Bulletin Winter 2002
Table 3. Balance of Payments 2001, 2002e and 2003f
| million
2001
2002e
2003f
• Merchandise trade balance (adjusted)
• Services
34,257
−17,380
36,644
−17,035
40,395
−19,726
• Net factor income from rest of the world
• Current international transfers
−17,677
455
−20,585
415
−22,112
263
−345
(−1⁄4)
−561
(−1⁄2)
−1,180
(−1)
Current Account
Balance on current account
(% of GNP)
Capital and Financial Account
Balance on capital account
2001
2002
Second
2002
First
Quarter
Half
654
15
12
Financial Account
• Direct investment
• Portfolio investment
10,972
−19,893
1,428
256
1,751
−14,396
• Other investment
• Reserve assetsa
10,579
−441
−1,482
236
11,459
501
1,217
438
−684
−1,526
−663
674
Balance on financial account
Net errors and omissions
aChange in reserves on a transactions basis, i.e. excluding valuation adjustments. A minus figure equals a net increase in reserve.
the growth of service exports across a range of categories
including computer and business services. Although such
transactions can be volatile, it is clear that the services balance
for the year will record a better outcome than previously
expected.
Factor income outflows, by contrast, were exceptionally high in
the first half of the year. A significant outflow was expected,
reflecting the strong growth in output by the chemicals sector,
which is largely foreign-owned and has relatively low domestic
costs as a proportion of sales. Other factors appear to be at work,
however, as there was also a very significant deterioration in the
balance for some other categories of income, such as those
covering interest flows. These very large net outflows contributed
to the significant divergence between the growth rate of GDP
and GNP in the national accounts for the first two quarters. As
noted by the CSO, however, the timing of factor income
outflows with the rest of the world can affect the pattern of GNP
growth in the quarterly national accounts. While the factor
income balance can be subject to large volatile movements, it
seems likely, at this stage, that outflows for the year as a whole
will exceed previous expectations. Taking these developments
into account, along with a further reduction in receipts of
international transfers, the overall current account deficit seems
likely to increase marginally from \0.3 billion or 1⁄4 per cent of
GNP last year to about \0.6 billion or 1⁄2 per cent of GNP this
year and to \1.2 billion or 1 per cent of GNP next year.
19
Quarterly Bulletin Winter 2002
Capital and Financial Account
There was a small surplus of some \15 million on the Capital
Account in the second quarter of 2002, compared to a deficit of
\3 million in the first quarter of the year. The financial account
showed a net credit balance of \0.4 billion in the second quarter
of 2002, following a net debit balance of \1.1 billion in the
previous quarter. The balancing item, representing the errors and
omissions in the balance of payments as a whole, was a debit of
\0.7 billion in the second quarter of 2002.
Direct investment into Ireland of \4.6 billion in the second
quarter of 2002 was significantly higher than in the first quarter
of the year. Reinvested earnings, predominantly in the
manufacturing sector, contributed largely to these inflows.
Outward direct investment of \3.2 billion in the second quarter
was the highest for some years. This high level is explained by
large equity outflows from the IFSC sector with these transactions
accounting for 92 per cent of total direct investment outflows.
There were small net portfolio investment inflows of \0.3 billion
in the second quarter of 2002, compared to net outflows of
\14.7 billion in the previous quarter. Portfolio investment
outflows of \21.9 billion in the second quarter were less than
half the level recorded in the previous quarter. While all asset
categories in portfolio investment saw a decline in the second
quarter, the most marked reduction related to equity
investments, reflecting the downturn in equity markets
worldwide. Portfolio investment inflows of \22.1 billion in the
second quarter of 2002 were also almost \8 billion lower than
in the first quarter. Reduced inflows into IFSC enterprises
(particularly collective investment institutions), accounted for all
of this reduction.
Financial transactions, other than direct and portfolio investment,
resulted in net outflows of \1.5 billion in the second quarter of
2002, following net inflows of almost \13 billion in the previous
quarter. Transactions in loans, currency and deposits comprised
the largest component for both assets and liabilities. Most of
these transactions were between non-IFSC enterprises and
residents of other EU member states.
The official external reserves amounted to \5,351 million at endSeptember 2002, including a valuation write-up of \12 million.
Output Trends and the Labour Market
Industry and Services Output
Following the slowdown in the industrial sector last year, output
growth recovered strongly during the first half of 2002. For the
first nine months of this year, the volume of manufacturing
output increased by 9 per cent, year-on-year. The quarterly
20
Quarterly Bulletin Winter 2002
profile of output growth shows seasonally adjusted, quarter-onquarter, increases in the volume of output of 9.7 per cent and
6.2 per cent in the first and second quarters of this year,
respectively. The third quarter performance was much weaker,
however, with a seasonally adjusted drop in the volume of
manufacturing production of 6.3 per cent between the second
and third quarters.
This third quarter fall in output was largely a consequence of a
drop of almost 20 per cent in the production of basic chemicals.
In recent years, the contribution of this sub-sector of
manufacturing, which in 2001 accounted for around one third of
total gross value added in manufacturing (in 1995 prices) but less
than 3 per cent of industrial employment, has tended to
dominate developments in the industrial sector. As indicated
before in this Bulletin, the weighting of the chemicals sector in
the CSO industrial output series, according to its share of total
gross value added, can largely determine aggregate industrial
output developments. This tends to overstate its relevance for
the domestic economy because the share of domestic
expenditures in its gross value added is low and a substantial
proportion of its profits are repatriated to the country of
ownership.
Chart 3
Volume of
Industrial Production
Year-On-Year % Change
50
40
30
20
10
0
-10
Q1 Q2 Q3 Q4
'99
Q1 Q2 Q3 Q4
'00
Q1 Q2 Q3 Q4
'01
Q1 Q2 Q3
'02
Manufacturing
When the broad chemicals and pharmaceuticals sectors are
excluded from the analysis, it transpires that the performance of
the rest of the industrial sector has been somewhat less volatile
this year than the aggregate figures suggest. The seasonally
adjusted quarter-on-quarter growth rates for industry excluding
chemicals have been 6.6 per cent, 0.6 per cent and 3.4 per cent
in the first, second and third quarters respectively. These figures
show that other sectors of manufacturing performed better in the
third quarter. In particular, the electrical and optical equipment
sector, essentially ICT products, continued its recovery and
recorded positive output growth for the third successive quarter.
Within this broadly defined sector, the output of office machinery
and computers was particularly strong, up 18.8 per cent, quarteron-quarter, in the third quarter and up 7.3 per cent, year-on-year.
Output of radio, television and communications equipment
remains very weak, however, down 31.4 per cent, year-on-year,
in the third quarter. The output of food products fell by 2.2 per
cent on a seasonally adjusted basis between the second and third
quarters and was down 3.8 per cent, year-on-year.
Hi-Tech
Traditional
The prospects for the final quarter of 2002 and the beginning of
2003 are not particularly favourable. The NCB Purchasing
Managers Index (PMI) Report on Manufacturing reported the
first contraction of the manufacturing economy for nine months
in October on the back of the decline in new orders and weak
output growth. The IBEC/ESRI monthly industry survey, however,
showed fairly strong positive expectations for production in
21
Quarterly Bulletin Winter 2002
Table 4. Manufacturing Output, Annual Percentage Change
Total
High-Technology
Traditional
1994
1995
1996
1997
1998
1999
2000
2001
2002e
2003f
123⁄4
211⁄4
8 1 ⁄2
191⁄2
211⁄4
15
153⁄4
101⁄4
8 3 ⁄4
7
171⁄4
271⁄4
121⁄2
271⁄4
291⁄4
203⁄4
19
14
11
81⁄4
63⁄4
123⁄4
2
51⁄4
41⁄4
0
5
−3
0
11⁄4
Average 1994-2003
14
183⁄4
31⁄2
August and September. Another quarter-on-quarter decline in the
seasonally adjusted aggregate industrial production index is
expected in the final quarter. On this basis, it is expected that
total manufacturing output will increase by around 83⁄4 per cent
this year. An improvement in the international economic
environment next year should allow some output growth as the
year progresses. However, the slowdown in output growth in the
second half of this year means the manufacturing sector will be
entering 2003 with less momentum than might have been
expected earlier this year. This should have some negative effect
on next year’s outturn. Moreover, as always, the aggregate
outturn will depend largely upon developments in the heavily
weighted chemicals sector. Notwithstanding the uncertainty that
this creates, it is expected that the volume of manufacturing
output will increase by around 7 per cent in 2003.
The performance of the services sector, which is less dependent
upon external economic developments than the traded
manufacturing sector, has differed markedly from the
performance of the industrial sector. The NCB PMI Report on
Services shows that the sector contracted significantly during the
second half of 2001. Some recovery was evident in the final
quarter of last year followed by strong growth in the first quarter
of 2002. Some moderation in growth was recorded in the
second quarter of this year; however, service sector activity
stabilised somewhat in the third quarter and reasonably strong
growth was evident in the September and October figures. The
services sector is expected to perform reasonably well in 2003
with some further growth in private consumption expenditure. In
terms of construction output, some positive though moderate
growth is expected in 2002 and 2003 mainly as a result of the
contribution of housing output and government capital
expenditure. However, as indicated earlier in this chapter, there
are significant downside risks to this forecast if public capital
expenditure is cut for next year.
Agricultural Output
Advance estimates of output, input and income in agriculture for
2002, due out in early-December, were not available at the time
of writing. After a reasonable performance in 2001, when
22
Quarterly Bulletin Winter 2002
Table 5. Summary of Agricultural Output and Income 2001, 2002e and 2003f
2001
\ million
Value
Goods Output at Producer Pricesa
4,876
Intermediate Consumption
3,056
Net Subsidies plus Services Output
less Expenses
Operating Surplus
2002e
% change in
Volume
Price
\ million
−6
−13⁄4
−41⁄4
1
−1⁄4
11⁄4
2003f
% change in
Value
Volume
Price
4,587
23⁄4
11⁄4
11 ⁄ 2
4,712
3,090
1
⁄2
3,108
794
231⁄2
980
2,614
−51⁄4
2,477
⁄2
1
⁄4
1
\ million
41⁄2
1,025
6
2,629
a Including the value of stock changes.
nominal incomes increased by 4.2 per cent, the current year has
been more difficult for the agriculture sector. This is attributable
to a number of factors including lower output prices and
unfavourable climatic conditions. CSO figures show that the
Agricultural Output Price Index fell by 4.3 per cent, year-on-year,
in September. This reflected declines of 4.6 per cent in livestock
prices, 7.8 per cent in milk prices and an increase of 6.7 per cent
in crop prices. The most notable decline in output prices has
been a fall of 16.6 per cent, year-on-year, in sheep prices. This
follows very high prices in 2001 following the ban on UK exports
of lamb during the foot-and-mouth outbreak. Higher input prices,
up 1.3 per cent, year-on-year, in September, have put further
pressure on margins in agriculture.
It is expected that a decline in farm incomes will be recorded
this year but that some recovery is likely in 2003. This forecast
assumes unchanged exchange rates. Any further appreciation of
the euro relative to sterling might put further pressure on farm
incomes.
The Labour Market
As expected, some deterioration in labour market conditions was
experienced in 2002. In the first three quarters of the year, total
employment increased by 1.5 per cent, year-on-year. This
compares with increases of 3.0 per cent and 5.1 per cent in the
corresponding periods of 2001 and 2000 respectively. The most
recent quarterly data show that employment increased by 0.5
per cent and the labour force by 0.8 per cent, year-on-year, in the
third quarter. Consequently, the unemployment rate increased
slightly from 4.3 per cent in the third quarter of 2001 to 4.6 per
cent in the same quarter of this year.
The employment situation varied significantly across sectors.
Most of the job losses over the past year have been in industry
where employment fell by 5.1 per cent (16,800 persons), yearon-year, in the third quarter. Occupational data suggest that most
of these job losses were among plant and machine operatives
while industrial earnings data, which show that average wage
growth in industry remains strong, suggest that job losses in
23
Quarterly Bulletin Winter 2002
Table 6. Employment and Unemployment 2001, 2002e and 2003f
(annual average ’000)
2001
2002e
2003f
Agriculture
Industry
Services
123
504
1,114
121
492
1,149
116
491
1,174
Total Employment
Unemployment
1,742
71
1,762
81
1,781
93
Labour Force
Unemployment Rate (%)
1,812
4
1,843
41⁄2
1,874
5
Note: Figures may not sum to the total because of rounding.
industry have been mostly concentrated among lower-paid
workers. Most of the jobs created over the past year have been
in public sectors, including education and health where
employment increased by 5.8 per cent (14,500 persons) in the
year leading up to the third quarter of 2002. Modest
employment growth was recorded in private sector services and
construction while the contraction of employment in agriculture
shows no sign of abating.
The slowdown in labour market conditions is perhaps not as bad
as might have been anticipated given the significant slowdown
in economic growth from 10.7 per cent in GNP terms in 2000
to an estimated 21⁄2 per cent this year. The current
unemployment rate of 4.6 per cent is less than one percentage
point higher than the lowest rate of 3.7 per cent recorded in
early 2001. Against this, it should also be noted that the headline
unemployment rate understates slightly the extent of the
downturn in the labour market. Over the past year, there has
been a decline in the male participation rate from 73.3 per cent
in the third quarter of last year to 72.1 per cent in the
corresponding quarter of this year. Most of this fall in male
participation has been among the 15-19 year old age group,
suggesting a lack of employment opportunities for young males,
which constitutes a type of hidden unemployment. In addition,
there has also been a decline in the average number of hours
worked per week from 38.2 hours in the third quarter of 2001
to 37.8 hours in 2002.
Live Register figures, which show a decline in the seasonallyadjusted register between August and October, suggest a
reasonably steady labour market performance in the final quarter
of 2002. It is estimated that total employment increased by
around 1.2 per cent in 2002. With an increase in the labour force
of around 1.7 per cent, this implies an average unemployment
rate of just under 41⁄2 per cent. Some further increase in the
unemployment rate is possible next year as economic conditions
are expected to remain reasonably subdued in the early part of
the year. It is possible that some firms, which have so far reacted
24
Quarterly Bulletin Winter 2002
to the slowdown in economic activity by offering less overtime
and possibly less regular hours to staff, might yet be forced to
lay off workers if demand conditions do not recover quickly.
Employment growth next year is expected to be around 1 per
cent while the labour force might increase by around 11⁄2 per
cent. This would imply an average unemployment rate of around
5 per cent in 2003.
The Public Finances
End-September 2002 Exchequer Outturn
The Exchequer Returns for end-September showed an Exchequer
surplus of \594 million for the first three-quarters of 2002. This
compares with an Exchequer surplus of \2,934 million for the
same period in 2001. Total current expenditure to endSeptember was \18,604 million. Of the two components of this,
Central Fund Services expenditure amounted to \1,520 million,
a decrease of 15 per cent on the outturn to end-September
2001. This partially reflects a reduction in the EU Budget
contribution for 2002 of \280 million. The second component,
net voted current spending in the first nine months totalled
\17,084 million, compared with \14,205 million to endSeptember last year. This 20 per cent rate of increase on lastyear‘s first three-quarters outturn compares with a projected
increase of 14 per cent for 2002 as a whole, as given in the postBudget Revised Estimates Volume (REV) which was published
last February.
Total current receipts to end-September amounted to \22,671
million. Non-tax revenue totalled \1,682 million, more than
double the amount received in the same period in 2001. This
reflects a transfer of \635 million from the Social Insurance Fund
and a payment from the Central Bank of Ireland of \250 million
in respect of accrued public moneys from the issue of coin. Tax
revenue amounted to \20,989 million, which was 2.6 per cent
higher, year-on-year. This compares with a Budget target increase
of 8.6 per cent for 2002 as a whole. Among the major tax
categories, Value-Added Tax and Excise have been performing
close to their Budget targets for the year as a whole. Value-Added
Tax was up 12.1 per cent, year-on-year, at end-September, with
a Budget target of 11.8 per cent, while the 9 per cent year-onyear rise in Excise to end-September was also marginally above
its 8.6 per cent Budget target.
With regard to direct taxes, Corporation Tax was 8.7 per cent
higher than the first nine months of 2001. A rise in the year-onyear rate of increase in this tax category was to be expected
from end-June (when a 4 per cent year-on-year rise was recorded
for the first six months) as the change in the payment date for
preliminary tax incorporated in the Budget took effect. The 8.7
per cent rise to end-September, however, was well below the
25
Quarterly Bulletin Winter 2002
Table 7. Exchequer Returns at End-September 2002
2001
2002
Budget estimate
% change
year-onyear
% of
Budget
estimate
Outturn
\ million
\ million
Current Expenditure
— Central Fund Servicesa
— Non-Capital Supply Servicesb
3,608
20,404
3,423
23,402
−5·1
14·7
1,520
17,084
−15·4
20·3
44·4
73·0
Total
24,012
26,825
11·7
18,604
16·3
69·4
Current Revenue
— Tax revenue
— Non-tax revenuec
27,925
812
30,328
2,068
8·6
254·6
20,989
1,682
2·6
140·0
69·2
81·3
Total
28,738
32,396
12·7
22,671
7·1
70·0
Current Budget Surplus
4,726
5,570
4,067
Exchequer borrowing for capital purposes
4,076
5,400
3,473
650
170
594
Total Exchequer Surplus
General Government Surplus
(% of GDP)
1·7
%
change
First Three-Quarters
Outturn
\ million
0·7
a Debt servicing, judicial salaries and pensions and EU Budget contribution.
b Government current expenditure on areas such as Social Welfare, Health, etc.
c Central Bank surplus income, National Lottery surplus, interest and dividends, etc.
Budget target increase of 25.5 per cent for the year as a whole.
In the Budget, Income Tax revenue was forecast to increase by
3.8 per cent in 2002. For the first nine months, however, tax
revenue under this category was down 10.7 per cent, year-onyear, only marginally lower than the 13.4 per cent rate of decline
to end-June. The negative rates of change in income tax revenue
appear to reflect a number of factors, including the impact of the
2001 and 2002 Budgets on the income tax base, the increased
outlay on Special Savings Incentive Accounts (which are offset
against income tax revenue), and the slowdown in economic
growth (in particular, a slowdown in the rate of employment
growth and a decline in the average number of hours worked).
The overall difference between current revenue and current
expenditure gave a current budget surplus of \4,067 million for
the first three-quarters of 2002. This compares with a \5,167
million current budget surplus for the same period in 2001.
Exchequer borrowing for capital purposes of \3,473 million at
end-September compares with a figure of \2,232 million over
the same period in 2001. Net voted capital spending totalled
\3,142 million, an increase of 20 per cent, year-on-year, above
the projected REV increase of 14.7 per cent for 2002 as a whole.
Non-voted capital expenditure was in line with expectations and
included \776 million paid into the National Pensions Reserve
Fund. Capital receipts amounted to \447 million, including \155
million received from the sale of ACC.
26
Quarterly Bulletin Winter 2002
2003 Abridged Estimates
Preliminary Outturn for 2002
In the 2003 Estimates, published on 14 November, the
Department of Finance provided details of the likely outturn for
government spending in 2002, alongside its projections for 2003.
On the whole, total net voted expenditure was estimated to be
close to the target outlined in the Revised Estimates Volume
(REV), published in February of this year. Total net expenditure
was projected to increase by 14.6 per cent in 2002 over 2001,
compared with a REV target of 13.8 per cent. With total net
expenditure having increased by 19.5 per cent in the first ten
months of the year, this implies that year-on-year expenditure
growth must effectively be flat in the remaining two months of
the year. Its components, net current expenditure and net capital
expenditure will have risen by 14.6 per cent and 14.3 per cent,
respectively, in 2002, marginally above the REV targets of 13.5
per cent and 14.7 per cent.
Outlook for Spending in 2003
The Estimates indicate that total net voted expenditure, current
and capital, in 2003 will be \29,663 million, an increase of \612
million or 2 per cent on 2002. Budget day expenditure measures
are likely to increase further the net outlay in 2003. Total net
current spending in 2003 is given as \24,395 million, an increase
of \941 million or 4 per cent. In absolute terms, the biggest
increases are in the areas of Health and Children (up \418
million, or 6 per cent), Education and Science (\318 million
higher, or 7 per cent), and Social, Community and Family Affairs
(an increase of \210 million, or 4 per cent). The net Exchequer
pay and pensions bill is estimated to increase by \634 million,
or 6 per cent, while the non-pay element of net current
expenditure will rise by \307 million, or 2.5 per cent.
Net voted capital expenditure is set to fall from \5,597 million in
2002 to \5,269 million in 2003, a decrease of \329 million or 7
per cent. Almost all major categories of expenditure will decline.
The three largest votes are each below their 2002 allocation with
Education being \103 million, or 17 per cent, less than the 2002
allocation, Environment and Local Government is \59 million, or
3 per cent, lower, while Transport is projected to be \80 million,
or 5 per cent, down on the 2002 outlay. Likewise,
Communication, Marine and Natural Resources‘ net capital
expenditure will fall by \59 million, or 30 per cent, and Arts,
Sport and Tourism‘s outlay by \63 million, or 36 per cent. Of the
remaining large votes, Enterprise, Trade and Employment is \44
million, or 16 per cent, higher in 2003 compared to the 2002
allocation, the OPW increases by \21 million or 10 per cent, and
Health and Children is up \4 million or 1 per cent.
27
Quarterly Bulletin Winter 2002
Table 8. Source and Application of Funds
\ million
January to
September 2001
January to
September 2002
1. Borrowing (−)/repayments (+):
Irish Government bonds listed on the Irish Stock Exchange
Other Irish Government public bond issues
EIB loans
Medium-term notes
Private placements
National saving schemes
Commercial paper
Miscellaneous debt
Borrowing from ministerial funds
1,678
136
543
62
26
471
165
−63
−71
409
−1,308
−4,709
567
163
95
90
−23
2,437
−8
80
2. Increase (+)/decrease (−) in Exchequer deposits and other balances:
Increase (+)/decrease (−) in Exchequer balance
Increase (+)/decrease (−) in other bank deposits
Increase (+)/decrease (−) in other balances
1,256
−364
1,095
525
1,902
1,241
430
231
Exchequer Surplus (1+2):
2,934
594
Exchequer Financing
The Exchequer recorded a surplus of \87 million in the third
quarter of the year which, added to net borrowing of just under
\1 billion, resulted in an increase of \1,084 million in Exchequer
deposits and other balances. In the nine months to endSeptember, the surplus amounted to \594 million and this
contributed to an increase of \1.9 billion in Exchequer deposits
and other balances. At end-September, funds held in
departmental balances and other accounts amounted to \3,952
million, compared with \2,050 million at the end of 2001. There
was net borrowing by the Exchequer of \1.3 billion in the first
nine months of this year, which contrasts with net repayments of
\1.7 billion in the same period last year.
Medium- and long-term borrowing in the first three quarters of
this year amounted to \3.8 billion. This reflected \4.7 billion in
borrowing by means of Irish Government bonds listed on the
Irish Stock Exchange, with other medium- and long-term
borrowing contracting by \907 million. This borrowing was
partially offset by repayments of commercial paper amounting to
\2.4 billion and also repayments of borrowings from Ministerial
Funds amounting to \80 million. A total of \23 million was raised
from national savings schemes in the first three quarters of this
year. In the same period in 2001, the contribution from this
source to Exchequer funding was negative to the tune of \165
million.
Financial Sector Developments
Overview
Private-sector credit firmed moderately in the third quarter of the
year. The pick-up in the annual adjusted growth rate in this period
partly reflected the impact of base effects, (i.e., exceptional items
that reduced credit in the three months to September 2001), but
even after adjusting for these, credit was a little stronger in the
28
Quarterly Bulletin Winter 2002
three months to end-September. This was mainly due to
property-related lending, i.e., residential mortgages and lending
to real estate activities. The annual growth rate of residential
mortgage lending, adjusted for securitisations, continued the
upward trend evident since the spring of this year, while the rate
of growth in lending to real estate activities remained strong,
albeit weaker than in previous years. Other categories of lending
were rather weak in the third quarter, including manufacturing,
construction and non-housing personal sector lending.
Official interest rates remained unchanged in the euro area up
to end-November and accordingly retail rates in Ireland remained
generally steady in this period. (The ECB announced reductions
in its key rates of 0.50 of a percentage point on 5 December.)
Short-term market interest rates in the euro area eased towards
the end of November reflecting market expectations of an
imminent reduction in official rates. Irish Government bond
yields fell in line with international trends over the period,
reflecting market perceptions concerning the prospects for
growth, inflation and interest rates in the euro area. Euro area
financial developments are discussed in more detail in the
chapter of this bulletin entitled ‘Developments in the
International and Euro Area Economy‘.
Money Supply
Ireland contributed \132 billion to the euro area‘s broad money
stock (M3) at the end of the third quarter of 2002, representing
close to 2.5 per cent of the total. This figure rose by \4.2 billion,
or 3.3 per cent over the quarter, compared with a fall of 2.4 per
cent in the same period in 2001. Debt securities with an initial
maturity of up to two years substantially contributed to this
difference. This item, which tends to be rather erratic, is
dominated by the activities of a small number of banks located
in the International Financial Services Centre (IFSC) and mainly
comprises issues of commercial paper to non-resident
counterparties. In the third quarter of this year, debt securities
contracted by \1.5 billion, which compares with a fall of \4.1
billion in the same three months of last year. Non-Government
deposits expanded by \5.1 billion in the three months to
September 2002, compared with an increase of \1.4 billion in
the same period last year. This item was boosted by \1.4 billion
in July of this year due to increased deposits with one institution
from a non-bank affiliate located in another monetary union
member state. Over the full quarter, almost all of the increase
was denominated in euro. The great bulk of the increase was in
deposits with an agreed maturity up to two years (\4.3 billion),
with deposits redeemable at notice up to three months
increasing by \645 million and overnight deposits (current
account balances) rising by \129 million.
29
Quarterly Bulletin Winter 2002
Table 9. Monetary Aggregates: Annual Rates of Change (%)
Residential
mortgagesa
Private-sector credit
Unadjusted
Adjustedb
2001 December
17·8
16·5
15·1
2002 January
February
March
April
May
June
July
August
September
October
17·9
17·8
18·3
18·9
19·2
19·4
20·0
20·4
21·1
21·2
14·9
15·3
13·6
11·5
10·3
9·1
10·7
12·4
13·0
12·8
13·3
13·6
12·2
10·5
11·9
11·8
12·5
13·8
13·5
13·5
a This series is adjusted for securitisations. (See Table A2 in the Statistical Appendix.)
b Adjusted for transactions between credit institutions and non-MFI IFSC companies and valuation effects arising from exchange-rate movements.
