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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. 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(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. 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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