In October, Ireland‘s contribution to euro area M3 increased by
just over \2 billion which was, for the most part, evenly split
between debt securities and non-Government deposits. The
increase in deposits was all euro denominated, with non-euro
balances falling by \961 million, and it was predominantly due to
increased deposits of other monetary union member residents.
Private-Sector Credit
Chart 4
Lending by credit institutions in Ireland to non-Government Irish
residents (i.e., private-sector credit) increased by almost \7 billion
in the third quarter of this year to \141 billion. This represents
an increase of 5.2 per cent, compared with growth of 1.6 per
cent in the same period last year. This difference is partly due to
lending to IFSC entities, which grew by \2.5 billion in the third
quarter of this year but by just \278 million in the equivalent
period last year. In addition, exceptional items contributed to a
base effect: intra-group restructuring in July and August of last
year reduced lending by \1.4 billion. Adjusting for the IFSC and
these exceptional items, the rate of increase in credit growth was
4 per cent in the third quarter of this year and around 3 per cent
in the same period last year. This reversed the trend of recent
quarters in which credit growth has tended to be weaker than a
year earlier. As a consequence, the annual rate of growth firmed
modestly over the quarter but it remains considerably below the
levels seen in recent years. In the first nine months of this year,
the annual adjusted rate of credit growth averaged 12.6 per cent,
compared with an average rate of 17.3 per cent for last year and
over 25 per cent in 2000.
Changes in
Private-Sector Credit
Year-to-year change
%
40
35
30
25
20
15
10
5
0
Sep Oct Nov Dec Jan
'01
'02
Feb Mar Apr May Jun
Unadjusted
Adjusted
Adjusted 3-month
moving average
30
Jul
Aug Sep
The annual adjusted growth rate for private-sector credit was
13.5 per cent in October, the same as September. Lending fell
by \682 million in the month; this was partly caused by a fall of
\384 million in IFSC lending and also reflected the fact that one
institution surrendered its banking licence but retained some of
Quarterly Bulletin Winter 2002
its former business, with the result that amounts formerly
included in private-sector credit are now excluded.
Much of the stronger growth in lending in the third quarter of
this year compared to last year was due to residential mortgages,
which have been growing relatively strongly since the start of this
year. Adjusted for securitisations, this item increased by \2.5
billion in the three months to end-September. This represents
growth of 6 per cent, the largest quarterly increase since the third
quarter of 2000. In the same period last year the increase was
\1.6 billion or 4.5 per cent. The annual adjusted growth rate of
residential mortgages has been on an upward trend since early
this year, rising from 17.8 per cent in December 2001 to 21.2
per cent this October, the latter being the fastest growth rate
since May 2001. By contrast, the annual adjusted rate of nonmortgage credit growth, while strengthening a little in the third
quarter, has generally been on a downward trend this year. This
figure fell again in October to 7.9 per cent, down from 15 per
cent at the end of 2001.
Sectoral Breakdown of Credit Growth
Three-quarters of the increase in private-sector credit in the third
quarter was due to personal sector lending and advances to the
financial sector. Almost all of the latter, however, reflected
lending to IFSC entities; excluding this, the increase in credit in
the three months to end-September was dominated by propertyrelated lending, with housing-related loans to the personal sector
and lending to real estate activities accounting for just over 80
per cent of the increase. These categories of lending were both
stronger than in preceding quarters, largely accounting for the
pick-up in credit growth in the three months to end-September.
Lending to the personal sector increased by \2.9 billion, a
percentage increase of 5.9 per cent which was the biggest
quarterly percentage increase since the summer of 1999. The
great bulk of this increase was housing-related: only \179 million
related to non-housing personal sector lending, a quarterly
increase of just 1.6 per cent. Real estate activities includes
development of real estate projects; buying, selling and letting of
self-owned property; real estate agencies and management of
real estate. Credit to this category rose by \956 million or 8.9
per cent, the largest quarterly percentage increase since June
2000. Other sectors recorded somewhat smaller increases that
were also larger than in preceding quarters, notably ‘Agriculture
and Forestry’ and ‘Electricity, Gas and Water Supply’. On the
other hand, lending to other sectors remained rather weak over
the quarter; for example manufacturing (up by \4 million or 0.1
per cent), construction activities (\62 million or 1.4 per cent),
and ‘Wholesale/Retail Trade and Repairs‘ (\83 million or 1.6 per
cent).
31
Quarterly Bulletin Winter 2002
Table 10. Change in Credit Institutions’ Non-Government Credit by Sector*
End-September 2001/
End-September 2002
\ million
Agriculture and forestry
Fishing
Mining and quarrying
Manufacturing
Electricity, gas and water supply
Construction
Wholesale/retail trade and repairs
Hotels and restaurants
Transport, storage and communications
Financial intermediation
Real estate and business activities
of which:
— Real estate activities
Education
Health and social work
Other community, social and personal services
Personal:
— House mortgage finance
— Other housing finance
— Other
Total
%
End-June 2002/
End-September 2002
% share
of change
\ million
%
% share
of change
143
7
−321
−714
182
353
679
592
265
3,856
2,387
4·5
2·6
−60·2
−12·0
30·4
8·5
15·3
13·6
13·1
9·8
17·7
0·9
—
−2·0
−4·4
1·1
2·2
4·2
3·6
1·6
23·6
14·6
135
1
−47
4
112
62
83
118
−7
2,568
1,082
4·2
0·4
−18·1
0·1
16·7
1·4
1·6
2·4
−0·3
6·3
7·3
1·9
—
−0·7
0·1
1·6
0·9
1·2
1·7
−0·1
36·2
15·3
2,272
103
84
77
8,617
7,861
−29
786
24·2
48·1
20·9
6·9
19·5
24·1
−3·7
7·3
13·9
0·6
0·5
0·5
52·8
48·2
−0·2
4·8
956
−26
23
36
2,941
2,665
98
179
8·9
−7·6
5·0
3·1
5·9
7·1
15·0
1·6
13·5
−0·4
0·3
0·5
41·5
37·6
1·4
2·5
16,314
13·1
100·0
7,088
5·3
100·0
* Data are unadjusted for IFSC lending and valuation effects.
In the year to end-September, lending growth was again
dominated by property-related lending, with housing-related
personal sector credit and advances to real estate activities
accounting for over three-quarters of the total increase
(excluding IFSC lending). Lending to real estate activities
increased by 24.2 per cent in the year to end-September which
was slightly stronger than in the twelve months to June, although
somewhat lower than annual growth rates recorded in recent
years. Lending to manufacturing was particularly weak in the year
to September, falling by \714 million or 12 per cent. There was
also a sharp fall in lending to the mining and quarrying category
(\321 million or some 60 per cent) but this reflected a once-off
item in the third quarter of last year. Lending to the construction
sector was relatively weak, growing by 8.5 per cent in the year
to September which represents a very marked slowdown from
the pace of growth in recent years. Non-housing personal sector
lending has also slowed considerably in recent years; it grew by
7.3 per cent in the year to September compared with annual
growth rates exceeding 20 per cent at times last year.
Chart 5
Selected Interest
Rates
%
8
6
4
2
0
Oct
'01
Nov Dec
Jan
'02
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
1 Month Interbank Rate
Clearing Banks' Prime Rate
Clearing Banks' Deposit Rate
25,000- 100,000 (Prior to Jan '02 £)
Marginal Lending Facility Rate
32
Nov
Financial Markets
Short-term money-market rates in the euro area were relatively
steady during the third quarter and at the start of the fourth at
slightly above the ECB’s main refinancing operations rate (i.e.,
3.25 per cent). However, rates eased during November as
markets began to discount an interest-rate reduction by the ECB,
and by end-November the one-month and three-month rates had
fallen to a little over 3 per cent. The ECB announced reductions
Quarterly Bulletin Winter 2002
Table 11. Euro Area Retail Bank Interest Rates (Provisional)
Monthly Average, %
Deposit interest rates
Lending interest rates
Overnight
To enterprises
To households
Up to 1
year
Over 1
year
Consumer
lending
For house
purchase
2001 December
0·74
6·18
5·69
9·81
5·52
2002 January
February
March
April
May
June
July
August
September
0·73
0·73
0·73
0·74
0·74
0·74
0·74
0·73
0·73
6·18
6·16
6·09
6·17
6·20
6·17
6·15
6·13
6·09
5·63
5·75
5·85
5·95
5·98
5·92
5·79
5·71
5·61
9·78
9·81
9·76
9·82
9·85
9·81
9·76
9·77
9·80
5·53
5·61
5·74
5·81
5·82
5·77
5·68
5·53
5·37
Source: ECB Monthly Bulletin. Rates are calculated as the weighted average of national rates. These rates should be used with caution as they are
not harmonised across the euro area.
of 0.50 of a percentage point in each of its key interest rates on
5 December, bringing the main refinancing operations rate to
2.75 per cent, its lowest level for three years. Retail interest rates
in Ireland were largely unchanged from end-June to endNovember, with the average of the standard variable mortgage
rate falling fractionally to 4.6 per cent. The clearing banks’ prime
rate, on which the cost of borrowing for many commercial
entities is based, which was steady at close to 4 per cent for
much of the year, fell to just under 3.8 per cent by endNovember.
Chart 6
Irish Yield Curve
Having breached parity against the US dollar for the first time in
over two years in mid-July, the euro declined later that month
and for the following three months fluctuated around a level just
below parity. From mid-October to mid-November, the euro
firmed against the dollar, breaching parity again, before reversing
this climb in the second half of November. In the eleven months
from end-December 2001 to end-November of this year, the
euro appreciated by 12.9 per cent against the US dollar, while
also rising by 5 per cent against sterling and 5.3 per cent against
the Japanese yen.3 Reflecting the strength of the euro this year,
the nominal trade-weighted competitiveness indicator for Ireland
increased by 4.3 per cent between end-2001 and the end of
November (see Table B4 in the Statistical Appendix),
representing a deterioration in competitive conditions for Irish
firms.
Bond Yields
%
6
5
4
3
2
1
0
O/N
Irish Government bond yields generally eased from around midMay to late September/early October, in line with international
trends as markets anticipated relatively weak international
growth prospects and reductions in official interest rates. The
Irish five-year yield fell from a peak of 5.1 per cent in mid-May
1-Wk
1-Mth
3-Mth
6-Mth
12-Mth
2 Year
5 Year
10 Year
31-Dec-01
28-Jun-02
31-Oct-02
3 Financial market developments in the euro area are discussed in more detail in the chapter
of this bulletin entitled ‘Developments in the International and Euro Area Economy’.
33
Quarterly Bulletin Winter 2002
Table 12. Irish Government Bond Yields and Differentials
End-month
5-year
bond
yield
%
Differentials against:
10-year
bond
yield
%
Differentials against:
Germany
UK
US
2001 December
4·35
−0·04
−0·75
−0·10
5·11
0·11
0·07
−0·02
2002 January
February
March
April
May
June
July
August
September
October
November
4·83
4·80
5·09
4·91
4·97
4·68
4·44
4·22
3·78
3·93
3·88
0·30
0·24
0·20
0·19
0·18
0·19
0·25
0·14
0·18
0·12
0·09
−0·17
−0·21
−0·30
−0·33
−0·31
−0·39
−0·32
−0·32
−0·43
−0·44
−0·69
0·49
0·62
0·29
0·46
0·60
0·61
0·87
0·97
1·20
1·14
0·59
5·21
5·22
5·47
5·37
5·38
5·16
5·01
4·82
4·54
4·74
4·63
0·28
0·26
0·22
0·24
0·22
0·22
0·27
0·23
0·27
0·20
0·15
0·31
0·21
0·19
0·17
0·11
0·14
0·15
0·18
0·17
0·16
−0·05
0·19
0·36
0·08
0·25
0·32
0·35
0·45
0·65
0·95
0·78
0·39
Germany
UK
US
Note: (−) denotes Irish yields are lower than foreign yields.
to a low of 3.75 per cent on 9 October, while the ten-year yield
eased from 5.5 per cent to just above 4.5 per cent in the same
period. In both cases, there was a modest firming thereafter.
Differentials with respect to German yields narrowed over the
second half of the year: the five-year differential contracted from
around 0.2 of a percentage point in June to around half that
at end-November, while the ten-year differential narrowed from
around 0.25 of a percentage point to just above 0.15 of a
percentage point in the same period. The Irish ten-year yield was
slightly above the euro area average until late August, but
thereafter they have generally been virtually the same. Over the
second half of the year, the Irish yield curve became slightly
flatter, as longer-term rates eased more than short-term rates.
Chart 7
Ten-year Yield Differentials
vis-à-vis Germany
end-October 2002
Percentage
Points
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
BE
34
ES
FR
IE
IT
NL
AT
PT
FI
Quarterly Bulletin Winter 2002
Monetary Policy Implementation by the Central Bank of Ireland
The implementation of euro area monetary policy is conducted on a
decentralised basis i.e., by the central banks of member countries. The
Central Bank of Ireland thus performs a number of functions in its role as
a member of the Eurosystem to contribute to the implementation of the
single monetary policy. For example, it forecasts liquidity requirements for
the domestic market and it regularly conducts money market operations
with eligible counterparties. The latter are domestic credit institutions that
meet general eligibility requirements to participate in Eurosystem
operations with the Bank. By November 2002 there were 40 such
institutions, including a number of IFSC banks. The Bank conducts regular
open market operations with domestic counterparties, chiefly main
refinancing operations (MROs) and longer-term refinancing operations
(LTROs). In addition, counterparties may access at the Bank the two
standing facilities of the ECB’s operational framework. These two facilities
are the marginal lending facility and the deposit facility, which may be
accessed at an institution’s initiative subject to certain conditions. Interest
rates charged by the Bank on borrowings and paid on deposits are those
determined by the Governing Council of the ECB for the whole Eurosystem.
At end-October, lending by the Bank to euro area credit institutions as part
of monetary policy operations amounted to \10.6 billion, of which \6.3
billion was under main refinancing operations and the balance was under
longer-term refinancing operations.
Monetary policy is executed in the context of the Eurosystem’s minimum
reserve requirement system. All credit institutions operating in Ireland,
whether under Irish law or on a branch basis, are required to keep an
amount equivalent to 2 per cent of specified liabilities on account with the
Bank. Compliance is determined on the basis of average daily reserve
holdings over a one-month ‘maintenance period’. The system contributes
to stabilising interest rates by providing institutions with some scope to
adjust the balance in their minimum reserve account, subject to meeting
the 2 per cent requirement on average over the maintenance period,
thereby smoothing the effect of day-to-day fluctuations in liquidity. In the
maintenance period from October 24 to November 23, institutions held
balances in their minimum reserve accounts with the Bank that were, on
average, \8.3 million more than required. Minimum reserve account
balances are remunerated at a rate based on the MRO rate, although
balances in excess of requirement are not remunerated. The Bank is
responsible for monitoring compliance of credit institutions in Ireland with
the minimum reserve system and it imposes sanctions for breaches of
obligations, which are based on the extent of the shortfall, in accordance
with the Council Regulation concerning the application of minimum
reserves.
The Bank participates in the Correspondent Central Banking Model
(CCBM) which facilitates the use of eligible assets in euro area monetary
policy operations on a cross-border basis. This enables, for example, a
counterparty in Ireland to use eligible assets deposited in another monetary
union member country as collateral to obtain liquidity from the Central
Bank of Ireland. At end-November, 20 of the Bank‘s counterparties
(including IFSC banks) were using the CCBM. Collateral with a nominal
value of \8 billion was held in custody accounts with other euro area
national central banks on behalf of the Bank, \6.5 billion in respect of
monetary policy operations and \1.5 billion in respect of intra-day credit.
The securities involved were mainly located in Germany, Italy, France,
Luxembourg, Belgium and Spain.
The Bank operates the Irish real-time gross settlement (RTGS) system, which
is linked to those of the other euro area countries through a system called
TARGET (Trans-European Automated Real-Time Gross Settlement Express
Transfer). This enables large value payments to be settled with the same
certainty and timing throughout the euro area. In the third quarter of the
year, there were over 154,000 payments using the Irish RTGS system, of
which the majority (53 per cent) were domestic with cross-border
payments accounting for the remainder. The daily value of cross-border
payments averaged \7 billion, while domestic payments using the system
averaged \11.2 billion per day.
35
Quarterly Bulletin Winter 2002
Domestic Prices, Costs and Competitiveness
Overview
Irish consumer price inflation, as measured by the Harmonised
Index of Consumer Prices (HICP), is likely to average 43⁄4 per cent
this year, up from 4.0 per cent in 2001. The rise in average
inflation this year reflects a sharp increase in the first quarter
followed by a gradual decline from the middle of the year
onwards. Headline inflation, as measured by the year-on-year
change in the HICP, increased from a rate of 3.9 per cent in the
final quarter of last year to 5.1 per cent in the first quarter of this
year but has since declined to 4.4 per cent in the third quarter.
The headline rate of increase in the Consumer Price Index (CPI)
has remained consistently below the rise in the HICP for much
of this year. The divergence between the two indices reflect the
impact of items included in the CPI but excluded from the HICP.
The most important of these items are mortgage interest
payments and the non-service component of insurance costs.
The rise in the CPI edged ahead of the increase in the HICP
in October as the effect of a number of mortgage interest rate
reductions in the fourth quarter of last year began to drop out of
the year-on-year comparison. For the year as a whole, the
headline increase in the CPI is forecast to average a little over
41⁄2 per cent, compared with an outturn last year of 4.9 per cent.
The rise in inflation at the beginning of the year was largely
accounted for by a significant step-up in services sector inflation
and the impact of higher indirect taxes introduced in the 2002
Budget. The gradual downward trend in inflation since then
reflects a modest decline in goods price inflation and a more
significant easing in services sector inflation during the course of
the year. Core services sector inflation peaked at over 9 per cent,
year-on-year, at the beginning of the year but had dipped below
7 per cent by October. The decline in core services sector
inflation contrasts with a persistently high rate of increase,
averaging over 10 per cent, for a range of regulated services such
as health insurance, taxi fares, education fees and social housing
rents. Individually, many of these items have little impact on the
overall rate of inflation, reflecting their relatively low weights in
the index, but collectively they have added about 1⁄2 per cent to
the overall increase in the HICP this year. Services sector inflation
overall, is forecast to average over 71⁄2 per cent this year, up from
6 per cent last year.
The deflator for Gross Domestic Expenditure (GDE) is a measure
of the change in price of aggregate domestic activity in the
37
Quarterly Bulletin Winter 2002
economy. This deflator is forecast to increase by about 51⁄4 per
cent in 2002, up from 4.8 per cent in the previous year. This
reflects an increase in the consumption deflator that is partially
offset by declines in the rates of change of both the investment
and public expenditure deflators.
While average services sector inflation has increased this year,
the outturn for goods price inflation, excluding movements in the
volatile items energy and unprocessed food, is likely to remain
broadly unchanged at about 21⁄4 per cent. However, while the
average increase last year reflected a rising trend, this year it
reflects a downward trend from 2.7 per cent at the beginning of
the year to 2.1 per cent in October. This modest downward trend
reflects the impact of weak goods prices internationally, a
gradual strengthening of the nominal exchange rate and an
easing of demand pressures this year. These factors served to
mitigate the impact of higher indirect taxes introduced in the
2002 Budget.
Table 1: Inflation Measures — Annual Averages (%)
Measure:
HICP
CPI
Services
Gross Domestic
Expenditure1
2001
4·0
4·9
6·0
4·8
2002f
2003f
4 3 ⁄4
41⁄2
7 1 ⁄2
51⁄4
3 1 ⁄4
4
5
4
The increase in average weekly earnings in the non-agricultural
sector is expected to average 71⁄2 per cent this year. This rate
of wage inflation, while representing a decline compared to the
outturn of about 9 per cent last year, is well in excess of rates
prevailing in our main trading partners. Nevertheless, reflecting
the strong productivity growth in the manufacturing sector
overall, unit labour costs are expected to decline this year.
However, overall indices of unit labour costs and productivity
are strongly influenced by the impact of a number of very
dynamic sectors, notably chemicals and pharmaceuticals, which
are relatively capital intensive. When the exceptional output
growth in these sectors is excluded, the growth in productivity
and the trend in unit labour costs for the remaining more labour
intensive sectors has been far more subdued in recent years.
Many of the firms in these sectors have struggled to maintain
competitiveness this year.
The outlook for wage inflation next year is uncertain and is to a
large extent contingent on the outcome of the negotiations
currently underway on a successor to the Programme for
Prosperity and Fairness (PPF). Nevertheless, against a
background of easier labour market conditions, a modest decline
in wage inflation seems likely. Such a deceleration, while
1 Gross Domestic Expenditure is a measure of domestic activity in the economy. It is defined
as the sum of consumption, investment, net current public expenditure and stock changes.
38
Quarterly Bulletin Winter 2002
welcome, may be insufficient to avoid a loss of competitiveness
and a consequent reduction in employment in the more labour
intensive sectors of industry.
The gradual downward trend this year in both goods and services
price inflation is expected to continue next year. The projected
decline in goods price inflation reflects the lagged impact of
recent exchange rate appreciation and a relatively subdued
outlook for demand both domestically and internationally. In
addition, both the GDE deflator and core domestically contested
services sector inflation are expected to decline against a
background of a further easing in labour market conditions and
a less robust expansion in domestic demand than has been the
case in recent years. Overall, the inflation rate, as measured by
the HICP, is forecast to average about 31⁄4 per cent next year.
The forecast for the average rise in the CPI next year is about 3⁄4
of a percentage point higher at just under 4 per cent. The
difference between the two forecasts reflects differences in
composition between the two indices. About 1⁄2 of a percentage
point is accounted for by mortgage interest payments, which,
even with the usual technical assumption of unchanged interest
rates, are expected to increase next year due to an increase in
the average size of mortgage outstanding. Reflecting the
cumulative increase in house prices of recent years, the average
size of mortgage in the CPI increases by about 1 per cent each
month in the absence of changes in mortgage interest
repayments. This is because new mortgages added to the sample
each month are much larger than older mortgages that drop out
as they are repaid. The remaining 1⁄4 of a percentage point gap
between the CPI and HICP forecast reflects other excluded
items, mainly services.
Consumer Prices
The HICP increased at an average rate of 4.4 per cent, year-onyear, in the third quarter of this year, compared with a rate of
4.8 per cent in the previous quarter and 3.9 per cent in the third
quarter of last year. The decline in the rate of inflation in the third
quarter reflected lower unprocessed food price inflation, lower
non-energy industrial goods price inflation and a decline in
services sector inflation partly offset by higher energy price
inflation. Excluding energy prices and unprocessed food, core
HICP inflation averaged 4.8 per cent, year-on-year, in the third
quarter of 2002 compared with a rate of 5.4 per cent in the
previous quarter and 4.3 per cent in the third quarter of 2001.
The rate of increase in the CPI was lower than that of the HICP
in the first half of 2002, reflecting differences in coverage
between the two indices. The most significant items, included in
the CPI but excluded from the HICP, are mortgage interest
payments and the non-service component of health, house and
39
Quarterly Bulletin Winter 2002
car insurance. Interest rates were cut in the second half of 2001
and, as a consequence, mortgage interest rates made a negative
contribution to the CPI in the first half of this year. This has been
partially offset by increases in car and house insurance rates that
have boosted the CPI inflation rate. In the third quarter, the rates
of increase in the CPI and the HICP converged. The CPI
increased at a year-on-year rate of 4.4 per cent in the third
quarter, down from 4.6 per cent in the previous quarter and 4.7
per cent in the third quarter of last year.
6
Consumer
Prices
5
Ireland: Consumer
Price Index
% Change, Year-on-Year
Chart 1
4
3
2
Ireland: EU Harmonised
Index of Consumer
Prices (HICP)
1
Euro-12: Monetary
Union Index of Consumer
Prices (MUICP)
0
Jan Feb Mar Apr May Jun Jul
'01
Aug
Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct
'02
The latest available consumer price data relate to October 2002
when CPI inflation increased to 4.6 per cent, year-on-year, from
4.5 per cent in the previous month. This increase was partly due
to a base effect due to the timing of mortgage interest rate
increases last year. Over the same period the year-on-year rate
of increase in the HICP declined from 4.5 per cent to 4.4 per
cent.
Producer Prices
Trends in output prices, as recorded in the Manufacturing Output
Price Index (OPI) and the Agricultural Output Price Index (AOI),
can provide potentially useful information regarding future price
developments at the retail level. Both indices have declined
during the first three quarters of this year.
The OPI has been on a downward trend over the last year,
reflecting, in the main, weak export prices. The export sub-index
of the OPI declined at a rate of 1.5 per cent, year-on-year, in the
three months to October 2002. Over the same period, the home
sales sub-index increased at a rate of 2.4 per cent. Overall, the
40
Quarterly Bulletin Winter 2002
OPI declined at an average annual rate of 0.3 per cent in the
three months to October 2002 compared with declines of 1.3
per cent, year-on-year, in the previous three months and 0.3 per
cent in the three months to October last year.
Chart 2
6
5
Manufacturing
Output Price
Inflation
4
% Change Year-on-Year
3
2
1
0
-1
-2
-3
-4
Home Sales
-5
Export Sales
-6
Total Manufacturing
Jan Feb Mar Apr May Jun Jul
'01
Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct
'02
The Agricultural Output Price Index declined at an average rate
of 4.9 per cent, year-on-year, in the third quarter of 2002
compared with an average rate of decline of 4.1 per cent, yearon-year, in the previous three months. Cattle prices were up by
0.7 per cent, year-on-year, in the third quarter and poultry prices
increased by 1.3 per cent over the same period. However, these
increases were more than offset by year-on-year declines of 18.2
per cent and 12 per cent, respectively, in the prices of sheep and
pigs. Overall, livestock prices were down by 4.9 per cent, yearon-year, in the third quarter. The price of milk was 8.2 per cent
lower, year-on-year, in the third quarter. Crop products were
stronger overall in the third quarter and increased by 4.3 per
cent, year-on-year.
Services Prices
Services sector inflation, as measured by the Services sub-index
of the HICP, has declined from a peak of 8.8 per cent in January
of this year to 7 per cent in October. Over the same period,
services sector inflation in the euro area as a whole increased
slightly from 3 per cent to 3.2 per cent. The decline in overall
services sector inflation in Ireland during the course of the year
is mainly accounted for by developments in the private sector.
Core HICP services sector inflation (excluding alcohol,
telecommunications and administered services which are subject
to government regulation) declined from 9.1 per cent in January
to 6.8 per cent in October, reflecting emerging weakness in
41
Quarterly Bulletin Winter 2002
domestic demand and labour market conditions. Over this
period, however, the rate of inflation for administered services
declined only slightly from 11.1 per cent to 10.8 per cent, while
the rate of price increase for alcohol related services declined
equally modestly from 8.0 per cent to 7.5 per cent. The annual
rate of increase in telecommunications prices eased slightly from
2.3 per cent in January to 1.6 per cent in October.
10
Services
Sector
Inflation
9
% Change Year-on-Year
Chart 3
8
7
6
5
HICP Services
(Overall)
HICP Core Market
Services
4
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun
'01
'02
Jul Aug Sep Oct
Note: Core Market Services equals HICP Services excluding telecommunications, alcohol and administered services.
The downward trend in services sector inflation is forecast to
continue in the year ahead. Core services sector inflation is
expected to decline against a background of a relatively modest
expansion in domestic demand and easier labour market
conditions. Administered services sector inflation is, however,
expected to remain high reflecting fiscal pressures, a carry over
from recent increases in health insurance and education fees and
the likelihood of increases in a range of other public services
including public transport costs and licence fees.
Pay
Wage data are now available for most sectors for the first half of
2002. The figures show considerable variation in pay
developments across sectors. Earnings growth remains
particularly strong in the industrial sectors. In the first six months
of the year, average hourly earnings in industry and construction
increased by 9.5 per cent and 12.2 per cent, year-on-year,
respectively. In the manufacturing sector, strong average wage
growth has coincided with a decline in employment numbers.
This suggests that job losses have mostly been concentrated
among the lower paid workers in the sector. Pay growth has
been less strong in some services sectors. Average weekly
42
Quarterly Bulletin Winter 2002
earnings in the public sector increased by 5.7 per cent, year-onyear, in the first half of 2002. The index of average earnings,
which excludes some effects of changes in employment
composition and is consequently a better measure of underlying
pay pressures in the public sector, increased by 6.4 per cent
during the same period. Wage increases have been very low in
the distribution and business services sector, at only 2.7 per cent,
year-on-year, in the first half of this year. The only available data
for banking, insurance and building societies relate to the first
quarter. They show year-on-year growth in weekly earnings of
9.6 per cent and a corresponding increase of 11.8 per cent in
the average earnings index (adjusted for composition).
11
Chart 4
10
Hourly Earnings
in Manufacturing
(in Local
Currency)
9
% Change Year-on-Year
8
7
6
5
4
3
2
Ireland
1
Major Trading Partners
0
1990
1991
1992
1993
1994
1994
1996
1997
1998
1999
2000
2001
e
2002
2003
f
It is expected that average non-agricultural earnings will increase
by around 71⁄2 per cent this year. The prospects for next year
remain particularly uncertain and much will depend upon
whether or not a new national wage agreement can be
negotiated to succeed the Programme for Prosperity and
Fairness and, if so, what the pay components will stipulate. As
indicated in the previous chapter, some further easing of labour
market conditions is expected in 2003. Average labour
productivity growth will remain lower than the very high rates of
the late 1990s and 2000. The combination of these factors
should put some downward pressure on wage growth next year.
However, earnings growth is still expected to remain well above
the levels prevailing in other euro area countries, partly as a result
of higher inflationary expectations. It is currently expected that
average non-agricultural earnings will increase by around 61⁄4 per
cent in 2003. With non-agricultural employment expected to
increase by around 11⁄2 per cent next year, this should imply an
increase in the non-agricultural pay bill of around 8 per cent next
year.
43
Quarterly Bulletin Winter 2002
Competitiveness
The strong competitive position of the aggregate manufacturing
sector masks considerable variation across sectors. Aggregate
unit wage costs continue to decline, down around 9 per cent,
year-on-year, in the first half of 2002; however the aggregate
picture, as given by CSO Unit Wage costs and Productivity
indices, is heavily influenced by the high weighting given to a
small number of sectors dominated by multinationals, notably
chemicals and pharmaceuticals. This weighting is determined by
the current share of gross value added in industry of these
sectors, at 1995 prices, and does not give an accurate reflection
of their importance for the Irish economy, either in terms of
domestic expenditures or employment.
110
Chart 5
105
100
95
90
85
Base: 1990=100
Irish Hourly
Earnings
& Unit Wage
Costs in
Manufacturing
Relative To Main
Trading Partners
(in Common
Currency)
80
75
70
65
60
55
50
45
Relative Hourly Earnings
Relative Unit Wage Costs
40
35
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
e
f
2002 2003
For many sectors of the Irish economy, recent developments in
productivity and unit labour costs have been much less
impressive. These sectors account for a significant amount of
manufacturing employment. A recent IMF exercise, which
weighted the Irish manufacturing sectors by employment rather
than output, showed that unit labour costs were broadly stable
between 1995 and 2000 but have been increasing sharply since
2001. This slowdown in competitiveness was a result of a
combination of slowing productivity growth and high wage
growth. The competitive position of many traditional sectors of
manufacturing was strengthened during the 1990s because of
competitive gains relative to the United Kingdom. However,
most of this improvement in competitiveness relative to the UK
was a consequence of the high value of sterling relative to the
Irish pound/euro rather than strong productivity growth for
traditional sectors. This leaves many sectors of the economy
vulnerable to a depreciation in the value of sterling, particularly
if the current high levels of wage growth continue.
44
Quarterly Bulletin Winter 2002
As indicated earlier, average earnings are expected to increase
by around 71⁄2 per cent this year with a slight moderation to
around 61⁄4 per cent in 2003. For the labour intensive, traditional
sectors of the economy, this implies a continuing increase in unit
labour costs. Employment in manufacturing has been falling since
the general economic slowdown began in 2001. These
competitiveness losses in some sectors suggest that more jobs
might be at risk if wage increases more in line with productivity
growth cannot be achieved in these sectors.
Asset Prices
There have been divergent trends in asset prices this year. In the
housing market, prices recovered strongly following tax changes
in the 2002 Budget. Retail property values also increased but the
industrial and office sectors declined. In line with trends
internationally, Irish equity prices declined sharply between May
and September and, despite a recovery since mid-October,
remain significantly lower on a year-on-year basis.
Chart 6
45
Fixed Asset
Values
40
35
% Change Year-on-Year
30
25
20
15
10
5
Agricultural Land
Commercial*
New Houses
0
-5
Q1
Q2 Q3 Q4
Q1
Q2 Q3 Q4
Q1
Q2 Q3 Q4
Q1 Q2 Q3
1998 1998 1998 1998 1999 1999 1999 1999 2000 2000 2000 2000 2001 2001 2001
Q4 Q1
Q2
Q3
2001 2002 2002 2002
*Jones Lang LaSalle Index of Capital Values
Official house price data from the Department of the
Environment and the permanent tsb index point to a strong
rebound in house prices this year following price declines in the
second half of 2001. Prices increased in the aftermath of tax
changes in the 2002 Budget that favoured investors. Increased
demand from investors stimulated renewed activity by first-time
buyers who had been holding back in the preceding period in
the hope that prices would decline. The market was also
supported by a pick-up in economic activity generally in the first
quarter of the year. Recent data from permanent tsb show further
price rises in the third quarter. However, since they are based on
45
Quarterly Bulletin Winter 2002
completed sales that may have been initiated two to three
months previously, the latest data from this source reflect market
conditions in the late summer rather than the autumn market.
According to official Department of Environment and Local
Government (DoE) data, house prices increased strongly in the
first half of this year. In the new house market, prices increased
at a quarterly rate of 4.8 per cent in the first quarter and by a
further 3.7 per cent in the second quarter. On a year-on-year
basis, according to DoE data, new house prices increased at a
relatively modest rate of 4.9 per cent in the second quarter of
this year, compared with an increase of 12.2 per cent in the same
period last year. In the second-hand market, the DoE recorded a
quarterly price rise of 6.4 per cent and a year-on-year increase of
6.6 per cent in the second quarter of this year compared with an
increase of 12 per cent, year-on-year, in the second quarter of
2001.
The permanent tsb (PTSB) index recorded an average quarterly
increase in new house prices of 1.4 per cent in the third quarter
of 2002, compared with an increase of 2.6 per cent in the
previous quarter. On a year-on-year basis, according to the PTSB
index, new house prices increased by 3.3 per cent in the third
quarter compared with an increase of 14.1 per cent, year-onyear, in the same period last year. The PTSB index records
stronger prices in the second-hand market compared to the new
house market this year. In the third quarter, according to the
PTSB index, the average price of an existing house increased at
a quarterly rate of 3.1 per cent and at a year-on-year rate of 6.1
per cent.
Last year’s Budget-induced stimulus to the market will only be
sustained until capital values adjust to restore investment yields
to their pre-Budget equilibrium. Thereafter, underlying market
conditions will drive house price trends. In the investment
market, the recent decline in private sector rents points to
emerging oversupply in the buy-for-rent sector that will put
downward pressure on prices. Given the outlook for the real
economy and the labour market and disposable incomes in
particular, demand from owner-occupiers is also likely to
moderate in the year ahead.
In the commercial property market, capital values have declined
in the office and industrial sectors, but prices continue to rise for
retail property. In the office market, the arrival of a large amount
of new development onto the market has coincided with a drop
in demand and, as a result, vacancy rates have risen sharply.
Against this background, capital values have declined. Headline
rents have stabilized but effective rents are declining when
incentives for new leases are taken into account. According to
the Jones Lang LaSalle (JLL) index, capital values for offices and
industrial property have declined on a year-on-year basis by 5.3
per cent and 3.7 per cent, respectively, in the third quarter of
46
Quarterly Bulletin Winter 2002
this year. In the same period last year, capital values for offices
were increasing at a year-on-year rate of 9.4 per cent and
industrial property capital values were increasing at a rate of 8.1
per cent, year-on-year. In the third quarter of this year, industrial
rents declined by 1.4 per cent, year-on-year, and headline office
rents increased by 1.2 per cent, year-on-year.
Capital values and rents for retail property continued to increase
in the third quarter of this year, according to the JLL index.
Capital values for retail property increased by 6.6 per cent, yearon-year, in the third quarter compared with an increase of 4.8
per cent, year-on-year, in the previous quarter and 10.9 per cent
in the third quarter of last year. The rate of increase in rental
values increased from 4.7 per cent, year-on-year, in the second
quarter to 5.5 per cent, year-on-year, in the third quarter of this
year.
200
Chart 7
180
160
Base: Jan. 1998=100
Irish and
International
Share Price
Indices
140
120
100
ISEQ
Dow Jones
Industrial
Frankfurt DAX
FTSE-100
80
60
J M M
'98
J
S
N
J M M
'99
J
S N
J M M
'00
J
S N J M M
'01
J
S
N J M M
'02
J
S N
Agricultural land prices increased by 16.6 per cent, year-on-year,
in the first quarter of 2002, compared with an increase of 7.0 per
cent, year-on-year, in the previous quarter and 10.9 per cent in
the same period last year. These data should be interpreted with
caution, however, since agricultural land sales account for a very
small proportion (0.2 per cent) of the total area farmed nationally
and the quality and location of land sold can vary considerably.
Turning to financial assets, the Irish Stock Exchange index (ISEQ)
declined sharply during the summer in line with trends
internationally. Although prices have recovered somewhat since
mid-October, they remain well down on a year-on-year basis. The
average value of the ISEQ in November of this year was almost
19 per cent lower than in November last year. Over the same
period, the Frankfurt DAX was down by 35 per cent while the
47
Quarterly Bulletin Winter 2002
New York Dow Jones Index (DJI) declined by 12 per cent and
the London FTSE was 22 per cent lower. Since January 1998, the
ISEQ has increased by just 0.8 per cent compared to an increase
of 9.6 per cent in the DJI and declines of 22 per cent and 25 per
cent respectively in the FTSE and DAX.
In general, Irish bond yields moved in line with those in the euro
area as a whole over the last year, with ten-year differentials with
respect to Germany averaging about 22 basis points in the
twelve months to end-November 2002. A more detailed analysis
of the bond market is contained in the euro area chapter.
Summary
Inflation in Ireland is forecast to average 43⁄4 per cent on a HICP
basis this year, up from 4 per cent last year. This increase is
largely accounted for by domestic factors. Services sector
inflation increased from an average of 6 per cent last year to 71⁄2
per cent this year while average goods price inflation, excluding
volatile factors, remained broadly unchanged at about 21⁄4 per
cent. The year-on-year increase in the HICP peaked at 5.1 per
cent in the first quarter and has been on a downward trend since
mid-year. This trend is expected to continue next year. Goods
price inflation is expected to decline against a background of
subdued demand conditions and reflecting the lagged impact of
the appreciation of the exchange rate this year. Some decline in
services sector inflation is forecast given the outlook for labour
market conditions and domestic demand. Overall, the increase
in the HICP is forecast to average 31⁄4 per cent next year. The
CPI is forecast to increase at an average rate of 41⁄2 per cent this
year, down from an average of 4.9 per cent last year. A further
decline in CPI inflation to about 4 per cent is forecast for next
year. Differences between the CPI and the HICP reflect the
different composition of the indices, particularly the exclusion
from the HICP of mortgage interest rates and the non-service
component of insurance costs. These forecasts are predicated on
the usual technical assumptions of unchanged interest rates and
exchange rates and assume no significant increase in indirect
taxes.
48
Quarterly Bulletin Winter 2002
An Timpeallacht Gheilleagrach
Is cosúil go mbeidh fás de thimpeall 21⁄2 faoin gcéad san
Olltáirgeacht Náisiúnta sa bhliain 2002, le linn don chúlra
eacnamaı́och idirnáisiúnta a bheith lag. Cé gur laghdú é seo ar
na rátaı́ a bhı́ ann sna blianta deireannacha seo tá sé beagáinı́n
nı́os fearr ná na rátaı́ fáis i limistéar an euro atá nı́os lú ná 1 faoin
gcéad, nı́os fearr freisin ná 21⁄4 faoin gcéad sna Stáit Aontaithe
agus nı́os fearr ná an fás diúltach sa tSeapáin. Nı́ haon ionadh
mar sin gur tháinig moilliú ar an bhfás san OTN ó 10.7 faoin
gcéad i 2000, ós rud é go bhfuil geilleagar na hÉireann an-oscailte
agus gur tháinig sriantachtaı́ cumais intı́re chun tosaigh, rud a bhı́
dosheachanta. Bhı́ an moilliú nı́os sciobtha agus nı́os fairsinge,
áfach, ná mar a ceapadh a bheadh sé.
Bhı́ roinnt tosca a chuidigh leis an dı́luasghéarú seo i gcúrsaı́
eacnamaı́ochta an bhliain seo caite. Ina measc bhı́ : an cur chun
donais suntasach in earnáil theicneolaı́ocht na faisnéise agus na
cumarsáide, na deacrachtaı́ a d’éirigh as baoil i ngeall ar an ngalar
crúb is béil, iarmhairt ionsaithe na sceimhlitheoirı́ ar an 11 Meán
Fómhair sna Stáit Aontaithe, teacht chun cinn sriantachtaı́ cumais
soláthair sa bhaile agus timpeallacht idirnáisiúnta a bhı́ i bhfad
nı́os laige go ginearálta. Tugann furmhór na meastachán ar
chumas táirgthe le tuiscint, áfach, gur ar éigean atá an leibhéal
gnı́omhaı́ochta reatha nı́os ı́sle ná leibhéal na lánfhostaı́ochta. Ba
chóir go mbeadh sé mar aidhm feasta ag an bpolasaı́
macragheilleagrach cuidiú leis an ngeilleagar filleadh ar an
leibhéal inbhuanaithe seo chomh luath agus is féidir. Toisc nach
bhfuiltear ag súil le feabhas suntasach sa gheilleagar idirnáisiúnta
go dtı́ anonn sa bhliain 2003, tá sé á thuar go bhfásfaidh an OTN
in Éirinn timpeall 3 faoin gcéad sa bhliain 2003 ach tá seans ann
go b’fhéadfadh an fás a bheith nı́os ı́sle mar gheall ar an
éiginnteacht sa timpeallacht eacnamaı́och idirnáisiúnta.
D’fhéadfadh roinnt tosca cabhrú chun fás is ionann agus fás lánfhostaı́ochta a shroichint arı́s. Má leanann an ráta ard boilscithe
a mhair ar feadh trı́ bliana suas go dtı́ 2002, beidh sé mar bhagairt
ar fhás is ar iomaı́ochas. Is féidir an ráta boilscithe seo, atá ard i
gcóimheas lenár macasamhla Eorpacha, a chur i leith lı́on áirithe
tosca. Tháinig méadú ar bhoilsciú ón taobh amuigh mar thoradh
ar dhı́mheas an euro i 2000. Ina theannta sin, thug fás buanaithe
os cionn 10 faoin gcéad, arna fhadú ag beartas airgeadaı́ochta
agus fioscach forleathnaitheach sna blianta 2001 agus 2002,
spreagadh mór don éileamh intı́re agus chuir sé leis na brúnna
boilscı́ocha. Ba léir ón ráta dı́fhostaı́ochta de 3.7 faoin gcéad a
sroicheadh sa chéad ráithe de 2001 agus a bhı́ nı́os ı́sle ná mar
ba ghnách agus ón mbrú nı́os ginearálta ar an mbonneagar go
raibh an geilleagar ag sracadh le sriantachtaı́ cumais.
49
Quarterly Bulletin Winter 2002
Rátaı́ arda fáis agus éileamh láidir ar lucht oibre ba shiocair le
neartú tábhachtach i bpá — ó mhéadaithe de 41⁄2 faoin gcéad i
1998 go dtı́ nı́os mó ná 9 faoin gcéad i 2001. Fé mar a d’fhógair
an Banc go minic, bı́onn sé deacair uaireannta stop a chur le
luasghéarú sa bhoilsciú mar go ndaingnı́tear ionchais boilscı́ocha
in iompar lucht socraithe pá agus praghsanna. Feictear an
mharthanacht seo sa mhéid gur tháinig méadú 8.8 faoin gcéad
ar an meántuilleamh tionsclaı́och uaire sa bhliain go dtı́ mı́
Meitheamh seo caite, fiú nuair a bhı́ coinnı́ollacha ar an margadh
oibre ag maolú go mór. Ar an dtaobh fioscach de is ionann
Meastacháin na Cáinaisnéise agus na hEarnála Poiblı́ a foilsı́odh
i Mı́ na Samhna agus freagairt chothromúil do thimpeallacht
gheilleagrach atá nı́os deacra, sa mhéid go bhfuil an fás sa
chaiteachas iomlán nı́os mó i gcomhréir leis an bhfás ionchasach
in ioncaim, cé gur dealraitheach go bhfuil an srian ar chaiteachas
le feiceáil nı́os mó ar thaobh an chaipitil, doscéala i ngeilleagar
ina bhfuil brúnna suntasacha ar an mbonneagar. Os a choinne
sin, b’fhéidir go gcabhróidh maolú sealadach ar infheistı́ocht
phoiblı́ chun an boilsciú in earnáil na tógála a ı́sliú.
Tá gá le hardaithe pá measartha chun a chinntiú go bhfillfimid ar
bhuanráta boilscithe nı́os isle agus go háirithe, chun
inmharthanacht na hearnála dúchasaı́ déantúsaı́ochta a
dhaingniú. Mar atá ráite cheana ag an mBanc agus i staidéar a
rinne an Ciste Airgeadaı́ochta Idirnáisiúnta le déanaı́, is beag
cosaint atá ag na hearnálacha dlúthfhostaı́ochta seo ar chailliúint
iomaı́ochais mar thoradh ar luachmhéadú an euro óna leibhéal
reatha atá measta faoina luach, dar le mórán tráchtairı́. Caithfear
fáiltiú freisin roimh bearta eile in aghaidh an bhoilscithe i bhfoirm
gealltanais chun trédhearcacht praghsanna agus iomaı́ocht
feabhsaithe a chur chun cinn, go háirithe in earnáil na seirbhı́sı́,
earnáil nach mbı́onn uirthi, de ghnáth, aghaidh a thabairt ar
iomaı́ocht idirnáisiúnta. Lena chois sin, mar a tugadh le fios i
Ráiteas an Fhómhair, is uirlisı́ tabhachtacha iad feasacht
tomhaltóirı́ agus oideachas leanúnach chun dálaı́ a chur ar fail
arı́s a chothódh cobhsaı́ocht phraghsanna.
Cúis imnı́ eile is ea an fás láidir leanúnach i gcreidmheas don
earnáil phrı́obháideach in Éirinn agus an t-ardú comhthreomhar i
bpraghsanna tithı́ochta. Tá roinnt áirithe tosca a d’fhéadfadh a
bheith ag spreagadh na bhforbairtı́ seo — coinnı́ollacha
creidmheasa buntáisteacha, chomh maith le tarraingt siar i
gcáinaisnéis na bliana 2002, chuid de na bearta cánach a tugadh
isteach roimhe sin chun infheistı́ocht i margadh na tithı́ochta a
dhı́mholadh. Cé go bhfuil roinnt mhaith tosca bunúsacha atá
measartha láidir taobh thiar den éileamh ar thithı́ocht, mar
shampla, déimeagrafaic agus fás fostaı́ochta, mar sin féin tá imnı́
ar an mBanc faoin athluasghéarú i bpraghsanna tithı́ochta.
Scrı́obh an Gobharnóir chuig cathaoirligh na n-institiúidı́
chreidmheasa faoi na cúiseanna imnı́ seo. Déanfaidh an Banc
faireachán ar na freagairtı́.
50
Quarterly Bulletin Winter 2002
Bhı́ an t-athshlánú eacnamaı́ochta domhanda nı́os laige agus nı́os
mı́chothroime ná mar a bhı́othas ag súil leis i 2002. Tar éis don
gheilleagar a bheith ag bisiú go mór sa chéad ráithe, tá an
móiminteam caillte aige. Cúis dı́oma a bhı́ sa ráta fáis agus
léirı́onn sé méid agus buaine na héiginnteachta a bhı́ faoi réim ó
lár na bliana. Bhı́ roinnt áirithe tosca ag cur dlús leis an
éiginnteacht seo, go mórmhór an meathlú sna margaı́ cothromais
agus airgeadais agus an méadú i dteannais gheopholaitiúla agus
a dtionchair ar na margaı́ ola. Go bunúsach, áfach, cuireadh
srian ar an athshlánú toisc go bhfuil mórán de na
mı́chothromaı́ochtaı́ suntasacha eacnamaı́ochta agus airgeadais
a tháinig chun tosaigh le linn an bhorrtha trádála a tharla roimhe
sin á gceartú fós. Uime sin, tá sé le tuiscint ón mbarraı́ocht
chaipitil domhanda atá fós ann go bhfuil ró-acmhainneacht
tháirgthe i gcónaı́ ann agus san am chéanna, is cúis imnı́ é an
éiginnteacht faoi luacháil na margaı́ cothromais.
51
Quarterly Bulletin Winter 2002
Developments in the International
and Euro Area Economy
Overview
The global economic recovery has lost much of its momentum
in recent months with weakness from mid-year continuing into
the final quarter. With the build up of economic and financial
uncertainty eroding consumer and business confidence in most
regions, there seems little prospect of global growth gathering
momentum in the near future. Thus, growth is expected to
remain modest until well into next year. The subdued economic
recovery is curtailing inflationary pressures in most regions and
headline inflation rates are generally expected to decline next
year. Notwithstanding some pressure in energy and services
prices, this has provided scope for further monetary easing,
allowing interest rates to decline by 50 basis points in both the
euro area and the US in recent months.
Section 1: The International Economic Situation
The global economic recovery has turned out to be weaker than
expected. After a strong inventory-led upturn in the first quarter
and despite support from positive trade developments, the
recovery failed to gather momentum. This led to a sharp decline
in equity prices and a considerable erosion of business and
consumer confidence, which in turn precipitated renewed
weakness. Notwithstanding some recovery in these elements
recently, there has been a significant delay in the expected
acceleration in the pace of economic expansion. Growth is now
generally forecast to remain modest until well into next year,
before gradually accelerating towards trend rates by late 2003
or early 2004. While world economic activity is forecast by the
OECD to expand by 2.8 per cent this year and 3.7 per cent in
2003, this incorporates strong performances from China and
India (estimated to account for around one third of growth),
which are relatively insulated from import penetration and so
provide little stimulus for other countries. Furthermore, averages
for growth this year reflects the strong build up of inventories in
the first quarter, which has not been sustained.
Chart 1
GDP Growth
% Year-on-Year
5
4
3
2
1
0
-1
-2
-3
This recovery contrasts sharply with similar phases in previous
business cycles. Usually, consumers exhibit pent-up demand in
the recovery phase, reinforced by a turnaround in the labour
market. Equity prices recover strongly, while the corporate sector
responds to improving conditions by increasing output, which
feeds through after a time to further increases in employment
and then to business investment. On this occasion, however, the
-4
Dec Mar
'98 '99
Jun Sep
Dec Mar
'00
Jun
Sep Dec Mar
'01
Jun
Sep Dec Mar
'02
Jun Sep
UK
US
Euro area
Japan
Source: EcoWin
53
Quarterly Bulletin Winter 2002
Chart 2
relatively short and mild nature of the preceding downturn did
not lead to a significant accumulation in saving while labour
shedding had been relatively mild. Thus, as is usual in the
recovery phase, consumer demand did not receive strong
support from the unwinding of precautionary savings and
rehiring of labour. This, in turn, led to a weak recovery in
industrial production. With considerable excess capacity
remaining in place, employment and investment growth has
been hampered. As the recovery failed to gather momentum,
equity prices, which were valued significantly above the longterm averages implied by traditional valuation methods, declined
sharply. This compounded the effect of economic weakness on
business and consumer confidence, which both deteriorated
markedly.
Industrial Production
Growth
% Year-On-Year
9
4
-1
-6
-11
-16
Sep
'98
Jan
'99
May
Sep
Jan
'00
May
Sep
Jan
'01
May
Sep
Jan
'02
May
Sep
Japan
US
UK
Euro area
Source: EcoWin
Chart 3
Unemployment Rates in the
Major Economies
%
7
11.5
6
10.5
5
9.5
4
8.5
3
7.5
Sep
'98
Jan
'99
May
Sep
Jan
'00
May Sep
Jan
'01
Euro area (Right Axis)
UK
US
Japan
Source: EcoWin
54
May Sep
Jan
'02
May Sep
The global recovery has also been quite uneven among the
major advanced economies. In the US, France and the UK,
relatively strong growth in private consumption supported by
considerable easing in fiscal policy have been driving domestic
recovery, thereby providing a stimulus for export-led growth in
the economies where private consumption contracted, especially
Germany, Italy and Japan. However, this stimulus began to
dissipate from around the middle of the year as the lagged effect
of the earlier slowdown became more fully felt in the labour
market. This was compounded by negative wealth effects from
strong declines in equity prices, which were particularly marked
in the US and, to a lesser extent the UK, although buoyant house
prices in both countries provided some compensation.
Nevertheless, negative net wealth effects and historically high
household debt repayments may put pressure on consumers to
increase their savings over the short to medium term.
Apart from equity prices, other financial market developments
have also played a key role in distinguishing this recovery from
previous upturns. While financial conditions usually tighten
during a downturn in economic growth, on this occasion they
have tightened significantly during the recovery phase. In capital
markets, spreads on corporate bonds have increased
considerably, particularly for lower investment grade firms, while
venture capital for start-up firms has almost dried up. In banking,
lending criteria have tightened, to reflect not only a more
uncertain economic outlook and an increase in bad debts, but
also the significant decline in the value of their holdings in equity
assets, to which banks have markedly increased their exposure in
recent years. As a result, increased risk aversion has significantly
reduced the benefit of accommodative monetary policy on
activity.
While forward-looking indicators suggest that growth will remain
modest in coming months, fiscal and monetary policy are
expected to continue to remain accommodative. Looking
Quarterly Bulletin Winter 2002
beyond the short-term increase in savings, a pick-up in private
consumption growth in the later part of next year, supported
by employment gains, should complement a gradual recovery in
business investment, to drive economic growth back towards its
potential rate. However, risks remain weighted on the downside.
In financial markets, there is little sign of investor caution
dissipating to allow a significant reduction in risk premia. In the
wider economy, imbalances remain significant and could act as
constraints on activity if they were unwound in a disorderly
manner. Meanwhile, further increases in unemployment could
postpone the recovery in consumption and excess capacity
could continue to retard business investment growth.
Chart 4
Inflation in the Major
Economies
%
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
International Price Developments
While inflation in most advanced economies has increased in
recent months, this was largely driven by sharp increases in
energy prices. In contrast, the tendency has been for core rates,
which usually exclude energy and some food items, to moderate
somewhat, reflecting the persistence of economic growth at rates
well below potential. However, significant inflationary pressure is
evident in many services, and headline rates for the euro area,
the US and the UK are at, or just above, 2 per cent. The main
exception is Japan, where deflation remains firmly embedded in
the economy.
Oil prices continued to increase strongly in the third quarter, with
the average price of UK Brent rising from about US$25 per barrel
at the start of July to around $29 by the end of September,
before declining back to around $25 during October, where it
has stabilised since. These movements largely reflected the
pattern of geopolitical tensions surrounding the Middle East.
However, there is recent evidence of some increase in supply.
Non-oil commodity prices have been increasing this year, largely
reflecting recovery from significant declines last year, on the basis
of both a subdued recovery in demand and some curtailment of
supply. The IMF’s index of non-oil commodity prices increased
by 3.4 per cent in the year to August, but was still lower than its
level at the start of last year.
0.5
0.0
-0.5
-1.0
-1.5
-2.0
Sep
'98
Jan
'99
May
Sep
Jan
'00
May
Sep
Jan
'01
May
Sep
Jan
'02
May
Sep
Euro area HICP
Japan CPI
US CPI
UK HICP
Source: EcoWin
Chart 5
Oil and Non-Oil
Commodity Price Indices
90
195
175
85
155
80
135
115
Headline inflation rates in most advanced economies reflect the
balance between subdued goods prices and more buoyant
services prices. Annual goods price inflation was 1.7 per cent in
the euro area in October and 0.1 per cent in the US, while
services rose by 3.2 per cent in the euro area and 3.4 per cent
in the US. The moderate increase in goods prices primarily reflect
intense international competition, weak domestic pricing from
below trend growth and excess capacity. Such factors do not
play such a large role in services, where activity is relatively
labour intensive and reflects more the robust earnings growth
that occurred up to early this year.
75
95
70
75
65
55
Sep
'98
Jan
'99
May Sep
Jan
'00
May Sep
Jan
'01
May Sep
Jan
'02
May Sep
Oil Commodity Price Index (Right Axis)
IMF Non-oil Commodity Price Index
Source: EcoWin
55
Quarterly Bulletin Winter 2002
Chart 6
With economic growth expected to remain subdued until well
into next year, global inflationary pressures are likely to moderate
in coming months, as earnings growth appears to be on a
downward trend and producer prices remain weak and assuming
a stabilisation of oil prices at around November levels. As a result,
financial markets expect that monetary policy will have scope to
remain accommodative for the foreseeable future.
US Contributions to GDP
2.0%
1.5%
1.0%
Section 2: Developments in the Euro Area’s
External Environment
0.5%
United States
0.0%
Real Economy and Inflation
-0.5%
-1.0%
Q1
'99
Q2
Q3
Q4
Q1
'00
Q2
Q3
Q4
Q1
'01
Q2
Q3
Q4
Q1
'02
Q2
Q3
Private Consumption
Government
The US economy continues to grow, but at a much more modest
pace than earlier expected. Having expanded by 5.0 per cent in
annualised terms in the first quarter (driven largely by inventory
replenishment) and by 1.3 per cent in the second quarter, the
US economy grew by 4.0 per cent in the third quarter, fuelled
primarily by attractive car financing deals and increased
government spending. The indications are that all of these effects
have since dissipated.
Investment
External Trade
Source: Datastream
Chart 7
US Confidence Indicators
70
150
65
140
60
130
55
120
50
110
45
100
40
90
35
80
30
70
Sep
'98
Jan
'99
May Sep
Jan
'00
May Sep
Jan
'01
May Sep
Jan
'02
May Sep
US Business Sentiment (Non-manufacturing)
US Business Sentiment (Manufacturing)
US Consumer Confidence (Right Axis)
Source: EcoWin
56
Relatively solid consumer spending and an upturn in external
demand drove a mild recovery in industrial production up to
mid-year. In contrast, and contrary to the normal business cycle
pattern, business investment failed to pick-up significantly, as
excess capacity remains considerable. Amid market disappointment
at the pace of economic expansion and concern at corporate
accountancy scandals, equity prices declined sharply in the
second and third quarters. Alongside faltering external demand
and increasing oil prices, this contributed to considerable
deterioration in business confidence in the third quarter.
Industrial production was scaled back and unemployment rose.
Meanwhile, weakening employment prospects and substantial
negative wealth effects fuelled a sharp decline in consumer
confidence.
Notwithstanding some improvements in confidence since late
October, economic activity appears to have become more
sluggish. Consumer spending appears more cautious, as
consumers reassess their rate of savings in the light of reduced
household net wealth and the high level of household debt. This
is so notwithstanding strong support for consumer income from
tax reductions, extended unemployment insurance, and,
particularly, a benign environment for mortgage refinancing,
amid negative real interest rates and buoyant house prices. With
regard to investment, however, the tightening of credit
conditions in financial markets has modified some of the positive
impact of new fiscal incentives and some improvement in
Quarterly Bulletin Winter 2002
Changes in Key Economic Variables in Selected Economies
Real GDP
Growth
%
Table 1
Inflationa
2003f
2001
2002f
2003f
2001
2002f
2003f
Current
Balance
of Payments
(% GDP)
2001 2002f 2003f
2·3
−0·7
1·5
2·6
0·8
2·2
4·8
5·0
5·1
5·8
5·5
5·2
6·0
5·6
5·2
2·8
−0·7
2·1
1·6
−1·1
2·0
1·9
−1·1
1·8
−3·9
2·1
−2·1
−4·9
3·2
−1·7
−5·1
3·8
−2·3
1·5
0·8
1·8
8·0
8·3
8·5
2·5
2·4
2·2
0·1
0·9
0·9
Belgium
Luxembourg
Germany
Spain
France
Irelandc
Italy
Netherlands
Austria
Portugal
Finland
Greece
0·8
1·0
0·6
2·7
1·8
5·7
1·8
1·3
1·0
1·6
0·7
4·1
0·7
0·8
0·4
1·8
1·0
4·5
0·3
0·1
0·7
0·4
1·6
3·6
2·1
2·5
1·5
2·5
1·9
4·2
1·5
1·6
1·9
1·5
3·2
3·9
6·6
2·6
7·3
10·5
8·7
3·8
9·6
2·0
4·9
4·1
9·2
10·4
6·9
3·0
7·8
11·2
9·0
4·4
9·2
2·7
5·6
4·7
9·3
10·1
6·9
3·5
8·1
11·2
9·4
5·0
9·2
3·5
5·7
5·1
9·5
9·8
2·4
2·4
2·4
2·8
1·8
4·9
2·3
5·1
2·3
4·4
2·7
3·7
1·6
2·1
1·6
3·5
1·9
4·5
2·5
4·0
1·7
3·5
1·7
3·8
1·4
1·7
1·4
3·0
1·8
4·0
2·3
2·7
1·6
2·8
2·0
3·3
3·8
—
0·1
−2·6
1·6
−0·3
0·0
0·6
−2·2
−9·4
6·4
−6·2
5·8
—
2·0
−2·4
1·8
−0·5
−0·8
3·1
−0·8
−7·8
6·5
−6·1
5·8
—
2·3
−2·6
1·4
−0·9
−0·5
3·6
−0·7
−6·9
6·5
−5·9
Non-Euro Area
Denmark
Sweden
1·0
1·2
1·5
1·7
2·0
2·5
4·3
4·0
4·3
4·0
4·2
4·1
2·4
2·4
2·4
2·3
2·0
2·2
2·5
3·0
2·4
3·9
2·8
3·5
2001
2002f
0·3
−0·3
2·0
Euro Areab
US
Japan
UK
Unemployment
Rate
%
%
a Consumer price index — excluding mortgage interest for UK.
b Greece became a member of the euro area on 1 January 2001.
c Central Bank of Ireland estimates.
f Forecast.
Source: OECD Economic Outlook, November 2002, (Preliminary Edition).
profitability. While federal government spending has been
expanding rapidly, particularly on defence, state governments
have started to implement significant cutbacks to their spending
plans.
While the headline rate of consumer price inflation has risen in
recent months — to 2.0 per cent in October from 1.5 per cent in
July — this has been largely driven by energy prices. The core
rate (excluding energy and seasonal food) declined to 2.2 per
cent (from 2.3 per cent) over the same period. Producer prices
rose strongly in October, driven by energy prices; prices are on
a mild upward trend when energy is excluded. Earnings growth
has eased throughout the year, in response to the weaker labour
market.
Chart 8
US Inflation Indicators
%
5.0
4.5
4.0
3.5
3.0
2.5
2.0
Policy Developments
On 6 November, the Federal Open Market Committee (FOMC)
responded to the emergence of weaker than expected activity
and greater uncertainty with regard to the economic outlook,
with further monetary easing of 50 basis points, bringing the
federal funds target rate to 1.25 per cent and a shift in its balance
of risks from weighted towards economic weakness to neutral.
This reflects the belief of the Committee that the accommodative
stance of monetary policy, coupled with still-robust underlying
growth in productivity, is providing important ongoing support
to economic activity. Fiscal policy is also providing strong
1.5
1.0
0.5
0.0
Sep
'98
Jan
'99
May
Sep
Jan
'00
May
Sep
Jan
'01
May
Sep
Jan
'02
May
Sep
US CPI
US Core Inflation
Employment Cost Index
Source: EcoWin
57
Quarterly Bulletin Winter 2002
Chart 9
support for growth, with the federal budget moving this year
from surplus in 2001 into a deficit estimated at around 1.5 per
cent of GDP this year.
US Interest Rates
%
8
Outlook
Official forecasts are for the US economy to expand by a little
over 2.0 per cent this year and around 2.75 per cent next year.
Business investment is expected to recover gradually over the
course of next year, based on the dissipation of uncertainty and
the need for investment replenishment following an extended
period of sharp contraction. This is expected to lead to a
turnaround in the labour market, which will benefit private
consumption, to allow the pace of expansion to accelerate
towards its potential rate later in the year.
7
6
5
4
3
2
1
Sep
'98
Jan
'99
May
Sep
Jan
'00
May
Sep
Jan
'01
May
Sep
Jan
'02
May
Sep
US 3-month market rate
Federal Funds Rate
Source: EcoWin
The outlook is subject to considerable uncertainty, however.
First, the labour market remains fragile so that recent economic
weakness could translate into a rise in unemployment. Second,
it is difficult to gauge when investment growth might recover,
particularly given current financing conditions. Third, US equity
prices remain both volatile and, according to traditional valuation
methods, expensive. Finally, official forecasts imply that the
current account deficit will remain above 5 per cent of GDP for
the foreseeable future; this is clearly unsustainable in the longrun and the timing and speed of adjustment is uncertain.
Japan
Chart 10
Japan: Business Investment
and Export Growth
% Year-on-Year
15
10
Percent
5
0
-5
-10
Real Economy and Inflation
The tentative recovery in the Japanese economy earlier this year
looks set to dissipate. The economy expanded by over 2 per cent
in the first three quarters of the year, largely driven by a strong
positive contribution from trade, supported by yen weakness.
This fed through to inventory replenishment and provided some
stimulus for industrial production. This had started to positively
affect domestic demand, as increased overtime hours and
stabilising employment provided some support for private
consumption. However, overall domestic demand remains
exceptionally weak. Earnings continue to decline, putting strong
pressure on consumer income while there is little support for
investment beyond that provided by external demand. This
reflects the environment of declining equity prices (the NIKKEI
index fell to new 19-year lows), the continuing erosion of
profitability due to deflation, and bank credit restrictions.
-15
Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep
'99
'99
'00
'01
'02
Export Growth
Business Investment Growth
Source: EcoWin
58
Deflation remains a defining feature of Japan’s current economic
situation. Consumer prices declined by 0.7 per cent in the year
to September, while the core rate, which excludes food, declined
by 0.8 per cent. The pace of deflation has, however, stabilised
over the past few months, as the impact of rising energy prices
and yen depreciation on import prices partly offset the effect of
Quarterly Bulletin Winter 2002
persistent underlying weakness in domestic demand. Moreover,
producer prices have levelled off. However, these factors may
turn out to be temporary and must be set against weak demand
and declining earnings, which have become embedded into the
economy. Thus, consumer prices look set to remain on a gradual
downward trend for some time, with official forecasts for
deflation to persist until at least 2004.
Chart 11
Japan: Tankan Survey
of Business Conditions
-5
-10
Policy Responses
With official interest rates effectively at zero, the implementation
of monetary policy easing is focused on the provision of excess
liquidity to the financial system (measured by banks’ current
account balances at the Bank of Japan) through money market
operations. At its meeting of 30 October, the Bank of Japan
decided to ease monetary policy further by raising its target of
excess reserves to 15-20 trillion yen (from 10-15 trillion yen).
Moreover, it increased its purchases of long-term government
bonds and extended the range of bills which it will purchase in
its open market operations. However, the reluctance of banks to
lend, combined with the weak financial position of the corporate
sector, considerably hinder the transmission of liquidity to the
money supply. While the monetary base is growing at a year-onyear rate of around 20 per cent, the year-on-year growth rate of
the money supply is around 3.0 - 3.5 per cent. At the same time,
the scope for fiscal stimulus is limited, due to the high ratio of
public deficit and debt to GDP.
-15
-20
-25
-30
-35
-40
-45
-50
Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep
'98
'99
'00
'01
'02
Source: EcoWin
Chart 12
Outlook
Quarterly rates of expansion are expected to slow later this year
and into next year, delivering 1 per cent growth for 2003. This
reflects near-term slowdown in export growth and persisting
weakness in domestic demand. Furthermore, significant
downside risks remain severe. Weakness in external demand
could completely dissipate recovery momentum, while high
levels of public and corporate debt make the economy
particularly vulnerable to financial market movements. Moreover,
much restructuring of the banking system has still to take place
and, while this will be beneficial in the long-term, the short-term
impact is likely to be negative.
Japan Inflation – Indicators
%
0.75
0.50
0.25
0.00
-0.25
-0.50
-0.75
-1.00
UK
-1.25
Real Economy and Inflation
-1.50
The strong recovery in the UK economy has slowed somewhat
since the middle of the year. While growth in the third quarter,
at 0.8 per cent, was higher than that of the second quarter (0.6
per cent), adjustments for the timing of extra holidays, for the
Queen’s Jubilee celebrations, show a weakening trend. Net trade
exerted a significant drag on growth in the third quarter and
increased the current account deficit to a new record high.
-1.75
Sep Dec Mar Jun
'98
'99
Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep
'00
'01
'02
Japan CPI
Japan Core Inflation
59
Quarterly Bulletin Winter 2002
Chart 13
UK Manufacturing Output
% Year-on-Year
4
3
2
1
0
-1
-2
-3
-4
-5
-6
-7
-8
-9
Sep Dec Mar Jun Sep
'98
'99
Dec Mar Jun Sep Dec Mar Jun
'00
'01
Sep Dec Mar Jun Sep
'02
Source: EcoWin
Chart 14
UK: Retail Sales Growth
and Unemployment
%
9
6.5
8
7
6.0
6
5
5.5
4
3
5.0
2
1
0
4.5
Sep Jan
'98 '99
May Sep Jan
'00
May Sep Jan
'01
May Sep
Jan
'02
UK Retail Sales (year-on-year)
UK Unemployment (Right Axis)
60
May Sep
Furthermore, it contributed to a sharp deterioration in industrial
confidence, which has remained weak into the final quarter.
However, private consumption remained relatively buoyant in
the third quarter while survey data on actual and prospective
retail sales in the final quarter appear robust. The strength of
consumer spending is particularly evident in the housing market,
with annual house price inflation running at well over 20 per cent
and household debt secured on dwellings increasing by around
13 per cent year-on-year. These developments are clearly
unsustainable and are a major source of concern for the Bank of
England. On the other hand, support from the labour market
for consumer income is waning, with employment decreasing
significantly and the rate of unemployment rising to 5.3 per cent
(from 5.1 per cent) in September. Business investment has now
contracted for seven successive quarters, and at an accelerated
pace, and there is little sign of an imminent pick-up. Surveys
suggest further deterioration in investment intentions and a
downward trend in new capital goods orders. However, public
investment and spending continues to increase rapidly, providing
considerable support to activity. The headline rate of inflation
(RPIX) rose to 2.3 per cent in October, from 2.1 per cent in
September, having reached a trough of 1.5 per cent in June. The
subsequent increases reflect a sharp rise in energy and housingrelated prices. Domestic inflationary pressure is also evident in
services, where prices rose by 4.8 per cent in the year to
September, in sharp contrast to goods prices, which have
declined by 0.7 per cent over the same period. Signs of
inflationary pressure in earnings have become more mixed,
however; while earnings growth has stabilised at rates
significantly below those of last year, there are signs of pent-up
wage pressures in the rapidly expanding public sector.
Policy Responses
Monetary policy has remained unchanged for the year up to
December. While robust consumer spending has generated
considerable inflationary pressure in services and housing, this
has been offset by weak pricing power in industry as firms
concentrate on maintaining market shares in a highly uncertain
global environment. The Bank of England’s latest Inflation Report
reflected considerable unease regarding house price inflation and
contained significant upward revisions to its inflation projection,
with the headline rate expected to exceed its 2.5 per cent target
by the end of the year and to remain above target for most of
next year before moderating thereafter. This projected increase
is mostly accounted for by energy and housing-related costs.
Financial markets anticipate no change in monetary policy until
late 2003, when rates are expected to rise. The recent Budget
provides for strong increases in government spending to
continue into the medium-term and the fiscal deficit is expected
to rise to 1.0 per cent of GDP next year.
Quarterly Bulletin Winter 2002
Three-Month Interest Rates
Table 2
Euro
US Dollar
Japanese
Yen
Sterling
%
%
%
%
31 July 2001
4·44
3·67
0·09
5·25
31 August 2001
4·25
3·46
0·07
4·93
28 September 2001
3·66
2·59
0·08
4·53
31 October 2001
3·52
2·20
0·08
4·22
30 November 2001
3·36
2·03
0·08
4·02
31 December 2001
3·29
1·88
0·10
4·11
31 January 2002
3·37
1·88
0·09
4·06
28 February 2002
3·37
1·90
0·11
4·06
29 March 2002
3·45
2·03
0·09
4·19
30 April 2002
3·38
1·92
0·08
4·15
31 May 2002
3·48
1·90
0·07
4·19
28 June 2002
3·44
1·86
0·07
4·15
31 July 2002
3·38
1·82
0·07
4·00
30 August 2002
30 September 2002
3·36
3·30
1·81
1·79
0·06
0·07
4·01
3·94
31 October 2002
3·26
1·69
0·07
3·95
29 November 2002
3·05
1·42
0·07
4·03
Outlook
The UK economy is forecast to expand by about 1.5 per cent
this year and around 2.0 per cent next year. External demand is
expected to recover from a weak performance so far this year.
While this should lead to a gradual turnaround in business
investment, the impact on domestic demand is expected to be
partly offset by moderating growth in private consumption, the
latter reflecting declines in equity prices this year and waning
support from the labour market. Public spending is likely to
continue to provide further support for growth, however.
Downside risks are similar to elsewhere, with the addition of a
risk in the evolution of house prices. The outlook for external
demand remains highly uncertain, which is of particular concern
as further increases in the current account deficit, already at
record levels, deepen the risk of sharp adjustment.
Section 3: Developments in the Euro Area
Chart 15
UK Inflation Indicators
%
6.5
3.5
6.0
3.0
5.5
5.0
2.5
4.5
4.0
2.0
3.5
3.0
1.5
2.5
Real Economy and Inflation
The recovery in the euro area economy has failed to gather any
real momentum, with GDP growth in the third quarter easing to
0.3 per cent, from 0.4 per cent in each of the first two quarters
of this year, according to a preliminary estimate from Eurostat.
This reflects the weak response of domestic demand to the pickup in net exports earlier this year. While there was a recovery in
industrial production in the first half of the year, driven largely
by external demand, improvements in industrial confidence
subsequently stalled, in line with a weakening in export orders.
Recent survey evidence indicates a contraction in industrial
1.0
2.0
Sep
'98
Jan
'99
May Sep
Jan
'00
May Sep
Jan
'01
May Sep
Jan
'02
May Sep
RPIX
Average Earnings – headline rate (Right Axis)
Source: EcoWin
61
Quarterly Bulletin Winter 2002
Chart 16
activity. The main impetus to domestic demand in the third
quarter is likely to have been private consumption, with retail
sales improving significantly and passenger car sales increasing
further from a relatively strong second quarter. However,
weakening consumer confidence, alongside some evidence of
deterioration in services activity and weakening employment
surveys, suggests that momentum could be dissipating in the
fourth quarter. Factors negatively affecting consumer confidence
include sharp declines in equity prices, rising unemployment and
perceptions that inflation is higher than official estimates. Despite
having contracted sharply since the end of 2000, there is, as yet,
little indication of a significant pick-up in business investment and
inventory restocking has also been weak. The subdued upturn in
consumer spending and external demand means that capacity
utilisation and corporate profitability remain weak. Fiscal policy
has been accommodative this year, with discretionary measures
in the form of both tax reductions and increased spending.
Euro Area Contributions to
GDP
1.4%
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
-0.0%
-0.2%
-0.4%
-0.6%
Q1
'99
Q2
Q3
Q4
Q1
'00
Q2
Q3
Q4
Q1
'01
Q2
Q3
Q4
Q1
'02
Q2
Private Consumption
Government
Investment
External Trade
Source: Eurostat
Chart 17
GDP Growth
% Year-onYear
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
-0.5
Dec Mar Jun Sep
'98 '99
Dec Mar Jun Sep Dec Mar
'00
'01
Euro area
Germany
France
Italy
Source: Ecowin
62
Jun Sep
Dec Mar Jun
'02
Sep
There are significant differences in the strength of economic
recovery between the three largest countries of the euro area.
Although declines in consumer and business confidence in the
third quarter were pervasive, French domestic demand had by
then generated significant momentum, in sharp contrast to
developments in Germany and Italy. Looking ahead, recovery in
France is expected to accelerate from early next year, while
growth in Germany and Italy is expected to remain subdued until
well into the year.
The upturn in the German economy has been very fragile;
growth in the first half of the year was based entirely on net trade
expansion, which more than compensated for contraction in
both private consumption and investment. The pass-through to
domestic demand from the external stimulus has, however, been
particularly weak and generally confined to industrial production.
Although private consumption began to respond tentatively in
the third quarter, little momentum was generated. Business and
consumer confidence have since declined sharply, in response
to the deterioration in the global economic outlook. Both
equipment and construction investment remain very weak,
having contracted for eight successive quarters, and there is little
sign of imminent improvement. Capacity utilisation remains low;
German equity prices have declined particularly sharply;
corporate pricing power remains weak, and banks have become
more cautious about granting loans in response to a wave of
bad debts and restructuring of the banking system. Construction
investment is, however, expected to receive a short-term boost
from reconstruction work, after flooding in August.
Official forecasts are for the German economy to expand by
around 0.5 per cent this year, largely reflecting a positive
contribution from net trade to GDP. An upturn in external
Quarterly Bulletin Winter 2002
demand is expected to feed through to a recovery in private
consumption by late next year, delivering a growth rate of
around 1.5 per cent for 2003. Investment is not expected to
respond until 2004, however. As elsewhere, risks to these
forecasts are predominantly on the downside. With domestic
demand so weak, the economy is particularly vulnerable to the
highly uncertain international economic outlook; recent declines
in consumer and business confidence, if sustained, could
precipitate a protracted deterioration in domestic demand; fiscal
policy looks set to tighten next year and declining consumer
price inflation is reducing the impact of monetary loosening.
The recovery in the French economy was balanced in the first
half of the year, with private consumption the main driver of
expansion, supplemented by improved external demand and
buoyant public expenditure. However, business investment
stagnated — despite the emergence of capacity constraints last
year — and unemployment rose steadily. Moreover, business
confidence declined significantly in the third quarter and demand
for investment goods remains particularly weak. The pace of
expansion in private consumption moderated significantly in the
third quarter, reflecting falling consumer confidence. There was
also a significant weakening in industrial production, as both
domestic and export orders declined markedly. Fiscal policy
continues to provide strong support, with government spending
expanding rapidly and income taxes declining significantly.
The French economy is forecast to expand by about 1 per cent
this year and at about double that pace next year. This forecast
is predicated on consumer purchasing power receiving a boost
later this year and next year from further reductions in income
taxes and declining consumer price inflation, while external
demand is projected to pick up early next year. However, it
remains to be seen to what extent consumers adjust their
spending to reflect their concern over rising unemployment,
while the external outlook is particularly dependent on the highly
uncertain prospects for the German economy.
Chart 18
Euro Area Confidence
Indicators
4
9
2
4
0
-2
-1
-4
-6
-6
-8
-11
-10
-16
-12
-21
-14
Sep
'98
Jan
'99
May Sep
Jan
'00
May Sep
Jan
'01
May Sep
Jan
'02
May Sep
Industrial Confidence
Consumer Confidence (Right Axis)
Source: EcoWin
The recovery in the Italian economy has been lacklustre, with
growth of just 0.2 per cent in the first half of the year. This was
achieved by robust growth in government spending and
inventory levels, which offset a contraction in private
consumption and investment. This weakness persisted into the
third quarter, according to a preliminary estimate of GDP. The
recovery in external demand has been relatively mild; relative
dependence on the German market and incipient
competitiveness problems inhibited growth, with Italian goods
losing share in many markets. Industrial production expanded
mildly in the third quarter, however, the first for almost two years,
although more recent surveys of industrial sentiment are mixed.
Private consumption looks set to remain sluggish, according to
63
Quarterly Bulletin Winter 2002
Chart 19
retail sales data, while consumer confidence has deteriorated
markedly; while unemployment has declined significantly so far
this year, in response to earlier structural reforms and wage
moderation, the latest indications are that employment growth is
slowing. It appears that high levels of perceived consumer price
inflation, as indicated by surveys and union pay demands, are
playing a role in depressing consumer sentiment.
Euro Area Unemployment
Rates
%
13
12
8
Official forecasts are for the Italian economy to grow by less than
0.5 per cent this year and a little over 1.5 per cent next year.
Private consumption is expected to remain sluggish into next
year, particularly as employment growth is slowing, but domestic
demand is expected to eventually benefit from the impact of
low real interest rates. However, the persistence of high relative
inflation could dampen any recovery in external demand, while
domestic demand is vulnerable to a significant adjustment in the
labour market.
7
Outlook
11
10
9
Sep
'98
Jan
'99
May
Sep
Jan
'00
May
Sep
Jan
'01
May
Sep
Jan
'02
May
Sep
Euro area
Germany
France
Italy
Source: EcoWin
Chart 20
Euro Area Monetary
Aggregates
Year-on-year growth
%
12
10
8
Monetary and Inflation Developments in the
Euro Area
6
4
2
0
Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep
'00 '01
'02
M3
Source: ECB
64
Official forecasts of economic growth in the euro area have been
revised down significantly in recent months, with the OECD and
European Commission both now expecting growth to be 0.8 per
cent in 2002 and 1.8 per cent in 2003 (compared to
expectations early this year of around 1.5 per cent and 3.0 per
cent, respectively). The pace of expansion is now expected to
remain modest until well into next year before accelerating
towards its potential growth rate of 2.5 per cent by year-end.
This is based on recovery in private consumption, supported by
a moderation in consumer price inflation to below 2 per cent for
most of next year, and a gradual recovery in external demand, in
line with a global upturn, feeding through to investment in an
environment of low interest rates. However, with domestic
demand expected to remain subdued for the time being, the
outlook is particularly vulnerable to developments in the global
economy, where downside risks predominate. Moreover, there
is relatively little scope for fiscal policy to provide further stimulus
in the large euro area economies.
Private Sector Credit
There have been large fluctuations in the growth rate of the
broad money supply, with the annual growth rate easing back to
7.0 per cent in October, from a sharp rise to 7.4 per cent in
September, and the three-month moving average rate declining
from 7.3 per cent in June to 7.1 per cent in October. This
downward movement reflects some unwinding of large portfolio
shifts into liquid assets, which occurred late last year amid high
levels of economic and financial uncertainty. However, such
uncertainty has dissipated much more slowly than expected this
year and monetary growth has been relatively slow to decline.
Quarterly Bulletin Winter 2002
Strong growth in the narrow money supply is also playing a role,
with currency holdings being steadily rebuilt following a strong
decline in the run-up to the cash changeover to the euro. While
more liquidity is available than would be needed to finance
sustainable, non-inflationary growth, there is little risk in the
current economic environment of this translating into inflationary
pressures in the near future, while the temporary factors driving
recent developments are expected to unwind in due course. On
the credit side, the annual rate of growth in total credit declined
from 4.5 per cent in June to 4.3 per cent in October. This
reflected a decline in credit to the private sector from 5.4 per
cent to 4.9 per cent and a rise in credit to government from 1.1
per cent to 2.1 per cent. Loans to the private sector have
stabilised at annual growth rates at, or just over, 5 per cent, in
line with the long-run average.
Chart 21
Euro Area Inflation
Indicators
%
4
3.5
3.0
3
2.5
2
2.0
1
1.5
0
1.0
The annual rate of headline inflation in the euro area (HICP)
has risen to 2.3 per cent in October from 1.8 per cent in June,
following a decline from a peak of 2.7 per cent in January. This
reversal of the downward trend is almost entirely due to
developments in energy prices; strong oil price increases over
recent months have been compounded by base effects from
significant declines in energy prices last year. The other main
source of inflationary pressure has been transport prices, which
is likely to reflect second round effects from increases in energy
prices earlier this year. Underlying inflation (the headline rate
excluding energy and unprocessed food) declined to 2.4 per cent
in October, having remained at 2.6 per cent from January to
June. This reflects a downward trend in the annual inflation rate
of non-energy industrial goods prices, to 1.3 per cent in
September, and stabilisation at around 3 per cent in annual
service price inflation.
Inflationary pressure along the chain of production remains
subdued, with producer prices increasing by just 0.1 per cent in
the year to September. While energy prices have risen strongly
in recent months, increases in producer prices in intermediate,
capital and consumer goods remain muted. Surveys suggest that
manufacturing input prices weakened further in October. Wage
pressures appear to be easing, following a strong rise in the first
quarter. The annual growth rate of unit labour costs declined to
2.4 per cent in the second quarter (from 3.2 per cent), reflecting
both a decline in annual growth in compensation of employees
and a rise in productivity. Moreover, early indications are that
this trend has continued into the third quarter, with an indicator
of negotiated wages declining to 2.6 per cent (from 2.8 per cent).
-1
0.5
-2
0.0
Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep
'98
'99
'00
'0
'02
Headline Inflation (Right Axis)
Unit Labour Costs
Compensation per Employee
Core Inflation
Source: EcoWin
Chart 22
ECB Interest Rates and
Money Market Rates
%
6
5
4
3
2
1
0
Feb
'01
May
Aug
Nov
Feb
'02
May
Aug
Nov
Marginal lending facility
The annual rate of HICP inflation is generally forecast to be 2.2
— 2.3 per cent this year and average around 2 per cent next year;
some upward pressure on inflation is expected to occur in the
final months of 2002, as base effects and planned increases in
Deposit rate
Main refinancing rate/Minimum bid rate
Marginal rate in main refinancing operation
EONIA
Source: EcoWin
65
Quarterly Bulletin Winter 2002
taxes and administered prices in a number of countries feed
through. However, inflation rates are expected to decline to
below 2 per cent over the course of 2003, due principally to the
lagged effect of the strengthening in the euro exchange rate this
year and to economic growth remaining well below potential.
The unwinding of both strong increases in services prices and
the indirect effects of previous oil price increases should support
this trend. Moreover, in the final quarter, oil prices have eased
markedly, the euro has appreciated somewhat and it has become
increasingly apparent that wage pressures are easing. The main
risk to the outlook is the possibility of renewed geopolitical
tensions leading to sharp increases in oil prices.
Chart 23
Selected Three-Month
Interest Rates
End-Week Data
%
7
6
5
4
Monetary Policy in the Euro Area
Haing remained unchanged since November 2001, the level of
official interest rates in the euro area was reduced by 50 basis
points on 5 December; the minimum bid rate on the
Eurosystem’s main refinancing operations declined to 2.75 per
cent while the rates on the marginal lending facility and the
deposit facility remain declined to 3.75 per cent and 1.25 per
cent respectively.
3
2
1
0
Apr May Jun Jul
'01
Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul
'02
Aug Sep Oct Nov
Note:
The rates shown in this
chart are London Market
mid-closing rates.
US Dollar
Japanese Yen
Pound Sterling
Euro
Source: EcoWin
Chart 24
Selected Official
Interest Rates
%
7
6
Analysis under the first pillar of the ECB’s monetary policy
strategy — monetary developments — shows that there is, at
present, little risk of the continuation of strong growth in the
money supply translating into inflationary pressure in the near
future given the economic outlook. Analysis under the second
pillar — the broad economic and financial market assessment and
inflation developments — provides increasing evidence that
economic growth will remain subdued until well into next year.
The persistence of economic weakness and the strengthening in
the euro exchange rate, which has occurred since early this year,
increases the prospect of inflation declining to below 2 per cent
in the course of next year and to remain in line with price stability
thereafter.
5
4
Section 4: Financial Market Developments
3
Money and Bond Market Developments
2
1
0
Mar
'01
May
Jul
Sep
Nov
United States
Japan
UK
Euro Area
Source: EcoWin
66
Jan
'02
Mar
May
Jul
Sep
Nov
Note:
The rates shown in this chart
are the main refinancing rates
for the euro-area, discount rate
for Japan, federal funds target
rate for the US and the base
rate for the UK.
Short-term money market interest rates have eased significantly
in the euro area and the US since the start of September but
have remained broadly unchanged in the UK. This reflects
expectations, later realised, of monetary easing in the US and
euro area.
While long bond yields in the major economies continued to
decline strongly, particularly in the US, in September, this was
fully offset by a rise in yields in October and November. These
movements reflect ‘‘safe haven’’ flows from equities, where
Quarterly Bulletin Winter 2002
prices continued to decline in September, and their subsequent
unwinding as equity markets experienced a rally. With short-term
rates falling sharply in the US and in the euro area, yield curves
in both areas steepened sharply between the start of September
and the end of November. The differential between euro area
and US 10-year bond yields has narrowed over the period.
Chart 25
Bond Yield: 10-year
%
6.8
6.3
Exchange Rate Developments
After consolidating around US$0.98 for most of the period from
early September to late October, the euro appreciated
somewhat thereafter to start a new period of consolidation
around parity. This resulted in euro appreciation of 1.3 per cent
against the US dollar between the start of September and the
end of November. This appreciation largely reflected weakness
in the US dollar, amid gathering evidence that the economic
recovery was slowing and some widening of interest rate
differentials in the aftermath of the decision of the US Federal
Reserve to reduce interest rates. However, the US dollar
stabilised towards end-November following more positive US
economic data and on some easing of geopolitical tensions.
5.8
5.3
4.8
4.3
3.8
3.3
Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct
'98 '99
'00
'01
'02
Euro area
US
The Japanese yen experienced a weakening trend against the
other major currencies during the period. Downward pressure
on the yen was prompted by renewed concerns regarding both
the economy and the prospects for bankings reform,
compounded by a further downgrade of Japan’s sovereign debt
rating. The euro appreciated by 5.6 per cent against the yen but
was broadly unchanged against sterling, as the latter benefited
from evidence of continuing strong domestic demand.
UK
Source: EcoWin
Chart 26
Exchange Rate
Changes for the Euro
End-week data
4
0
-4
-8
-12
-16
-20
-24
-28
-32
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
'01
'02
Note:
United States Dollar This chart shows
percentage changes
Pound Sterling
in Euro exchange
Yen
rates by reference
Source: ECB
to 31 December 1998.
67
Quarterly Bulletin Winter 2002
Section 2
The articles in Section 2 are in the series of signed articles on
monetary and general economic topics introduced in the autumn
1969 issue of the Bank’s Bulletin. Any views expressed in these
articles are not necessarily those held by the Bank and are the
personal responsibility of the authors.
Quarterly Bulletin Winter 2002
Japan — A Case History in Deflation
by Anne Marie McKiernan1
ABSTRACT
Having been a model for economic development for decades after the
mid-20th century, Japan then went through a protracted downturn in the
1990s. This has been accompanied by persistent deflation, the only such
example in an industrialised economy in recent times. For this reason, and
given the size and importance of Japan in the global economy, it is valuable
to assess how this deflationary environment developed and the lessons
which can be learned therefrom. This article reviews the background to the
economic problems of the 1990s, especially the bursting of asset price
bubbles and their effects on the financial and corporate sectors. While
monetary and fiscal policy easing was used extensively, it failed to generate
the expected boost to activity and inflation and, in the process, stretched
both policies close to their conventional limits. Clear lessons emerge from
this review, especially the importance of the interaction between
microeconomic reforms and macroeconomic policy effectiveness, the need
to take early account of the reduction in effectiveness of monetary policy
as nominal interest rates reach zero, and the significant costs for growth of
delaying restructuring.
1. Introduction
Japan has undergone a sustained period of economic weakness,
which shows little sign of abating in the short term. The 1990s are
often characterised as Japan’s ‘‘lost decade’’, when the economy
averaged growth of around 1.5 per cent per annum, compared
to around 4 per cent per annum in the 1980s. This period
included a couple of severe recessions and several tentative
upturns which failed to become self-sustaining, despite
accommodative fiscal and monetary policies. With the economy
still characterised by economic weakness and deflation, and with
a number of serious constraints clouding the authorities’ policy
choices, the outlook for Japan remains a matter of considerable
concern.
This economic weakness has been accompanied by persistent
deflation, i.e., a situation where prices fall continuously.
Consumer price inflation followed economic growth downward,
falling below zero in mid-1994 and remaining negative apart
from a brief period around 1997. This type of persistent deflation
is markedly different in effect from short periods of deflation
which are expected to be temporary. Prolonged deflation is
associated with deflationary expectations taking root in the
economy, effectively locking in a spiral of economic decline.
Expectations of falling prices discourage consumption and
investment and interfere with resource allocation. Moreover, to
the extent that there is insufficient downward flexibility in
1 The author is Senior Economist in the European Monetary Affairs and International Relations
Department. She would like to gratefully acknowledge helpful comments and suggestions
from Mark Cassidy and John Flynn. The views expressed in this paper are not necessarily
those held by the Bank and are the personal responsibility of the author.
69
Quarterly Bulletin Winter 2002
nominal wages, real wages will rise to hurt employment and
production. Deflation is particularly harmful when debt levels are
high. With flexibility in nominal debt contracts also typically
lagging behind price developments, deflation increases real
debts. To the extent that debtors then have to cut spending and
sell assets to meet their obligations, deflation can generate a
spiral of falling incomes and asset prices and rising real debt,
inducing widespread bankruptcies and generalised financial
sector weakness.
Significantly, deflation also tends to render monetary policy
ineffective. As nominal interest rates can not go below zero,
falling price levels imply that real interest rates can never become
negative. Thus, monetary policy cannot be loosened sufficiently
to counteract the deflationary forces. Moreover, banks tend to
respond to the rise in debt and generalised economic weakness
by restricting credit, effectively tightening monetary conditions
further. Japan is the only example of an industrialised economy
which has experienced protracted deflation in recent times. As
such, it provides a striking illustration of how the deflationary
spiral described above can gain hold and be perpetuated by
policy errors and inadequate reform.
Given Japan’s size, its inability to escape from a deflationary
spiral also has major implications for global economic prospects.
Japan is the second largest country economy in the world and
accounts for about 8 per cent of global demand, while the nonJapan Asian region, with which it obviously has extensive links,
accounts for about a quarter of global activity. Alongside these
real economic interlinkages, there is also the potential, through
other channels, for further spillovers onto other regions. Japan’s
large and rising structural current account surplus reflects the fact
that domestic savings are significantly greater than required to
finance domestic needs, leaving a surplus which flows into
international investments. Behind this development, however,
lies a series of imbalances, between private savings and public
dissavings, which carry the risk of disorderly correction and
associated financial market volatility.
In that context, it is useful to review how Japan’s economic
problems developed and the lessons which other countries can
learn from its deflationary experience. The background to Japan’s
economic malaise, which has its roots in economic overexpansion followed by the bursting of an asset price bubble in
the early 1990s, is set out in Section 2. The negative effects of the
bursting of the bubble, and the subsequent economic slowdown,
were made worse by a failure to tackle deep-rooted problems in
the financial and corporate sectors at an early stage. Important
aspects of the financial and corporate sectors and their link to
Japan’s current situation are explored in Section 3. At the time,
the authorities relied on fiscal and monetary stimulus to
70
Quarterly Bulletin Winter 2002
reactivate growth, but the weaknesses in the financial and
corporate sectors ensured that the normal transmission, from
policy easing to domestic demand, was seriously impaired. This
created a vicious circle, where the failure of demand to recover
prompted more policy stimulus, bringing Japan to its present
position where fiscal and monetary policy are close to their
conventional limits and huge imbalances have built up in the
economy. Section 4 highlights the main issues facing fiscal and
monetary policy at this time. In recognition of the fact that selfsustaining growth and an ending of deflation are unlikely to be
achieved without tackling the structural problems in the financial
and corporate sectors more vigorously, the key features of such
reforms are set out in Section 5. Section 6 presents some of the
key lessons which can be learned from the Japanese experience.
2. Background to Japan’s economic problems
The Japanese economy enjoyed a period of considerable growth
in the second half of the 1980s, when private consumption and
investment expanded rapidly. Optimistic expectations of
sustained growth and easy access to finance helped to fuel a
surge in investment spending. Large firms invested heavily in
equipment and buildings, with the buoyant equity market
providing a relatively cheap source of funds. The low level of
interest rates and the traditionally close relationships between
banks and industrial groups (which included crossshareownership) also enabled firms to access bank loans
relatively cheaply; the official discount rate halved between end1985 and early 1987, to 2.5 per cent. This helped to fuel a sharp
rise in indebtedness of small and medium sized firms in
particular, especially in real estate investment, where overvalued
collateral was used as a basis for loans. These developments took
place against a background of a very weak credit risk evaluation
culture and a corporate governance framework which did not
place a high emphasis on shareholder returns or on transparency.
The surge in investment spending was largely concentrated in
unproductive resources, such as land and buildings. The resulting
low marginal efficiency of capital ensured that this spending did
not contribute markedly to an improvement in potential growth
in the economy.
The combination of the above factors led to a surge in land and
equity prices in the late 1980s, creating an asset price bubble.
By early 1989, the Bank of Japan (BoJ) began raising official
interest rates to try to counter the overheating. The buoyancy of
economic activity was, eventually, reduced in 1990 when, amidst
tight monetary policy and weaker world growth, the Japanese
stock market bubble burst at the beginning of the year. Land
prices continued to rise, however, and the BoJ increased the
official discount rate further in the period up to August 1990.
Thereafter, growth slowed more rapidly, inflation started to fall
71
Quarterly Bulletin Winter 2002
and the land price bubble also burst. As discussed in the next
section, the effects on the financial and corporate sectors were
severe and contributed to the sharp decline in economic growth.
After a 4-year expension, GDP growth peaked at 5 per cent,
year-on-year, in February 1991, to be followed by an unusually
long recession, lasting almost three years.
The most severe correction was in business and residential
investment growth, which fell from a peak of 8 per cent in 1991
to −4 per cent in 1993 (Chart 1). This reflected the combination
of a cyclical downturn and a structural decline associated with
capital losses arising from the bursting of the asset price bubble.2
These losses were estimated at around 2 years’ worth of GDP.3
Further factors weighing on investment were high levels of debt,
excess capital stock, a fall in expected future earnings and limited
access to credit. The return on capital, which was already low in
international terms, fell further, thus deterring future investment.
Chart 1
Japanese GDP Contribution
6
5
4
3
2
1
0
-1
-2
1990
1991
1992
Private Consumption
1993
1994
1995
Government
1996
1997
1998
Investment
1999
2000
2001
External Trade
Source: Datastream
The other main weakness in the first half of the 1990s was in
net exports (Chart 1), reflecting weak international demand and
considerable yen appreciation.4 Private consumption clearly
2 Since their 1991 peak, commercial land prices have experienced cumulative declines of
over 60 per cent, while equities have lost three-quarters of their value from their 1990
peak.
3 Source: OECD Economic Survey, Japan (1998).
4 The negative wealth effect arising out of the collapse of asset prices and worsening
economic conditions contributed to greater risk aversion in investors’ portfolio investment
decisions, prompting an increase in domestic bank deposits and investments. By limiting
the supply of capital available for investment in foreign markets at the prevailing exchange
rate, this contributed to a sharp appreciation of the yen between 1991 and 1995.
72
Quarterly Bulletin Winter 2002
slowed but did not contract significantly until later in the decade.
As section 3b below highlights, the corporate sector initially
undertook quite limited restructuring, which ensured that
unemployment did not rise markedly for some time.
Considerable fiscal stumulus in this period supplemented weak
private domestic demand and, eventually, helped the economy
to recover. The effectiveness of fiscal and monetary easing was,
however, undermined by the deficiencies in the financial and
corporate sectors.5 As a result, the subsequent two-and-a-half
year upturn clearly lacked strength.
However, the significant increase in the budget deficit in the first
half of the 1990s had, by then, raised concerns regarding the
sustainability of the fiscal situation. In expectation that the upturn
was more solid than actually proved to be the case, fiscal policy
was tightened quite sharply in 1997. This led to a significant
weakening in activity and meant that the economy was quite
vulnerable to further deflationary pressures, both domestic and
international. In the event, the economy suffered its most severe
post-War recession and, apart from a brief pick up towards the
end of the decade, has undergone a sustained period of
weakness since.
The renewed weakening in domestic demand growth, which
began in 1996, was reinforced by the crisis in a number of South
East Asian economies in 1997-98. This depressed sentiment and
contributed to the crisis in the financial sector in 1997-98, which
further reduced the availability of credit and thereby exacerbated
the decline in business investment.6 On a longer-term basis,
investment growth had also come under downward pressure
from the forces of deindustrialisation in the economy, the falling
labour force and the increased focus on raising productivity and
profitability of capital, rather than on increased capital
expenditure.
Private consumption reacted more severely in this recession, as
higher unemployment and increased uncertainty and future job
prospects, combined with low income growth and negative
wealth effects, depressed consumer spending. Unemployment
which had risen from 2.1 per cent in 1990 to 3.4 per cent in
1997, then rose more rapidly and has now been above 5 per
cent since mid-2001. Given the age profile of the population,
households tried to boost their savings for retirement and to
restore wealth. In this environment, stimulative fiscal and
monetary policies were much less effective than had previously
been the case and prices continued to come under downward
pressure. By 1998, deflationary forces had set in and, since 1999,
the consumer price index has shown negative growth.
5 See Ramaswamy (2000) for a more complete review of this issue.
6 See Sekine (1999) for further details.
73
Quarterly Bulletin Winter 2002
Chart 2
Japanese Inflation (CPI)
%
4
3
2
1
0
-1
-2
1990 1991 1992
Source: EcoWin
1993 1994
1995
1996 1997
1998
1999
2000
2001 2002
These trends in investment and consumption exacerbated the
structural net savings surplus of the private sector, which rose
from 2 per cent of GDP in 1992 to 8 per cent in 1998. Although
net dissavings of the public sector — to finance fiscal expansion
— increased sharply in the same period, the overall effect was a
considerable rise in the surplus of Japanese savings available to
invest abroad. As a consequence, Japan’s importance as a net
lender to the rest of the world grew dramatically. Between 1990
and 1999, Japan’s stock of net external assets rose from 10 per
cent of GDP to almost 30 per cent.
Chart 3
GDP Growth
%
year-on-year
8
7
6
5
4
3
2
1
0
-1
-2
-3
-4
1990
1991
1992
1993
Euro area
Source: EcoWin
74
1994
1995
UK
1996
1997
1998
1999
Japan
2000
2001
2002
US
Quarterly Bulletin Winter 2002
3. The effects of the asset price falls on the
financial & corporate sectors
Structural impediments in the financial and corporate sectors
played a key role in exacerbating economic weakness. The main
factors are set out below and involve the effects of cultural
practices, which slowed the pace of reform, combined with sideeffects arising from the bursting of the asset price bubble.
a. Financial Sector
Japanese financial institutions have traditionally held a
combination of securities issued by their borrowing corporate
customers, which are referred to as cross-shareholdings. Thus,
the immediate effect of the bursting of the bubble was a severe
erosion in banks’ capital positions from the falls in these asset
prices. The fall in land values also reduced the value of collateral
held against loans. This, combined with the failure of borrowers
to realise income expectations formed in the bubble era,
generated a massive bad-loans problem.
These problems were exacerbated by increasing competition
arising from financial liberalisation. The combination of shrinking
demand for borrowing and growth in the number of lending
institutions brought about a significant narrowing in lending
margins. In addition, the official attitude of the regulatory
authorities towards the sector was one of extreme regulatory
forbearance.7 Insolvent institutions were kept afloat by lack of
disclosure or by merging with a healthy rival, but no public funds
were made available for resolving the problems at that stage.
With this official attitude of complacency, banks made little effort
to restrain their excessive risk-taking or to tackle their weak risk
evaluation culture. The continuing fragility of the banking system,
in turn, limited its ability to extend new loans and support any
economic recovery.
The outcome of these influences was a banking system with
chronically low returns, while shouldering high and increasing
risks. Even the strongest banks were saddled with substantial
amounts of non-performing loans (NPLs) and a severe shortage
of capital. The crisis in South East Asia constituted another shock
to banks’ capital positions. As major lenders in the region,
Japanese banks suffered substantial losses on outstanding loans.
Moreover, the renewed downturn in the domestic economy
aggravated the bad loan problem. As a result of this combination
of factors, banks moved to reduce their lending, prompting a
‘‘credit crunch’’.
7 This is referred to as the ‘‘convoy’’ system, where the pace of regulatory change for the
sector (a fleet) is set according to the adaptive capacity of the weakest institution (the
slowest ship in the fleet).
75
Quarterly Bulletin Winter 2002
The escalation in the problem prompted the authorities to
undertake more concerted action. This included the provision of
public funds for recapitalising solvent banks and writing off nonperforming loans, as well as stricter standards for loan
classification and provisioning. Although the immediate credit
crunch was alleviated, these measures did not succeed in
substantially alleviating Japanese banks’ major problems of low
returns, shortage of capital and massive non-performing loans.8
Moreover, a change in Japan’s disclosure standards in 2001 — to
record the value of equities at the current, rather than the
purchase, price — exacerbated concerns regarding the adequacy
of banks’ capital.
The further decline in the equity market since then has
undermined banks’ balance sheets even more. Japanese banks
continue to have problems related to the quality of the assets
they hold. They have insufficient revenues relative to their
balance sheets, highlighting the need for more rationalisation and
bankruptcy in the industry to bring average lending margins up
to levels, which will facilitate the resumption of normal credit
creation.
b. Non-Financial corporate sector
The corporate culture in Japan has generally favoured capital
accumulation and rapid export growth to a greater extent than
shareholders’ returns. This facilitated corporate sector overinvestment during the bubble era, further supported by the very
expansionary monetary policy of the mid- to late-1980s. As a
result, excessive indebtedness and huge overcapacity built up in
the corporate sector. The collapse of the bubble caused a decline
in net worth of about one-sixth of the sector’s total balance sheet
in 1991 alone. Alongside stagnant growth, this prompted a surge
in bankruptcies and a decline in already low profitability. In
addition, firms were left with an enormous overhang of excess
capacity; over a decade later, this has yet to be worked off.
Despite these problems and faced with disappointing sales and
profit prospects, firms did not engage in severe cost reduction.
This reflects a combination of factors. Firstly, the effects of the
‘‘lifetime employment system’’, which favours lifetime
employment and seniority-based pay, ensures that long-term
employees dominate decision-taking; this mitigated against
considerable employment and wage cuts. Second, the practice
of cross-shareholdings encouraged firms, which had invested in
each others’ shares, to develop their business based on these
relationships, rather than applying efficiency criteria to costs and
sales decisions. In addition, high levels of regulation and
sheltering from foreign competition in many areas contributed
8 Banks’ take up of restructuring funds was much less than expected, as they did not want
to reveal publicly the extent of their problems, or were delaying write-off of loans in
anticipation of collateral price increases (especially land) in coming years.
76
Quarterly Bulletin Winter 2002
to high input costs. Lax accounting rules, which hampered the
application of market discipline, reduced firms’ incentive to
tackle these problems. The official stance was also one of slow
reform. As a result, the corporate sector’s balance sheet
continued to contain too much debt but not enough profit.
The failure to tackle these problems more proactively at the start
meant that the corporate sector remained under severe pressure
throughout the decade. Thus, despite considerable easing in
monetary and fiscal policy, the sector generally had too little
access to funds to support its business needs. Although the pace
of restructuring has picked up in recent years, a considerable
burden of adjustment remains.
As the above illustrates, many aspects of the Japanese economy
in this period involved suppressing the signalling capacity of
relative price mechanisms, which are necessary for optimum
resource allocation. In particular, the banking and financial sector
was cushioned from having to deal with the consequences of the
bursting of the asset price bubble, through lack of effective
market discipline and limited application of mark-to-market
principles. In the corporate sector, labour market practices
discouraged any attempt to deal with the problems proactively.
This position was facilitated by the corporate sector’s
interlinkages with the financial sector — e.g. through crossshareholdings — which discouraged corporate restructuring
which would have had adverse consequences for banks’ balance
sheet positions. Banks and monetary policy normally play a
central role in transmitting information via relative price and
interest rate mechanisms. Indeed, the traditional intermediation
role of banks owes much to their ability to bridge the information
asymmetry between lenders and borrowers through a pricing
mechanism. In this phase, however, their willingness and ability
to do so was limited by market failure, induced by structural
impediments in the economy.
4. Fiscal & Monetary Policy in the 1990s
a. Fiscal policy
The shock to the economic system presented by the asset price
declines, accompanied by the ongoing weakness of private
demand, prompted the authorities to undertake significant fiscal
easing. Between August 1992 and 2002, the Japanese
government undertook expansionary fiscal policy in every year
except 1997 and announced almost a dozen fiscal stimulus
packages, amounting to almost a cumulative one-third of GDP
approximately. This expansionary policy appears to have played
an important role in providing short term support to economic
growth. However, it achieved far lower returns on spending than
might have been expected. Although the empirical evidence
from a range of surveys on the size of fiscal multipliers does not
reach a clear conclusion, it appears that long run government
77
Quarterly Bulletin Winter 2002
spending multipliers in Japan are now lower than was the case
in earlier periods.9 Lower fiscal multipliers for both government
consumption and investment spending contributed to a decline
in the aggregate government spending multiplier in the last two
decades, compared to the preceding two. Some of the factors
contributing to these low multiplier effects include:
i. the real economic stimulus was much lower than the
headline figures suggested. Significant portions of
spending allocated to new projects consisted of financial
measures — such as loans provided to government
financial institutions — which would not directly impact
on aggregate demand;
ii. the quality of public spending was often relatively
unproductive. Many projects were included in fiscal
packages on the basis of political rather than economic
considerations. The decline in the multiplier for
government consumption spending partly reflects a shift
in spending towards the provision of health services —
where a number of inefficiencies have been identified —
for an ageing population;
iii. productivity and profitability were not enhanced as
much as possible, given the weak projection selection
processes, cost overruns, and a bias towards projects
located in rural areas. The latter have lower estimated
returns to public capital compared to projects in large
urban areas, where public/private investment
complementarities are greater;
iv. a shift in public investment spending towards sectors
with a relatively low return to public capital — such as
agriculture and road construction — contributed to the
reduction in the multiplier on public investment
spending.
v. implementation difficulties at local level often meant that
the actual increase in public works spending fell far short
of the amounts provided for in the stimulus packages;
vi. tax cuts were largely saved by households and firms,
who were seeking to rebuild their financial positions.
However, a decade of such fiscal support has led to a fiscal
position which is considered to have become unsustainable. The
general government budget deficit has reached about 7 per cent
of GDP — approximately 6 per cent of which is structural — while
the debt/GDP ratio is estimated at about 140 per cent. When
the liabilities of government non-financial institutions, the social
9 Kalra, S. (2002), ‘‘Fiscal Policy: An Evaluation of its Effectiveness’’, Japan — Selected Issues,
IMF. For the sample period 1981-2000, government spending multipliers peaked at 0.4
after 2 quarters and were effectively zero after 3 years. These represent similar short term
but much lower long term multipliers to those applying in the earlier period of 1961-1980.
Tax multipliers in 1981-2000 amount to about 0.4-0.5 in the short run but fall to about 0.3
after 5 years.
78
Quarterly Bulletin Winter 2002
security fund and the welfare pension system are combined, this
increases government debt by an additional 150 per cent of GDP
approximately.10 The IMF has recently estimated that a surplus of
about 0.75 per centage point of GDP per annum would be
needed to stabilise the debt ratio by 2007, and then only at the
very high level of 134 per cent of GDP.11 The extent of fiscal
savings which Japan needs to undertake to move its public
finances onto a sounder footing is considered greater than any
fiscal correction undertaken in other industrialised countries. This
reflects its starting points of a higher debt/GDP ratio (broadly
measured) and a larger structural deficit. Given the magnitude of
the fiscal problem, the elimination of the deficit in the medium
term will be very problematical, especially in view of the
expected increase in transfer payments as a result of population
aging.
Chart 4
Japanese Fiscal Positions
%
%
4
140
120
2
100
0
80
-2
60
-4
40
-6
20
-8
0
1990
1991
1992
1993
1994
1995
1996
General Government Financial Balance
1997
1998
1999
2000
2001
General Government Debt
(Right Hand Axis)
Source: OECD
As a result, the onus on the authorities has moved from
continuing to provide support to domestic demand, to begin
designing reforms aimed at facilitating substantial fiscal savings
in the medium term. This is necessary to maintain investor
confidence in the Japanese Government Bond (JGB) market and
in the economy more generally. Unusually, in view of its size,
most of the fiscal expansion has been financed domestically. This
10 Many of the fiscal stimulus packages included projects which were recorded under local
government, so the general government budgets and debt figures underestimate the full
effect of fiscal expansion.
11 Japan — 2002 Article IV Consultation, Staff Report, IMF.
79
Quarterly Bulletin Winter 2002
reflects the traditionally high level of private sector savings in
Japan.
Normally, a country faced with a fiscal burden the size of Japan’s
would have to pay a much higher risk premium on its JGBs.
However, the availability of significant private savings, combined
with traditionally large holdings of JGBs by Japanese financial
institutions, have made it possible, so far, for the government to
finance its debt at exceptionally low rates of interest. As
highlighted in Section 4 below in the discussion on monetary
policy, the BoJ and commercial banks have significantly
increased their holdings of JGBs in recent years.
Chart 5
Japanese 10-Year Bond Yield
9
8
7
Percemt
6
5
4
3
2
1
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001 2002
Source: EcoWin
In the current fiscal environment, any undue delay in fiscal
consolidation increases the risk of an unsustainable debt spiral.
By leading to a sharp rise in bond yields (through a higher risk
premium), such a move would increase the debt- and deficitfinancing burden of the Japanese government. Moreover, this
would deplete the value of JGBs held by Japanese financial
institutions, thereby exacerbating the problems of the already
fragile banking system. It would also increase long term financing
costs for business investment. Furthermore, Japanese
households, which also hold JGBs, are also susceptible to the risk
of a fall in bond prices. This could encourage consumers to
spend less in order to rebuild their savings, thereby exacerbating
the problem of already weak private consumption.
The authorities face a difficult dilemma with regard to fiscal
policy. On the one hand, there is clearly a need to address fiscal
80
Quarterly Bulletin Winter 2002
consolidation as early as possible. However, this is complicated
by the fact that the current economic conjuncture is still very
worrisome, with deflationary forces still negatively influencing
activity. There is a serious risk, therefore, that a downturn in fiscal
support could generate a deflationary spiral, by widening the
already-wide gap between demand and supply. In the near term,
therefore, it would be inappropriate to pursue fiscal
consolidation aggressively.
This policy dilemma is compounded by the need to step up the
pace of economic restructuring, which is clearly a top priority.
But to do so would be likely to worsen the current economic
situation, by increasing insolvencies and unemployment, lending
further weight to the argument to delay fiscal consolidation.
However, the longer the delay in consolidation, the greater the
risk that fiscal dynamics could become completely unsustainable.
b. Monetary policy
To address the economy’s ongoing weakness, monetary policy
has been progressively eased since 1991. This monetary policy
stance led to an official discount rate of 0.5 per cent or below
since 1995 and, in 1999, the short-term interest rate target
effectively reached zero. Table 1 below sets out the major
monetary policy decisions taken by the BoJ over the 1990s. The
BoJ engaged in considerable liquidity provision to bring interest
rates to these exceptionally low levels. As a result, the monetary
base12 expanded at an annual average rate of 8 per cent over
the five-year period 1996-2001.
Chart 6
Japanese Interest Rates
%
9
8
7
6
5
4
3
2
1
0
1990
1991
1992
1993
1994
1995
Japanese official interest rates
1996
1997
1998
1999
2000
2001 2002
Japanese short-term market interest rates
Source: EcoWin
12 This consists of all banknotes and all current deposits which banks and other financial
intermediaries hold at the central bank.
81
Quarterly Bulletin Winter 2002
Table 1: Monetary Policy Decisions in the 1990s
Date
Monetary Policy Decision
1990
March & August
Two increases in official discount rate, from 5.0% to
5.25 per cent and 6.0 per cent.
1991
July, November &
December
Three reductions in official discount rate, to 5.5 per
cent, 5.0 per cent and 4.5 per cent.
1992
April & July
Two reductions in official discount rate, to 3.75 per
cent and 3.25 per cent.
1993
February & September
Two reductions in official discount rate, to 2.5 per
cent and 1.75 per cent.
1995
14 April
Reduction in official discount rate, to 1.0 per cent.
8 September
Reduction in official discount rate, to 0.5 per cent.
Main policy rate target becomes Rate on
uncollateralised overnight call loans — to be kept
slightly below the official discount rate on average.
1998
9 September
Guide target rate down to 0.25 per cent.
Provide more ample funds if necessary to maintain
market stability.
1999
12 February
Guide target rate to 0.15 per cent first &
subsequently encourage it to move as low as
possible: effectively a ‘‘zero interest rate policy’’
(ZIRP).
9 April
Agree to retain ZIRP until deflation over (Target rate
fell to 0.02 per cent on average).
2000
11 August
ZIRP lifted. Target rate raised to 0.25 per cent.
2001
9 February
New Lombard-type facility introduced, at 0.35 per
cent, to provide funds on demand against collateral
(rather than on BoJ auction dates).
28 February
Target rate lowered from 0.25 per cent to 0.10 per
cent; ODR reduced to 0.25 per cent.
19 March
Important shift in BoJ strategy — from interest rate
targeting to directly targeting banks’ current-account
deposits at BoJ, at Y5 trn (effectively a return to
ZIRP).
14 August
Increase in guideline for excess balances in current
accounts, from Y5 trn to Y6 trn.
18 September
Reduction in official discount rate to 0.1 per cent
(from 0.25 per cent).
Increase in guideline for excess balances in current
accounts, to above Y6 trn.
19 December
Increase in guideline for excess balances in current
accounts, to Y10-15 trn.
Increase in outright purchase of long-term
government bonds, from Y600 bn p.m. to Y800 bn.
p.m.
Make further use of Commercial Paper & Assetbacked Securities, & look at broadening the range of
eligible paper.
2002
28 February
Provide ample liquidity towards the end of a fiscal
year (31/3), irrespective of guideline for excess
current account balances (Y10-15 trn.)
Increase in outright purchase
government bonds, to Y1 trn. p.m.
30 October
of
long-term
Increase in guideline for excess balances in current
accounts, to Y15-20 trn.
Increase in outright purchase of long-term
government bonds, from Y1 trn p.m. to Y1.2 trn. p.m.
Extend maturities of bills purchased in open market
operations.
Source: Compiled from Bank of Japan data.
82
Quarterly Bulletin Winter 2002
In normal circumstances, the presence of such considerable
liquidity in the financial system, at practically zero interest rates,
would be expected to generate significant credit creation,
fuelling spending and eventually inflation. However, on this
occasion it did not succeed in stimulating domestic demand or
inflation. In part, this reflected the fact that, while nominal interest
rates were falling, the worsening deflation problem meant that
real interest rates were rising. Moreover, the strengthening of the
currency during 1999 and early 2000 ensured a further
tightening in monetary conditions. In addition, some of the
monetary base increase was absorbed by the banking system, to
deal with cash-flow shortages arising from the expansion in nonperforming loans.
Chart 7
Japanese Real Interest Rate
4
3
2
1
0
-1
-2
-3
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Source: EcoWin
More particularly, a number of special factors help to explain
why the significant monetary base expansion did not succeed
in stimulating growth. These arose from the combination of the
weakness in the financial sector’s balance sheets and the special
constraints which a zero nominal interest rate policy entails,
which are set out below.
Why monetary base expansion failed to translate into money
supply & economic growth
When the BoJ adopted the Zero Interest Rate Policy (ZIRP) in
February 1999, it moved to supply additional funds to the money
market to guide its target ‘‘call rate’’ (the uncollateralised
overnight call rate) down to zero per cent. This took place
through open market operations, where the BoJ extended
liquidity in exchange for collateral (such as short-term JGBs and
other short-term assets). Normally, banks do not hold
83
Quarterly Bulletin Winter 2002
considerable excess liquidity on their own balance sheets for
lengthy periods; rather, they use the funds to create credit, on
which they earn a margin over and above their cost of liquidity.
However, at zero interest rates, excess liquidity became
essentially costless for banks to hold.13 Moreover, short-term
assets and cash reserves become close substitutes, as there is
practically no opportunity cost to holding cash rather than shortterm assets earning close to zero per cent. In fact, transactions
costs on assets may make cash holdings more attractive.
These factors encouraged banks to access increasing amounts of
liquidity in the money market. This eventually resulted, in early
2001, in the banking system holding current account balances at
the BoJ of around Y5 trillion (\40 billion) on a daily basis. This
level of excess liquidity was consistent with keeping the target
call rate stable at practically zero per cent.14
Chart 8
Japanese Monetary Base Growth
%
40
35
30
25
20
15
10
5
0
-5
-10
1990
1991
1992
1993
1994
1995 1996
1997
1998
1999
2000
2001
2002
Source: EcoWin
In March 2001, the BoJ effectively changed its monetary policy
strategy from an interest-rate target to a monetary base target,
by announcing that it would directly target the level of these
outstanding current account balances. This decision was taken
to explore the possibility of undertaking further monetary policy
easing, even after nominal interest rates had reached zero. The
rationale was that, if higher amounts of liquidity were injected
into the system, and led to even greater surpluses of funds in
13 Estimates by BoJ economists suggest that, even if excess reserves were increased to 100
times their current level, the cost of holding these reserves would still amount to only
0.9% of banks’ aggregate annual business profit. Source: Oda and Okina (2001), ‘‘Further
Monetary Easing Policies under the Non-Negativity Constraints of Nominal Interest Rates’’.
14 The rate is not exactly zero due to the existence of various transactions costs.
84
Quarterly Bulletin Winter 2002
banks’ current accounts, this would eventually trigger more
credit creation. Moreover, given the historical link between
strong growth in the monetary base/money supply and inflation,
further growth in liquidity would help to generate inflationary
expectations, which are necessary to arrest deflationary
tendencies. The initial target was for an ongoing level of Y5
trillion (\40 billion). As deflationary forces worsened, this target
was increased in a series of steps, to its current level of Y15 - 20
trn. (\12 - 16 billion).
However, the sizeable increase in liquidity in the money market
has not been matched by significant liquidity creation throughout
the economy. The problem in Japan has been that the credit
creation mechanism — whereby financial institutions with
considerable liquidity extend credit to businesses and consumers
— has not been functioning properly. This is a result of the weak
balance sheet position and poor corporate profitability of the
financial sector, which have made financial institutions unwilling
to extend new loans. Bank lending to the economy fell by 4 per
cent in the past year. Banks have been able to increase their
holdings of cash reserves (monetary base) while reducing their
business and consumer lending (credit creation), without
incurring a cost of funds, a classic case of the liquidity trap. At
the same time, there appears to have been a lack of effective
demand by businesses and consumers for additional credit. This
reflects the increase, in real terms, in the burden of corporate
and household debt, as a result of ongoing deflation. The overall
effect has been to impair the monetary transmission mechanism.
The combination of unlimited availability of liquidity, a reluctance
by banks to generate new lending, and a return on some shortterm financial assets which is too low to cover transactions costs,
has encouraged many financial institutions to turn to the JGB
market for an investment opportunity. Banks can borrow funds
in the money market at practically zero cost and buy JGBs, which
are currently yielding around 1 per cent. Reflecting this trend,
banks’ claims on the government grew by 25 per cent in 1999
and 40 per cent in 2000 before stabilising somewhat last year.
The banking sector now accounts for some 15 per cent of the
JGB market, considerably higher than the norm in other
countries. The perverse incentive structures of the ZIRP mean
that the present level of yields on JGBs does not appear to
contain a premium commensurate with the risks of holding those
assets. For example, a number of downgrades in the credit rating
of Japanese government debt over the past year were not
directly accompanied by any increase in yields.
Financial institutions now have such significant holdings of
liquidity and JGBs that their incentive to demand more liquidity
through open market operations (OMOs) has become limited.
When financial institutions are reluctant to engage in significant
85
Quarterly Bulletin Winter 2002
credit creation and hold significant excess cash reserves, the
ability of the central bank to increase the monetary base further
through OMOs becomes seriously impaired. This was
highlighted early in 2001, where some of Japan’s open market
operations were characterised by underbidding.
Thus, while the low levels of interest rates and the growth in
monetary base give a picture of exceptionally loose monetary
policy, in practice the functioning of the transmission mechanism
between these variables and money supply and real activity has
been seriously impaired.15 Not only did monetary base expansion
fail to stimulate economic growth as expected, it also did not
markedly stimulate broad money supply growth, which averaged
only 3 per cent per annum over the past five years. Table 2
below highlights the contrast between the size of the monetary
base expansion, compared to growth in the money supply. The
expected outcome — that expanding money supply growth
would generate inflationary expectations — has failed to
materialise in Japan. This highlights an essential problem with
quantitative easing: a central bank can generally control the
monetary base but not directly determine money supply and
prices, changes in which are needed to transmit signals to
economic activity.
Chart 9
Japanese Money Supply Growth
%
15.0
12.5
10.0
7.5
5.0
2.5
0.0
-2.5
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
Source: EcoWin
15 The money supply refers to the monetary base (M1) and total credit created in the
economy.
86
Quarterly Bulletin Winter 2002
Table 2: Monetary Base expansion in Japan
Percent changes from a year earlier
Money
Supply
Monetary
Base
Banknotes in
circulation
Coins in
Circulation
Current
account
balances at
BoJ
1999
3.6
7.3
6.1
1.4
30.1
2000
2.1
7.6
7.4
1.4
14.9
2001
2.8
7.4
7.2
1.4
14.9
2002 Q1
Q2
Q3
3.6
3.5
3.3
27.8
31.2
24.2
12.3
15.6
13.3
1.6
1.9
2.0
245.6
232.5
141.5
Date
Source: Compiled from Bank of Japan data.
What more can monetary policy do to support the economy?
An analysis of the deflationary experiences of Sweden and the
US in the 1930s suggests that more sustained and aggressive
monetary base expansion may help to lift the economy out of a
deflationary spiral.16 Moreover, IMF research suggests that,
despite the apparent reduction in the effectiveness of the
monetary transmission mechanism in recent years, it is still
statistically significant, to the extent that a 25 per cent monetary
base ‘‘shock’’ could boost prices by 1 per cent within a year.17
Given the lags in monetary policy transmission, it is too early to
conclude that the recent monetary policy easing through
monetary base expansion has been ineffective. While the
problems of financial institutions have clearly undermined the
effectiveness of monetary policy, the credit channel does not
appear to have completely broken down.18
The unusual nature of Japan’s policy conundrum has prompted
many researchers, commentators and international institutions to
propose a number of exceptional monetary policy measures.
These are discussed more fully in Annex 1. Briefly, they include
undertaking a huge quantitative easing in the monetary base,
through printing money or expanded OMOs, to refuel positive
inflation expectations. These could be used to pay for
government debt or to finance deficits, to buy corporate paper
or for foreign exchange market interventions to weaken the yen.
The advantages and risks of such strategies are set out and the
latter help to explain why, so far, the authorities have officially
refused to adopt such measures. In essence, the issue reduces to
whether the potential — and unpredictable — success from an allout effort to arrest deflation is deemed to outweigh the costs.
The cost of failure of unorthodox monetary policy actions would
be potentially very damaging to the credibility of the authorities.
16 Whereas Japan’s monetary base increased by a cumulative 44% between 1999 and mid2002, US base money increased by 60% in the three years following the departure from
the Gold Standard in 1933, and Swedish base money increased by 92% over the 5 years
from late-1931.
17 Baig, (2002) ‘‘Monetary Policy Effectiveness in a Deflationary Environment’’, Japan —
Selected Issues, IMF.
18 The credit channel refers to the ability of households and corporations to raise funds for
their spending plans through the extension of credit from the banking sector.
87
Quarterly Bulletin Winter 2002
5. Structural Reform Priorities
The combination of the ineffectiveness of earlier macroeconomic
policy easing, the limited room for manoeuvre with fiscal and
monetary policy, and, in particular, the impediments to growth
exerted by financial and corporate sector weakness, has led to
an increasing focus on the need for economic restructuring in
Japan. This is required to provide an appropriate environment for
revitalising growth and would, preferably, take place in the
context of broadly supportive macroeconomic policies. This
would help to limit the short term adverse impact of such reforms
on economic activity and deflation.
Structural reform essentially means reallocating productive
resources such as labour, land and capital, to enhance
productivity in the overall economy. In normal circumstances, it
may be prompted by significant changes in the economic
environment such as globalisation, ageing, policy regime shifts,
and shocks to economic activity. Efficient reallocation usually
requires addressing incentive structures to enable market-based
principles to apply more fully.
Bearing in mind the severity of the shock to the Japanese
economy — the bursting of asset price bubbles — the
implementation of restructuring measures has been
disappointingly slow. Concern at the extent to which economic
activity has remained weak appears to have made the authorities
more reluctant to pursue the reform agenda with zeal. This
highlights the policy dilemma facing the authorities: sustained
growth is not likely to be made possible without deep structural
reform, but such reform is difficult to undertake when the
economy is already weighed down by deflation. Nevertheless,
any further delay in restructuring is likely to be very costly, in
terms of limiting future growth.
Financial sector restructuring
A major restructuring priority is Japan’s banking system, which
continues to suffer from chronically weak profitability and
insufficient capital. At the root is the non-performing loans
problem. The ability of banks to provision appropriately against
these loans is constrained by their poor capital and profitability
positions.19 Moreover, limited application of mark-to-market
principles for banks meant that, until recently, they had little
incentive to downgrade loans, which were at-risk, to nonperforming status. Although NPL write-offs have increased
considerably in recent years — and total about one-sixth of GDP
over the past decade — there is widespread acceptance that the
19 The major banks made a net loss equivalent to 9 per cent of capital in 2001. Although
all major banks remained above the regulatory minimum, the quality of capital has been
deteriorating and remains vulnerable to market risks. Source: Japan’s Financial Services
Agency.
88
Quarterly Bulletin Winter 2002
extent of the problem is much greater than official write-offs and
classifications might suggest. Total NPLs and loans at risk of
default in the future have actually been increasing all the time, as
weak economic activity and deflation have eroded debt servicing
capacity, while increasing the real value of outstanding debt.
Priorities for restructuring of this sector include identifying the
true extent of the NPL problem and developing an appropriate
strategy/timetable to deal with it. Banks currently lack incentives
to aggressively tackle the problem of bad or potentially bad
loans; indeed, they have an incentive not to deal with these loans
at present, in the hope of higher recovery values for debt and
collateral in the future.
Many private analysts assess that tackling the full extent of the
NPL problem in the near term would result in bank capital ratios
falling below the regulatory minima. Given the difficulties which
banks would face in raising sufficient funds from the market, it is
generally perceived that there is little alternative to a public funds
injection into systemically important banks, subject to
appropriate conditionality. Although Y15 trn. is currently
available in the Deposit Insurance Corporation’s (DIC) Crisis
Management Account for this purpose, this is not sufficient to
deal with the full extent of the problem. Total NPLs were
estimated at Y90 trn. by Japan’s Financial Services Agency in
2001, but are estimated by private agents to be significantly
higher.
An alternative approach would be to write off NPLs over a
number of years, to allow provisions to be paid from profits
without impacting on capital. This, however, would have a
number of negative effects. It would postpone resolution of
fundamental problems, such as excess corporate capacity and
leverage, continued access to credit for some unviable borrowers
and the ongoing implications of deflation. Moreover, profits are
not likely to be sufficient to enable NPL write-offs of a sufficiently
large degree, while capital does not appear strong enough to
remain immune from the effects of such write-offs, even if spread
over a number of years.
The Japanese authorities remain reluctant to use public capital
injections for the financial sector. This reflects their concerns at
the potential for moral hazard, the dilution of private shareholder
value, and the potential for government interference in the
operation of commercial banks. The official view is that the bulk
of the NPL problem has been recognised, following a new
system of special inspections, and that there is little likelihood of
bank capital falling below regulatory minima. In that light, they
believe that banks should rebuild capital through improved
profitability and through accessing market, rather than public,
funds.
89
Quarterly Bulletin Winter 2002
Improving profitability in financial institutions requires, however,
a number of radical changes in practice in the sector. While
banks have taken measures to cut costs, more stringent efforts
are required on this front. More appropriate pricing of credit risk
and a boost to fee income is also needed to enhance lending
margins. Low-yielding corporate lending needs to be curtailed
and appropriate incentive and governance structures need to be
developed to generate pressure to raise rates of return. There is
also a general belief that government financial institutions, which
do not pay market rates for funds and thus can undercut
commercial banks’ lending terms, should be subject to market
pressures. This would encourage them to source more funds
from capital markets and undergo downsizing.
The phased removal of the blanket deposit guarantee is to be
finalised in April 2003, which raises the potential for problems
in weaker institutions.20 The potential for deposit movement is
significant — those covered by the guarantee at present amount
to 20% of GDP and, prior to changes in the guarantee this year,
large depositors showed a willingness to take funds out of
weaker institutions. This further underscores the need to deal
with bank weaknesses as early and as broadly as possible.
Corporate sector restructuring
The scale of reform which needs to be undertaken in this sector
remains immense. On the one hand, unproductive fixed assets
continue to depress corporate returns on assets and returns on
equity. Excess capital, based on the capital/output ratio, is
estimated at about 8 per cent of GDP.21 Other estimates suggest
that restructuring or liquidation of more than 1.5 million
companies would be required to relieve the excess capacity
overhang. But, on the other hand, reduced private investment
expenditure over the past decade has made Japan’s capital stock
increasingly obsolete, suggesting that productivity and potential
growth have been reduced. Japanese corporations also remain
excessively leveraged, particularly among firms with less than Y1
bn. in assets — which have an average debt/equity ratio of about
double that of their US equivalents.
Progress with corporate restructuring has, however, been very
disappointing. Low interest rates — which allow problem loans to
be serviced at least for the moment — appear to have reduced
pressure on corporations to restructure, while those firms which
have announced restructuring plans have concentrated more on
short-term cost-cutting measures rather than addressing excess
capacity. The continued reluctance to restructure or liquidate
companies is adding to excess capacity and deflationary
20 Full deposit insurance protects depositors against the collapse of institutions with which
they hold funds. In April 2001, a phased reduction in deposit insurance coverage in Japan
was introduced and, from April 2003, no bank deposits above Y10 million will be insured.
However, current deposits in excess of this amount are estimated at around Y100 trillion,
or 20 per cent of GDP.
21 Source: IMF.
90
Quarterly Bulletin Winter 2002
pressures, with the latter hampering the operations of healthier
companies. Rates of return remain low, and there has been little
success in reducing the still significant excesses of capital, debt
and employment.
Concerns about the immediate impact of restructuring on
unemployment appear to be a factor impacting on the
authorities’ lack of enthusiasm for strong reform. However, given
that revitalising the corporate sector is a prerequisite for renewed
economic growth, this suggests that reforms need to be designed
to ease the transitional costs of corporate restructuring. These
could include, inter alia, more public spending on active labour
market policies and temporarily extending the duration of jobless
benefits in periods of structural change.
Strong corporate restructuring is also tied up with progress in
financial sector reform. Given that the bulk of firms’ excess
leverage is owed to banks, banks will need to agree restructuring
plans with potentially viable debtors, push non-viable debtors
into liquidation, and dispose of unwanted loans to third parties.
But, for banks to have the capacity and incentives to move
forcefully in this way, they will need to recognise and provision
against their problem loans.
This underscores the need for continued regulatory pressure on
banks. Japan’s approach to regulatory reform has, however, been
piecemeal rather than strategic. Further reforms are needed to
revitalise the real estate market, where tax distortions and legal
impediments reduce market liquidity; to improve competition, by
lowering entry barriers and encouraging business formation; and
to correct shortcomings in corporate governance. With regard to
the latter, there is a need to move from the culture based on
relationship lending to one based on market discipline, which
would boost the incentive to cut excess capacity and increase
profitability. While a number of changes have been undertaken
to address deficiencies in this area, further reforms are needed
in accounting standards; transparency provisions; removal of
barriers to takeovers; appointment practices for boards of
directors, and executive compensation schemes.
6. Lessons learned from Japan’s experience of
economic slump & deflation
The breadth and persistence of Japan’s economic problems have
spawned a considerable amount of research and analysis, in the
search for lessons for other countries which could find
themselves in similar situations. Despite a myriad of views
regarding the appropriate policy sequencing and choices for
Japan over the years, the following points appear particularly
noteworthy:22
22 See, especially, ‘‘Preventing Deflation: Lessons from Japan’s Experience in the 1990s’’,
Ahearne et al, Board of Governors of the Federal Reserve System, International Finance
Discussion Papers, Number 729.
91
Quarterly Bulletin Winter 2002
A. Macroeconomic Policy issues
(i) The extent and breadth of the slump was unanticipated by
all sectors of the economy. At the beginning of the 1990s, most
observers — both public and private, Japanese and international
— did not appreciate how deep and protracted the economic
slowdown would be. Moreover, financial market indicators
(including bond yields, the yield curve, spreads, and futures) did
not suggest that such an outcome was considered a major risk.
Private sector surveys point to firms being overly optimistic about
sales and profits prospects. Only in the latter part of the decade
did a fundamental reassessment of Japan’s prospects take place.
(ii) In light of the above, macroeconomic policy did not make
enough allowance for the asymmetric risks facing the economy
— namely, the risk of a prolonged downturn and deflation, with
the possibility of nominal interest rates hitting their lower bound
of zero. Accordingly, policy was not loose enough. Moreover,
the fact that the overly-expansionary stance of monetary policy
in the second half of the 1980s had fuelled an asset price bubble
probably weighed on the BoJ’s assessment of the size of stimulus
required in the early 1990s.23
(iii) the effectiveness of monetary policy easing was hindered
by financial sector weakness, but further, earlier, easing might
still have been effective.
(iv) although fiscal expansion prevented the economy from
falling further into recession, it was not sufficiently well
designed to maximise the macroeconomic impact. Public
spending should have been geared towards more productive
uses, aimed at raising productivity and the potential growth rate
of the economy. Early fiscal stimulus packages should have had
more tax elements.
(v) In hindsight, the policy mix should have been tilted more
towards monetary easing, especially in the early stages when
monetary policy would have been more effective than it was in
later stages. This would have ‘‘saved’’ some room for manoeuvre
with fiscal policy when monetary policy was becoming less
effective, as it got nearer the zero lower bound.
(vi) Related to the above, given the costs of deflation, a further
precautionary lowering of interest rates should be undertaken
when there is a risk of deflation. If, ex post, this proves to have
been too stimulative, interest rates can be increased. The
alternative scenario — that monetary policy is not loosened
23 The view that monetary policy was, at the time, adequately stimulative, is supported by
Taylor-style monetary policy rules using expected inflation and output gap estimates from
the period. Using ex post data, however, these rules suggest that monetary policy was
too tight in the first half of the 1990s, mainly because inflation turned out to be lower
than forecast.
92
Quarterly Bulletin Winter 2002
enough and deflation sets in — is much more difficult to contain.
It requires much more policy easing but, as Japan proves, with
more uncertain results.
B. Structural Issues
(vii) restructuring the financial and corporate sectors should
have been undertaken from the start, when the easing of
macroeconomic policies would have been able to provide most
support. Delaying reform has proved to be extremely costly for
the Japanese authorities, in terms of a decade of economic
underperformance and the loss of flexibility with policy tools. The
experience of other countries which have undergone the
bursting of asset price bubbles and the associated weakening of
their financial sectors — such as Sweden in the 1990s — highlight
the value of an early and broad-based package of reforms,
possibly including public money, to tackle the problem.
(viii) Over-reliance on the bank lending channel of
transmission, from monetary policy easing to economic activity
and prices, leaves an economy especially vulnerable to problems
emanating from the banking sector.
(ix) Over-investment in largely unproductive assets such as
land and buildings creates a considerable overhang of excess
capacity, which can weigh on economic activity over a long
period. This contrasts with over-investment in more productive
assets (e.g. business investment in the US in the second half of
the 1990s), which helps to increase productivity and potential
growth in the economy. Moreover, as business investment tends
to have a shorter obsolescence period, generally speaking this
enables any overhang to be worked off more quickly.
7. Concluding Remarks
Japan provides a salutary lesson in how a combination of
inappropriate corporate practices, financial sector weakness, the
bursting of an asset price bubble and inadequate or inefficiently
designed macroeconomic easing can lead to a prolonged
deflationary slump. Fortunately for other industrialised countries,
they are unlikely to find themselves facing such a coincidence of
factors in the future. Nevertheless, to counteract complacency in
the international community regarding the risk of such a slump
being encountered elsewhere, it is important to reiterate the
point that the Japanese situation was never anticipated and, a
priori, policy easing was seen as more than adequate to meet
the expected outcome. This suggests that, when considerable
downside risks to the economic and inflation outlook exist, they
deserve to be accorded much more weighting in policy setting,
especially when the economy is at a particularly worrisome
conjuncture. Furthermore, as macroeconomic policy is more
effective before the onset of such downward pressures, this
should be reflected in policy setting.
93
Quarterly Bulletin Winter 2002
Japan’s experience also highlights the importance of the
interaction of microeconomic issues with macroeconomic policy.
This view is already well entrenched internationally, where there
has been increased emphasis on the need for an acceleration in
structural reform, to enable the optimum benefit to be extracted
from macroeconomic policies. Japan’s experience stresses how
macroeconomic policy can be rendered ineffective — or, at least,
considerably less effective — when structural problems are
pervasive. Moreover, Japan’s economic record stresses the
importance of sequencing in this debate. Had fiscal and
monetary policy easing been accompanied earlier by structural
reforms, they might, together, have prevented Japan’s
deflationary slump. Moreover, the short term costs of
restructuring would have been easier to bear. What is abundantly
clear from an analysis of Japan is the undesirability of trying to
overcome sluggish economic performance, which is the result of
micro inefficiencies, with macroeconomic demand management
alone.
It is understandable why, politically, it is extremely difficult to
undertake severe restructuring when the economy is already
excessively weak. However, the last decade in Japan highlights
that the short term costs of structural reform need to be weighed
against the ongoing costs of below-par economic performance
over a protracted period of time. Structural reforms can play a
very important part in limiting, rather than exacerbating, potential
downside risks to the economic outlook over the long-term.
Bibliography
Ahearne, Alan and Joseph Gagnon, Jane Haltmaier, Steve Kamin,
Christopher Erceg, Jon Faust, Luca Guerrieri, Carter Hemphill,
Linda Kole, Jennifer Roush, John Rogers, Nathan Sheets and
Jonathan Wright (2002) ‘‘Preventing Deflation : Lessons from
Japan’s Experience in the 1990s’’, Board of Governors of the
Federal Reserve System, International Finance Discussion
Papers, Number 279.
Baig, (2002) ‘‘Monetary Policy Effectiveness in a Deflationary
Environment’’, Japan-Selected Issues, IMF.
Bayoumi, Tamin and Charles Collyns, eds. (2000) Post-Bubble
Blues: How Japan Responded to Asset Price Collapse,
International Monetary Fund, Washington, D.C.
Bayoumi, Tamin (2000) ‘‘The Morning After: Explaining the
Slowdown in Japanese Growth in the 1990s,’’ in Bayoumi,
Tamin and Charles Collyns, eds. Post-Bubble Blues: How Japan
Responded to Asset Price Collapse, International Monetary
Fund, Washington, D.C.
94
Quarterly Bulletin Winter 2002
Bernanke, Ben and Mark Gertler (1995) ‘‘Inside the Black Box:
The Credit Channel of Monetary Policy Transmission,’’ Journal
of Economic Perspectives, 9, 27-48.
Bernanke, Ben (2000) ‘‘Japanese Monetary Policy: A Case of SelfInduced Paralyses?’’ in Mikitani, Ryoichi and S. Adam Posen,
eds., Japan’s Financial Crisis and its Parallels to U.S. Experience,
Institute for International Economics, Washington, D.C.
Blinder, A.S. (2000) ‘‘Monetary Policy at the Zero Lower Bound:
Balancing the Risks: Summary Panel,’’ Journal of Money Credit
and Banking, 32, 1093-1099.
Bordo, Michael D. and Angela Redish, ‘‘Is deflation depressing?
Evidence from the Classical Gold Standard’’.
Clouse, James, Dale Henderson, Athanasios Orphanides, David
Small, Peter Orphanides, and Peter Tinsley (2000) ‘‘Monetary
Policy When the Nominal short-Term Interest Rate is Zero,’’
Finance and Economics Discussion Series, 2000-51, Board of
Governors of the Federal Reserve System.
Flynn, John and Anne Marie McKiernan (2000), ‘‘Global
Economic Imbalances’’, Central Bank of Ireland Spring Bulletin.
Friedman, Benjamin M. (2000) ‘‘Japan Now and the United
States Then: Lessons from the Parallels,’’ in Mikitani, Ryoichi
and S. Adam Posen, eds., Japan’s Financial Crisis and its
Parallels to U.S. Experience, Institute for International
Economics, Washington, D.C.
Fujiki, Hiroshi and Shigenori Shiratsuka (2001), ‘‘Policy Duration
Effect under the Zero Interest Rate Policy in 1999-2000 :
Evidence from Japan’s Money Market Data’’, IMES Discussion
Paper, No.2001-E-10, Institute of Monetary and Economic
Studies, Bank of Japan.
Fukui, Toshihiko (1996) ‘‘Recent Conduct of Monetary Policy by
the Bank of Japan,’’ speech to the Research Institute of Japan,
November 13, 1995, excerpted and translated in Bank of
Japan, Quarterly Bulletin, 2, February, 11-19.
Goodfriend, Marvin (1997) ‘‘Comments on chapter by Kazuo
Ueda,’’ in Iwao Kuroda, ed. Towards More Effective Monetary
Policy, MacMillan Press, London, in association with Bank of
Japan.
Goodfriend Marvin (2000) ‘‘Overcoming the Zero Bound on
Interest Rate Policy,’’ Journal of Money Credit and Banking, 32,
1007-1035
International Monetary Fund (2000), World Economic Outlook,
Washington, D.C., May.
95
Quarterly Bulletin Winter 2002
Kalra, S (2002), ‘‘Fiscal Policy: An Evaluation of its Effectiveness’’,
Japan-Selected Issues, IMF.
Krugman, Paul (1998) ‘‘It’s Baaack! Japan’s Slump and the
Return of the Liquidity Trap,’’ Brookings Papers on Economic
Activity, 2.
Kuttner, Kenneth N. and Adam S. Posen (2002) ‘‘Passive Savers
and Fiscal Policy Effectiveness in Japan,’’ manuscript prepared
for the CEPR-CIRJE-NBER Conference on Issues in Fiscal
Adjustment, Tokyo, December 13-14, 2001.
Makin, John (2001), ‘‘Japan’s Lost Decade: Lessons for America,’’
American Enterprise Institute Economic Outlook, February.
Mieno, Yasushi (1994) ‘‘Roles of Financial and Capital Markets
under Current Japanese Monetary and Economic Conditions,’’
speech to the Capital Markets Research Institute, December
7, 1993, excerpted and translated in Bank of Japan, Quarterly
Bulletin, 12, February, 5-13.
Mikitani, Ryoichi and S. Adam Posen, eds. (2000), Japan’s
Financial Crisis and its Parallels to U.S. Experience, Institute for
International Economics, Washington, D.C.
Mori, Naruki, Shigenori Shiratsuka and Hiroo Taguchi (2001),
‘‘Policy Responses to the Post-Bubble Adjustments in Japan: A
Tentative Review’’, Monetary and Economic Studies, 19 (S-1),
Institute for Monetary and Economic Studies, Bank of Japan,
pp. 53-102.
Morsink, James and Tamin Bayoumi (2001), ‘‘A Peek Inside the
Black Box: The Monetary Transmission Mechanism in Japan,’’
IMF Staff Papers, 48, 22-57.
OECD, Economic Outlook (various).
OECD, Economic Survey of Japan (various).
Oda and Okina, ‘‘Further Monetary Easing Policies under the
Non-Negativity Constraints of Nominal Interest Rates:
Summary of the Discussion based on Japan’s experience’’,
Monetary and Economic Studies (Special Edition), Institute for
Monetary and Economic Affairs, February 2001.
Okina, Kunio and Shigenori Shiratsuka (2001) ‘‘Asset Price
Bubbles, Price Stability and Monetary Policy: Japan’s
Experience’’, IMES Discussion Paper Series, Institute for
International Economic, Washington, D.C.
Perri, Fabrizio, (2001) ‘‘The Role of Fiscal Policy in Japan: A
Quantitative Study,’’ Japan and the World Economy, 13, 387404.
96
Quarterly Bulletin Winter 2002
Posen, Adam S. (1998) Restoring Japan’s Economic Growth,
Institute for International Economics, Washington, D.C.
Ramaswamy, Ramana (2000) ‘‘Explaining the Slump in Japanese
Business Investment,’’ in Bayoumi, Tamin, and Charles Collyns,
eds. Post-Bubble Blues: How Japan Responded to Asset Price
Collapse, International Monetary Fund, Washington, D.C.
Saito, Makoto and Shigenori Shiratsuka (2001), ‘‘Financial Crises
as a Failure of Arbitrage: Implications for Monetary Policy’’,
Monetary and Economic Studies, 19 (S-1), Institute for
Monetary and Economic Studies, Bank of Japan, pp.239-270.
Sekine, T. (1999) ‘‘Firm Investment and Balance-Sheet Problems
in Japan’’, IMF Working Paper, 99/111.
Shimizu, Yoshinori (2000), ‘‘Convoy Regulation, Bank
Management, and the Financial Crisis in Japan,’’ in Mikitani,
Ryoichi and S. Adam Posen, eds., Japan’s Financial Crisis and
its Parallels to U.S. Experience, Institute for International
Economic, Washington, D.C.
Shirakawa, Masaaki, (2002) ‘‘One Year Under ‘Quantitative
Easing’,’’ IMES Discussion Paper Series, Institute for Monetary
and Economic Studies, Bank of Japan.
Shiratsuka, Shigenori (2001a), ‘‘Is the a Desirable Rate of
Inflation? A Theoretical and Empirical Survey’’, Monetary and
Economic Studies, 19 (2), Institute for Monetary and Economic
Studies, Bank of Japan.
Shiratsuka, Shigenori (2001c), ‘‘Asset Prices, Financial Stability
and Monetary Policy: Based on Japan’s Experience of the Asset
Price Bubble’’, in Marrying the Macro- and Microprudential
Dimensions of Financial Stability, BIS Papers, No. 1, pp.261284.
Svensson, Lars (1997), ‘‘The Zero Bound in an Open-Economy:
A Foolproof Way of Escaping from a Liquidity Trap,’’ Monetary
and Economic Studies 19(S-1), February.
Taylor, John B. (2001), ‘‘Low Inflation, Deflation and Policies for
Future Price Stability’’, Monetary and Economic Studies, 19
(S-1), Institute for Monetary and Economic Studies, Bank of
Japan, pp. 35-51.
Ueda, Kazuo (2001), ‘‘Japan’s Liquidity Trap and Monetary
Policy,’’ speech to Japan Society of Monetary Economics,
Fukushima University, September 29.
Yoshino, Naoyuki and Eisuke Sakakibara (2002), ‘‘The Current
State of the Japanese Economy and Remedies,’’ Asian
Economic Papers, 1:2, 111,127.
97
Quarterly Bulletin Winter 2002
Annex 1: How to Make Monetary Policy more
effective in Japan?
To achieve lower real interest rates, but faced with the lower
bound of zero on nominal interest rates, a number of
unconventional — and largely untested — measures have been
proposed by international and domestic commentators to try to
make monetary policy more effective. These centre around the
BoJ undertaking a very significant quantitative easing in the
monetary base — i.e. increasing the amount of banknotes in
circulation and/or the total of current account deposits held by
banks and other financial intermediaries at the BoJ. This could be
carried out through greater provision of liquidity in open market
operations, and/or through printing money. Quantitative easing
in the monetary base is largely advocated on the grounds that
(i) if sufficiently large, the increase in the monetary base
would eventually find its way from the banking sector
into the economy through increased bank lending (credit
creation). By alleviating any credit constraints on
businesses and consumers, this increases their ability to
spend and invest;
(ii) a sharp increase in the monetary base would, through
the ‘‘money multiplier’’ effect, lead to such growth in the
overall money supply that inflation expectations would
be triggered. In expectation of increasing prices,
businesses and consumers would then increase
spending.
Advocates of monetary base expansion suggest that its
effectiveness would be enhanced if it were accompanied by an
explicit positive inflation target. This would communicate to the
public that base money would continue to increase until a
positive rate of inflation had been achieved, thus encouraging
positive inflation expectations to take hold.
However, the above benefits from monetary base expansion
might not be realised if
(i) banks were not willing to engage in further credit
creation — despite a substantial increase in liquidity
provided by the BoJ — due, perhaps, to worries about
repayment capacity of new borrowers;
(ii) businesses and consumers were unwilling to borrow.
Then, the increase in supply of funds for lending would
be largely ineffective.
Some critics maintain that the extent of the quantitative easing
undertaken so far has not been sufficient — that what is needed
is a very significant growth in the monetary base, of the order of
50-60% (compared to 30% year-on-year in July 2002 and an
average of 8% per annum in 1996-2001).
98
Quarterly Bulletin Winter 2002
As the monetary expansion undertaken in Japan so far has
concentrated on open market operations, printing more money
at this stage might be a more effective way of influencing
inflation expectations. If the BoJ were to undertake a major
increase in printing money, this could be introduced into the
economy by the BoJ:
a. purchasing more Japanese government bonds (JGBs).
This is called monetising government debt, and could be
used for new and/or existing debt;
b. printing money for government which would be used to
purchase goods and services. This amounts to
monetising the government deficit, or part thereof;
c. purchasing foreign exchange or other foreign assets,
which would depreciate the yen;
d. purchasing corporate bonds or equities;
e. distributing cash directly to households, e.g. as ‘‘windfall
payments’’ in cash.
In this way, monetisation could, theoretically, achieve the
following objectives:
(a) through the announcement effect of a
monetisation: induce expectations of inflation;
major
(b) if used to buy more JGBs: generate an interest rate effect
by driving down the yield;
(c) if used to buy foreign exchange : generate a trade
stimulus by weakening the yen vis-à-vis other currencies;
(d) if used by government to buy more goods and services:
generate a demand boost;
(e) if used to buy corporate bonds and/or equities: generate
more domestic demand;
(f) if cash payouts to households are spent: generating more
consumption demand.
Risks of a Monetisation Strategy
The BoJ has been opposed to a large-scale monetisation strategy,
in view of the risks which it would entail for monetary, fiscal and
exchange rate policy:
(i) Extending the BoJ’s role in the JGB market through
monetisation amounts to an effective underwriting of
government bonds by the BoJ, at a time when the risk
rating of those bonds is declining. This would constitute
a major risk to the BoJ’s balance sheet, which could
damage its credibility and impair its ability to conduct
monetary policy in the future.
99
Quarterly Bulletin Winter 2002
(ii) This could also impart a moral hazard aspect to fiscal
policy, by loosening fiscal discipline, which could,
counterproductively, lead to an increase in long-term
interest rates. This would have adverse consequences on
banks’ balance sheets, given their large holdings of JGBs.
(iii) The effect of further BoJ involvement in the JGB market
would be to create an incentive for the BoJ to avoid
capital losses on bonds. Thus, the BoJ would have an
incentive to suppress a rise in short-term interest rates,
because the larger its holding of long-term bonds, the
larger its potential losses would be when short-term
interest rates begin to rise. Such a perverse incentive
would, if acted upon, have negative consequences in the
long run. Its existence could also undermine the
credibility of the BoJ.
(iv) The fact that the monetary base expansion that has been
undertaken so far has been ineffective undermines
confidence in further quantitative easing. A willingness
by the BoJ to supply more liquidity in OMOs is no
guarantee that financial institutions will be willing to take
it up.
(v) Expanding outright purchases of private sector securities
and buying tangible assets would have a positive wealth
effect on some citizens and not on others, creating legal
and political problems. It would also expose the BoJ to
credit risk.
(vi) The moral hazard problem would also apply to the direct
financing of the government deficit by the BoJ. (There is
a legal prohibition on such direct financing of the
government deficit by the BoJ, although this restriction
can be lifted temporarily in extraordinary circumstances).
Having the BoJ or Ministry of Finance purchasing goods
and services would be politically unacceptable, when the
public expenditure system is regarded as not delivering
value for money.
(vii) purchasing foreign exchange could provoke opposition
from Japan’s major trading partners, and would probably
need a multilateral agreement with the US and the euro
area to be effective. Japan’s trading partners in Asia
would be particularly opposed to and badly affected by
yen depreciation.
(viii) Given the unprecedented nature of monetisation
processes, it is difficult to see how one could be
managed so well as to prevent it from getting out of hand
(i.e. generating uncontrollable inflation risks).
The Japanese authorities face a difficult dilemma on the
operation of monetary policy. While all of the above reasons
100
Quarterly Bulletin Winter 2002
explain why the Bank of Japan has been reluctant to extend its
monetary base expansion beyond its current level, the fact that
deflationary pressures have become entrenched in Japanese
economic psychology means that the case for trying more radical
and risky policy measures has become more pressing. If the
deleterious effects on economic activity of ongoing deflation
were seen to outweigh the potential negative effects of a largerscale monetisation, then such a move could come to be seen as
an appropriate initiative for the authorities to take.
101
Quarterly Bulletin Winter 2002
An Overview of Monetary Policy in the US
by Karl Whelan*
ABSTRACT
With the introduction of monetary union, the US Federal Reserve system
has become a common reference point against which to compare the
procedures and policies of the fledgling ECB. This paper provides a brief
overview of US monetary policy. The paper discusses the legal and
institutional structures underpinning the Federal Reserve system, the
process by which policy decisions are made, and the strategy that the
Federal Reserve has used in implementing monetary policy in recent years.
1. Introduction
With the introduction of monetary union, the central banks of
the euro area are now pursuing a common monetary policy.
Because the European experience of setting a single monetary
policy across an economy as large as that of the euro area has
been very limited, the US Federal Reserve system has become a
common reference point against which to compare the
procedures and policies of the fledgling European Central Bank
(ECB). This paper provides a brief overview of the structure and
policy framework of the Federal Reserve.
The paper begins with a description of the legal and institutional
structures underpinning the Federal Reserve system, the process
by which policy decisions are made, and how these policy
decisions are communicated to the public. It then moves on to
discuss the strategy that the Federal Reserve has used in
implementing monetary policy in recent years, focusing on a
comparison of actual policy with that recommended by
systematic interest-rate rules, and on the role of monetary
aggregates. Finally, there is some comparison of the Federal
Reserve’s approach to monetary policy with that of the ECB’s.
2. Institutional Details
2.1 Structure of the System
The Federal Reserve System — known popularly as the Fed — was
founded in 1913 in response to a series of banking crises which
had beset the US under its previous system in which there were
numerous ‘‘national banks’’ with each entitled to issue
banknotes. The modern structure of the system dates from 1935,
with the setting up of a central management body in Washington
D.C. known as the Board of Governors or Federal Reserve Board,
and the Federal Open Market Committee (FOMC) which was
charged with the formulation of monetary policy.
* The author is an economist in the Bank’s Economic Analysis, Research and Publications
Department. The views expressed in this Paper are not necessarily those held by the Bank
and are the personal responsibility of the author. He would like to thank Frank Browne,
John Frain, Rafique Mottiar and Tom O’Connell for helpful comments.
103
Quarterly Bulletin Winter 2002
In addition to their roles in formulating monetary policy through
the FOMC, the Board and the Fed’s twelve regional banks play
a number of other roles in national economic policy. For
example, the Board has responsibility for contributing to the
smooth functioning of payment systems and financial stability in
general, and also has a range of regulatory responsibilities for
the banking system, including approval of bank mergers and the
monitoring of compliance with congressional laws such as the
Community Reinvestment Act. The reserve banks also play a role
in monitoring and regulating the banks in their region and in the
distribution of currency.
The membership of the FOMC consists of the seven Governors
of the Federal Reserve Board (including the Chairman), the
president of the Federal Reserve Bank of New York, and four
other regional bank presidents chosen on a rotating basis from
the other eleven regional district banks. The Committee has eight
scheduled meetings per year but sometimes takes monetary
policy decisions outside these meetings (typically meeting by
telephone conference) if economic circumstances are judged to
have changed a lot since the previous meeting.
2.2 Independence and Accountability
Although the Fed is an independent body with the sole power
to set US monetary policy, its underlying legislative framework
allows elected politicians to have an important influence on the
long-term strategy of monetary policy and requires the Fed to be
accountable to the other branches of the federal government.
The political influence on the long-term strategy of monetary
policy has two elements, the first of which is the political nature
of the process by which senior Fed officials are appointed. All
Governors are chosen by the President and approved by the
Senate, and are appointed to non-renewable fourteen-year terms.
This process can allow a President to influence the composition
of the Board in a manner that encourages the policies that the
administration would like to see pursued. However, the long
length of Governors’ terms and the fact that these terms cannot
be renewed means that, once appointed, Board members are
relatively free from political pressures.
The President also appoints two Governors to act as Chairman
and Vice-Chairman of the Board for renewable four-year terms.
This re-appointment process places some limits on how much
the Chairman can depart from the economic policy preferences
of the President. That said, the current Chairman, Alan
Greenspan, is very highly thought of by participants in
international financial markets, and the approach of US
administrations over the past decade has largely been to leave
policy decisions to the Fed, with administration members usually
refusing to comment on matters relating to monetary policy.
104
Quarterly Bulletin Winter 2002
The second influence that the federal government has on the
long-term course of monetary policy is its ability to set the Fed’s
objectives through legislation. For example, the Full Employment
and Balanced Growth Act of 1978 — usually known as the
Humphrey-Hawkins Act — establishes a number of long-term
goals for monetary policy (this issue will be discussed in greater
detail below). Although such acts of Congress are not intended
to allow politicians to control the month-to-month operation of
monetary policy, the Humphrey-Hawkins Act does require the
Fed to update Congress on its performance. The Act also
requires the Fed to produce a twice-yearly report to Congress
reviewing recent macroeconomic events and the policy stance
and providing forecasts for major macroeconomic variables for
the year ahead. After the release of this report, the Chairman is
required to appear before two congressional committees to
testify on the state of the economy, and to answer questions
from congressmen and senators.
While these factors allow for a relatively important degree of
centralized oversight, the Fed’s structure was also designed to
allow for inputs from different regions and from the private
sector. Its regional district banks exist as separate corporate
entities with local member banks as stockholders. The directors
of these district banks are then appointed to represent local
business, banking and consumer interests. The regional bank
presidents, who can vote on the FOMC, are appointed by these
directors, although these appointments must be approved by the
Board of Governors.
3. How Policy is Made: FOMC Meetings
3.1 Pre-Meeting Preparations
The process by which the FOMC makes monetary policy
decisions begins a number of weeks prior to the actual meeting.
During this period, Federal Reserve staff prepare materials to
assist the committee in making its decision. In particular, the staff
prepares three formal documents. Staff at the Board prepare the
Bluebook, which discusses the various policy options open to the
committee and analyses the likely reaction of financial markets
to the policy decision, while staff at the regional district banks
prepare the Beige Book, which provides qualitative descriptions
of the state of the economy in the various regional districts based
largely on discussions with local business contacts.
Perhaps the most important staff input into the policy process
is the Greenbook, which is also prepared by Board staff. The
Greenbook contains a description of macroeconomic and
financial developments over the inter-meeting period, as well as
a detailed discussion of the staff’s forecasts for all the major
macroeconomic variables. The staff forecast focuses on the next
eight to ten quarters and is constructed in an essentially
105
Quarterly Bulletin Winter 2002
judgemental fashion. Specifically, the forecast is built from the
ground up based on a large number of disaggregated forecasts
for various expenditure categories, price indices, and so on.1
While the analysts that construct these forecasts make extensive
use of econometric modelling, the forecast is not restricted to
match that of the Board’s large-scale structural econometric
model, known as FRB-US. However, the Board staff uses FRB-US
for a number of important purposes and, in the policy process,
this model is used to describe a number of alternative scenarios
to the base forecast.
In addition to the extensive set of materials prepared for all
FOMC members, each of the Fed’s district banks has a staff of
economists that brief their bank presidents on the state of the
national and local economies, and these economists generally
prepare independent forecasts to those produced by the Board
staff. The research departments of the various district banks often
tend to have expertise in different areas of macroeconomic
modelling so, in addition to the Board’s forecast, committee
members have often seen forecast simulations from vector
autoregressions and more theoretically-based dynamic general
equilibrium models.
3.2 The Meetings
In addition to the members of the committee, FOMC Meetings
are attended by a significant number of other Federal Reserve
staff. These include the alternating members of the committee
(the non-voting regional bank presidents), advisors to each of the
bank presidents (typically, the director of the research
department at the regional bank), and a number of senior staff
from the Board’s economics departments.
The committee’s meetings usually begin with brief statements by
senior Board staff on the outlook for the domestic and
international economies, and by a representative of the Open
Market desk on operational issues for monetary policy over the
inter-meeting period. Committee members usually question the
staff on these statements, and then the Chairman leads a
discussion of the state of the economy, with each of the
Governors and regional bank presidents contributing their
opinions. The regional bank presidents usually discuss recent
developments in their region at this point.
After these initial statements, the Chairman usually outlines his
preferred policy decision and each of the Governors and regional
bank presidents comment on this proposal. Finally, a (usually
unanimous) vote of the committee is taken on the proposed
policy directive and a public statement concerning the decision
1 See Sims (2002) for a discussion of forecasting practices at various central banks
including the Fed.
106
Quarterly Bulletin Winter 2002
is agreed upon. The Chairman’s role in leading the policy
discussion and in setting the terms of the debate usually has a
crucial influence on the decision that is taken. As a result, while
theoretically the Chairman has only one vote, in practice he
bears a very important responsibility for the strategy of monetary
policy, and this responsibility is re-enforced by legal requirements
that he be responsible for publicly articulating and defending the
Fed’s policy stance to Congress.
3.3 After The Meetings: Public Communications
After the FOMC makes a decision, the public communication of
events at the meeting proceeds in various stages. Immediately
following the meeting, a statement is issued outlining the policy
decision. In recent years, this has taken the form of the
announcement of an explicit target for the federal funds rate, the
interest rate on short-term loans of bank reserves. The Fed
controls this rate by buying and selling securities to either add or
subtract liquidity in the inter-bank reserves market. The statement
also provides an indication of whether the committee views the
economic circumstances as pointing towards either tightening or
loosening of policy in the immediate future. Recently, the
statement has also included the details of the vote on policy,
describing who voted for and against the policy decision, and
the preferred decision of those who voted against. This
information was previously released with a delay.
About a month after the meeting, a more detailed set of minutes
are released, which provide more information on the
committee’s views on the state of the economy. Finally, about
five years after the meeting, a full transcript of what took place
is made available. Thus, ultimately, everything said at the
meetings is for the public record. The transcripts, currently
available through the end of 1996, provide an important insight
into how monetary policy decisions are taken. For example, the
transcripts provided the basis for the description above of how
FOMC meetings usually proceed.
4. The Policy Framework of the Federal Reserve
The underlying objectives of the Federal Reserve are not set out
in a single constitution or piece of legislation. Rather, the goals
of monetary policy are understood to coincide with the
objectives of national economic policy, as set out in the
Employment Act of 1946 and the Humphrey-Hawkins Act of
1978 (described above). These objectives include economic
growth in line with the economy’s potential to expand; a high
level of employment; stable prices, and moderate long-term
interest rates. Here, we discuss how the Fed has implemented
monetary policy in pursuit of these goals.
107
Quarterly Bulletin Winter 2002
4.1 The Role of Inflation and Output
While central banking practice around the world has seen a
movement in recent years towards price stability as the sole goal
of monetary policy, the Federal Reserve has a mandate to pursue
both price stability and economic growth in line with the
economy’s potential. An important line of research has recently
explored how US monetary policy has responded to the two
elements of this dual mandate.
In a well-known paper, John Taylor (1993) showed that monetary
policy under the chairmanship of Alan Greenspan (whose term
began in late 1987) was well described by a simple rule under
which the federal funds rate was a simple function of inflation
and output. Specifically, the so-called Taylor rule relates the
federal funds rate to deviations of output from a trend level, and
of inflation from a target of two per cent. Algebraically, the Taylor
rule can be written as:
i(t) = α + β (π(t) − 0.02) + γ(y(t) − y*(t) )
where i(t) is the federal funds rate, π(t) is the four-quarter per
cent change in an aggregate price measure, y(t) is the log of real
GDP, and y*(t) is a measure of the trend level of y(t).2
Figure 1
The Taylor Rule
12
10
8
6
4
2
0
Dec-87
Dec-89
Dec-91
Federal Funds Rate
Dec-93
Dec-95
Dec-97
Dec-99
Dec-01
Estimated Taylor Rule
2 The use of logs implies that the term entering the interest rate rule can be interpreted as
the percentage deviation of output from its trend level.
108
Quarterly Bulletin Winter 2002
Figure 1 illustrates the fit of an econometrically-estimated version
of the Taylor rule, estimated over the sample 1987:Q4 to
2002:Q2. The regression underlying this chart followed the
original work of Taylor in using the GDP deflator as the price
index, and in measuring trend GDP as the fit from a regression
of the log of GDP on linear and quadratic time trends. The figure
shows that this simple rule explains most of the variation over
the past fifteen years in the federal funds rate: The R-squared for
the regression is 0.65. This evidence confirms that the Taylor rule
appears to provide a reasonable first-order approximation to
actual Federal Reserve policy over this period. And not
surprisingly, given its prominence in recent academic discussions,
it is believed that the staff’s Bluebook prepared for the FOMC
contains discussions of the policy choices consistent with the
Taylor rule as well as other systematic policy rules.
It would be a mistake, however, to over-estimate the extent to
which US monetary policy can be summarized by a simple rule.
To illustrate this point, consider the following three examples of
periods when policy deviated from the Taylor rule.
The Credit Crunch: Figure 1 shows that following the recession
of the early 1990s, the federal funds rate was kept about one per
cent below the level predicted by a Taylor rule until about the
middle of 1994. An examination of transcripts from FOMC
meetings during this period reveals that committee members
were concerned about a ‘‘credit crunch’’ due to US banks
adopting tighter credit standards. As a result, the FOMC felt that
financial conditions were tighter than the low federal funds rate
would have suggested, and so deliberately deviated from the
usual prescriptions of a Taylor-style rule. The committee appears
to have offset this policy by then adopting a tighter-than-normal
monetary policy for a period beginning in late 1994.
The Asian Crisis: Another policy move that ran directly counter
to the prescriptions of the Taylor rule was the decision to cut the
federal funds rate by 75 basis points in late 1998. At this time
the US economy was expanding at a rapid pace and the Taylor
rule was calling for interest rate increases. However, the Fed’s
interest rate cuts followed a default by Russia on its debt and a
set of large devaluations of Asian currencies which together led
to a very high level of uncertainty and instability in global
financial markets. The Fed’s interest rate cuts were widely seen
as helping to restore calm to international financial markets, and
this example illustrates how some of the Fed’s other goals, such
as the maintenance of financial stability, can at times cause it to
behave in a different manner than would be suggested by a
simple interest rate rule based on the behaviour of US inflation
and output.
109
Quarterly Bulletin Winter 2002
The Late 1990s: Another example of how US policy does not
appear to have followed the simple Taylor rule relates to the
apparent instability over time in the coefficients on the estimated
rule. Ball and Tchaidze (2002) have demonstrated that there was
a break in the estimated Taylor rule in 1996. Figure 2 provides
an illustration of this break: It shows that a Taylor rule estimated
using data up to 1996:Q4 provides a poor description of actual
Fed policy in the late 1990s. The pre-1996 Taylor rule would
have called for much higher interest rates during both the
expansion of the late 1990s and the subsequent slowdown.
Figure 2
A Pre-1996 Estimated Taylor Rule
12
10
8
6
4
2
0
Dec-87
Dec-89
Dec-91
Federal Funds Rate
Dec-93
Dec-95
Dec-97
Dec-99
Dec-01
Pre-1996 Estimated Taylor Rule
Technically, the main reason for the difference between the
estimated policy rules shown in Figures 1 and 2 is that the pre1996 rule places a much higher weight on the output gap than
the rule estimated over the full sample. It is widely believed that
the reason for this change in the weight assigned to the output
gap is that, from the late 1990s on, the FOMC disagreed with
the implications of this series for the difference between actual
and potential output. In particular, Chairman Greenspan and
other Fed officials spoke on many occasions about a resurgence
in US productivity growth and its implications for a faster pace
of growth in potential output. This pattern, however, was not
fully reflected in the simple measure of trend output incorporated
into the Taylor rule. Thus, the FOMC appears to have viewed
the US economy as being less ‘‘over-heated’’ than the traditional
measure of the output gap suggested it was.
110
Quarterly Bulletin Winter 2002
These examples illustrate some of the reasons why actual interest
rate policy has sometimes deviated from the recommendations
of the Taylor rule, often for periods of a couple of years. One
aspect of these deviations that has been noted by a number of
researchers is that the federal funds rate appears to have been
somewhat ‘‘smoother’’ than predicted by the Taylor rule. As a
result, some have suggested that the Fed also places some value
on keeping the interest rate stable, and empirical Taylor rules
estimated by researchers have often incorporated a lagged
federal funds rate term to capture this element.3 However, the
examples just discussed illustrate that a statistically significant role
for the lagged funds rate in an econometric regression may not
reflect a desire to smooth interest rates. Rather, this may simply
reflect the fact that other considerations not well captured in
the Taylor rule tend to affect monetary policy, and that these
considerations may lead to relatively persistent deviations from
this rule.4
4.2 The Role of Money
A noteworthy aspect of the recent conduct of US monetary
policy is the very limited role played by the monetary aggregates.
This reflects, in part, the views of Fed officials that setting
monetary policy via targets for monetary aggregates has not
proved effective in the past.
The role of the monetary aggregates in US monetary policy has
changed significantly over time. Up until the late 1960s, Fed
policy was set much like it is today, with short-run targets for the
federal funds rate. However, this period saw the monetarist
school of thought associated with Milton Friedman becoming
more influential. Friedman documented the long-run relationship
between the price level and the supply of money, and during the
1970s the Fed began to focus more on explicitly managing the
money supply. In 1978 the Humphrey-Hawkins Act imposed the
requirement that, as part of its semi-annual report, the Fed should
announce explicit targets for the money supply and explain any
deviations from these targets. Then, starting in 1979 under the
chairmanship of Paul Volcker, the Fed implemented policy by
explicitly managing the level of reserves to meet these money
growth targets. This approach resulted in a substantial increase
in the volatility of the federal funds rate, as this rate moved
around to fit the specific rate of reserves growth that the Fed was
targeting.
Although monetary policy over this period was highly successful
in reducing inflation, Fed officials became unhappy with a
number of practical difficulties associated with the implementation
of monetary targeting. Specifically, the historical link between the
money supply and the price level relies on the assumption of a
3 See, for instance, Woodford (1999) for a discussion of this issue.
4 See Rudebusch (2002) for a further discussion of this position.
111
Quarterly Bulletin Winter 2002
relatively stable monetary velocity. However, deregulation and
technological innovations in financial markets led to substantial
changes in monetary velocity during the 1980s. Thus, over the
course of the 1980s the Fed gradually placed less emphasis on
the monetary aggregates as indicators of inflationary pressures,
and returned to implementing policy by managing the federal
funds rate.5
In recent years, the Fed has become more explicit about the
limited role that the monetary aggregates play in its approach to
policy. For example, consider the following quote from the
official document Purposes and Functions of the Federal Reserve
System:
The usefulness of the monetary aggregates for indicating the
state of the economy and for stabilizing the level of prices
has been called into question by frequent departures of their
velocities from historical patterns.
In 2000, the Fed asked to be relieved of its responsibility to
report annual monetary targets to Congress and the request was
approved.
4.3 Policy Debates
While most observers have been satisfied with the performance
of US monetary policy in recent years, there remain a number
active debates concerning how policy should be conducted.
One of these debates concerns whether the Fed should adopt
an explicit inflation target, as has been done in a number of other
countries. Although Taylor-rule style econometric analysis has
pointed to an implicit target of about 2 per cent, there has been
a substantial debate as to whether an explicit target would be
preferable. Advocates argue that while Alan Greenspan is widely
thought to have a credible commitment to low inflation, there is
nothing committing the Fed as an institution to low inflation after
his departure as chairman. Indeed, Clarida, Gali, and Gertler
(1999) and others have argued that the high inflation of the
1970s was the result of the failure of the Fed to be sufficiently
aggressive in fighting inflation at that time: Econometric estimates
of Taylor rules for this period report low coefficients on inflation.
An explicit inflation target may prevent such a regime from
happening again, and this proposal is known to have some
backing within Federal Reserve circles. For example, former
Governor Laurence Meyer and current Governor Ben Bernanke
are known to favour an explicit target, on the grounds that this
would improve the transparency of monetary policy and help to
‘‘anchor’’ expectations of low inflation.
5 Meyer (2001) provides a clear and useful discussion of the role of the monetary
aggregates in Federal Reserve policy.
112
Quarterly Bulletin Winter 2002
In contrast, others have argued against an explicit inflation target
on the grounds that it would limit the flexibility that the FOMC
requires to meet its various goals. More generally, some argue
that an explicit inflation target could be construed as a
repudiation of the Fed’s legal ‘‘dual mandate’’ to foster growth
as well as low inflation. However, the dual mandate itself has
also been the subject of active debate. While theoretical work
has shown that Taylor-style rules that react to both output and
inflation tend to produce good economic outcomes, there are
also some relevant arguments for policy rules that do not
explicitly incorporate stabilization of output.6
One argument against the dual mandate is essentially theoretical
in nature. Economic theorists have shown how, under some
conditions, a policy-maker that credibly commits to a policy of
low inflation with no regard to output can, paradoxically, face an
improved trade-off between inflation and output, with cost
shocks requiring smaller adjustments to output to maintain stable
inflation.7 A more practical argument against explicit attempts
to stabilize output is associated with Athanasios Orphanides, an
economist at the Federal Reserve Board. Orphanides (2002)
argues that the gap between actual and potential output is very
difficult to observe, and that past policy errors have sometimes
been the result of reacting to mis-measured output gaps. For
example, Orphanides argues that the 1970s FOMC actually
followed a policy similar to the Taylor rule characterizing the
Greenspan era, with their failure to contain inflation resulting
from their consistent overestimation of the size of the output
gap. He recommends that, in light of these measurement
uncertainties, central banks should not attempt to stabilize
output around some measure of potential.
5. Comparisons with the ECB
The relatively positive performance of the US economy over the
past fifteen years has often led to praise for the Fed’s approach
to monetary policy. However, this does not necessarily imply that
the Fed provides an appropriate model upon which monetary
policy in Europe should be based. As we have discussed above,
a number of economists and policy-makers believe that the longrun performance of US monetary policy could be improved by
the adoption of a legal framework similar to that of the ECB. In
addition, the institutional structures of the Federal Reserve are
quite different from that of the ECB, and thus may call for a
different policy framework.
Perhaps the most obvious difference between the Fed and the
ECB’s approaches to monetary policy relates to their legal
6 Woodford (2001) contains a brief and useful discussion of a number of theoretical issues
related to Taylor rules.
7 Clarida, Gali, and Gertler (1999) discuss this issue in depth.
113
Quarterly Bulletin Winter 2002
mandates. The Fed has a somewhat loosely-defined mandate
which places price stability and output growth roughly on an
equal footing. In contrast, the Maastricht treaty strictly sets the
ECB’s mandate as being the maintenance of price stability, with
other goals such as output growth only being pursued to the
extent that they do not prejudice this primary goal. In addition,
while the Fed appears to have an implicit inflation target of about
2 per cent, the ECB interprets its price-stability mandate as
explicitly implying an inflation rate of under 2 per cent. That the
US economy has performed well under the Fed’s guidance is
not, however, in itself an argument against the ECB’s policy
framework. In fact, there is an active debate in US policy circles
over whether the Fed should also have an explicit inflation target
and whether price stability should be the sole or principal
responsibility of monetary policy.
In addition, the difference in legal structures perhaps suggests
that the arguments for an explicit mandate and quantitative
inflation target are stronger for the ECB than for the Fed. As
discussed above, power in the Federal Reserve System is quite
centralized, and the Fed is highly accountable to a single
governmental authority. In contrast, the more diffuse dispersion
of power among the separate countries of the ECB enforces the
usefulness of an explicit mandate in ensuring that monetary
policy meets its objectives.
A more technical difference between the two central banks is
the emphasis placed on monetary aggregates. The Federal
Reserve has explicitly rejected targeting of the monetary
aggregates as a means of implementing monetary policy, and has
de-emphasized money in its presentation of policy decisions. This
is often contrasted with the ECB’s policy strategy, which has a
quantitative reference value for money growth as one of its two
‘‘pillars’’. However, there is perhaps less difference between the
Fed and ECB’s philosophies in relation to money than initially
meets the eye. For example, page 47 of the official document
The Monetary Policy of the ECB makes clear that the ECB does
not view the first pillar as implying strict monetary targeting. It
states:
The reference value is not a monetary target. The ECB does
not attempt to keep M3 growth at the reference value at
any particular point in time by manipulating interest rates.
However, deviations from M3 are closely analyzed in the
context of other economic data in order to extract
the information they contain regarding the risks to price
stability.
The document then cites variations in velocity as the principal
reason not to respond ‘‘in a mechanical way to deviations of M3
growth from the reference value.’’ Thus, the difference between
the Fed and ECB’s attitudes towards the role of the monetary
114
Quarterly Bulletin Winter 2002
aggregates is more subtle than is sometimes suggested.
Moreover, recent debates over the role of the first pillar in the
ECB’s strategy has provoked some important research examining
the information that monetary aggregates contain for forecasts
of inflation in both the US and the euro area.8 Such research may
further encourage convergence of opinion on the appropriate
role for money in the formulation of monetary policy.
References
Altimari, Nicoletti (2001). Does Money Lead Inflation in the
Euro Area?, ECB Working Paper No. 63.
Ball, Laurence and Robert Tchaidze (2002). ‘‘The Fed and the
New Economy’’, American Economic Review, Vol 92(2),
pp. 108-114.
Clarida, Richard, Jordi Gali, and Mark Gertler (1999). ‘‘The
Science of Monetary Policy: A New Keynesian Perspective’’,
Journal of Economic Literature, Vol. 37(4), pp. 1661-1707.
Meyer, Laurence (2001). ‘‘Does Money Matter?’’ Federal
Reserve Bank of St. Louis Review, September/October,
pp. 1-15.
Orphanides, Athanasios (2002). Monetary Policy Rules and the
Great Inflation, Federal Reserve Board, Finance and
Economics Discussion Series, 2002-8.
Rudebusch, Glenn (2002). ‘‘Term Structure Evidence on Interest
Rate Smoothing and Monetary Policy Inertia’’, Journal of
Monetary Economics, Vol 49(6), pp. 1161-1187.
Rudebusch, Glenn and Lars Svensson (2002). ‘‘Eurosystem
Monetary Targeting: Lessons from US Data’’, European
Economic Review, Vol 46, pp. 417-442.
Sims, Christopher (2002). The Role of Models and Probabilities
in the Monetary Policy Process, working paper, Princeton
University.
Taylor, John (1993). ‘‘Discretion versus Policy Rules in
Practice’’, Carnegie-Rochester Conference Series on Public
Policy, December, Vol. 39, pp. 195-214.
Woodford, Michael (1999). Optimal Monetary Policy Inertia,
National Bureau of Economic Research Working Paper
No. 7261.
Woodford, Michael (2001). ‘‘The Taylor Rule and Optimal
Monetary Policy’’, American Economic Review, Vol. 91(2),
pp. 232-237.
8 For example, see Rudebusch and Svensson’s (2002) study for the US and Altimari’s
(2001) study for the euro area. Such research may further encourage convergence of
opinion on the appropriate role for money in monetary policy.
115