The ECBs Monetary Policy Strategy and the Euro Area Enlargement Massimo Rostagno European Central Bank The views expressed in this presentation are those.

The ECB’s Monetary Policy Strategy

and the Euro Area EnlargementMassimo RostagnoEuropean Central Bank

The views expressed in this presentation are those of the speaker and do not necessarily represent those of the

European Central Bank or the Eurosystem

Skopje 30 May 2008

Overview

• The ECB’s Mandate

• The Quantitative Definition of Price Stability

• The Safety Margin

• Euro Adoption: The Perspective of the ECB and New Members

• Paths to Euro Adoption: Two Polar Options

• Are There Patterns?

• Conclusions

• Dual Mandate“To furnish an elastic currency [and] to afford means of re-discounting commercial paper” [Federal Reserve Act, 1913]

* * *“Maintain the growth of monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates” [Full Employment and Balanced Growth Act, 1978]

• Primary Objective“The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the objectives of the Community” [The Treaty, Article 105]

* * *Community Objectives include: “sustainable non-inflationary growth”, “high level of employment”, “raising the standards of living” [The Treaty, Article 2]

Comparison: The Fed

Price stability boosts Potential in the long term Reduces uncertainty regarding the level of future

prices and encourages the formation of productive capital

Minimizes noise by which high inflation erodes price signals

Reduces the distortion of the fiscal system (fiscal drag)

Minimizes the inflation tax on small savings

Why Price Stability in the Medium Term?

Evidence (Benati, 2007): 1% permanent increase in inflation now would cut GDP level 10 years from now by 1.3%-2.3%

• Year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2% over the medium term

Clarification of the Strategy (8 May 2003)

• The Governing Council will aim to maintain inflation rates close to 2% over the medium term

The Quantitative Definition of Price Stability

Quantitative Definition of Price Stability

Why not – Asymmetry within Dual Mandate

– Price index measurement uncertainty

– “Minimal incremental benefits” given proven commitment to price stability

Why – Anchor for inflation

expectations

– Yardstick for accountability

– Makes long-run commitment to price stability binding in the short run

Comparison: The Fed

Euro area US Euro Area US

2002-2007* 2.06 2.21 0.15 0.40

1990-1998 2.80 3.49 0.44 0.471999-2007* 1.86 2.47 0.08 0.14

1995-2002 0.075 0.216

Sensitivity of long-term inflation forecasts to short-term inflation forecasts

Long-term inflation expectations 2) (percentage per annum)

Sources: Consensus Economics Forecast, Reuters and ECB internal calculations. *Data refers to up to J une 2007 1) Refer to 10-year rates. 2) Long-term inflation expectations are extracted from Consensus Economics Forecast. Data are collected on a semi-annual basis and refer to a horizon of 6-10 years. 3) Reported coefficient measures co-movement of survey-based 10-year and 1-year ahead inflation expectations. Source: Castelnuovo, E., Nicoletti-Altimari, S., and Rodriguez-Palenzuela, D. (2003).

Average Standard deviation

Break - even inflation rates 1) (percentage per annum)


Source: ECB calculations. See J.C. Trichet (2007): “The euro and is Monetary Policy” (speech delivered at the Conference “The ECB and its Watchers”, Frankfurt, 7 September) UPDATED 20.5.2008

Was price stability conducive to macroeconomic stability? Low inflation volatility … … did not de-stabilize real activity

Why “inflation below but close to 2%”?

... Below 2% The costs of inflation are minimised at below 2%

... Close to 2% Measurement Bias in HICP Zero inflation restricts Central Bank room for manoeuvre

in case of negative demand shocks (Zero Lower Bound problem)

Inflation Differentials across countries: if average inflation is too low it brings zero or negative inflation to richer countries


Inflation (and Growth) Differentials across Countries


… can be temporary Local adjustment to asymmetric shocks

Differences in Fiscal Policies and Structural Policies

…. but can be more persistent: catching-up processes Less productive countries catch up to higher

productivity levels …

… wages increase in the tradable (catching up) sector …

… wages increase in the non-tradable sector as well …

… where, however, productivity does not increase so much.

This causes systematically higher inflation in catching up countries

Inflation (and Growth) Differentials across Countries


… can be temporary Local adjustment to asymmetric shocks

Differences in Fiscal Policies and Structural Policies

…. but can be more persistent: catching-up processes Less productive countries catch up to higher

productivity levels …

… wages increase in the tradable (catching up) sector …

… wages increase in the non-tradable sector as well …

… where, however, productivity does not increase so much.

This causes systematically higher inflation in catching up countries

Inflation in productive countries steadily lower than average

Table: “Steady-state” inflation rates implied by Balassa-Samuelson effects according to

selected studies.

Sample Alberolaand

Tyrväinen

1975-95

HICPproxy

IMF

IMF(1999a)

1960-96

Canconeriet al.

73-97

De Grauwe &Skudelny

1971-95

Sinn &Reutter

87-95

Averageof all

columns

Actualaverage

HICP1995-2002**

Belgium 3.1 2.0 3.8 2.6 2.1 1.8 2.6 1.7

Germany 1.3 1.9 1.5 1.0 1.7 1.0 1.4 1.3

Greece - 2.7 2.8 - - 5.3 3.6 3.8*

Spain 3.1 2.3 - 2.4 2.0 2.5 2.5 3.0

France 1.7 1.9 2.8 2.4 1.6 2.3 2.1 1.5

Ireland - 3.4 3.0 - - 3.4 3.3 3.1

Italy 2.4 1.9 2.7 2.8 2.4 2.5 2.5 2.8

Netherlands 2.3 2.3 1.6 - 2.0 2.4 2.1 2.5

Austria 1.8 2.5 - 1.8 2.5 2.4 2.2 1.5

Portugal - 2.7 4.3 - 2.1 1.8 2.7 3.0

Finland 2.4 2.3 2.9 2.4 1.4 3.7 2.5 1.6

Euro area 2.0 2.0 2.0 2.0 2.0 2.0 2.0 1.9

Max-min 1.8 1.5 2.8 1.8 1.1 4.3 2.2 2.5

Standard dev. 0.6 0.4 0.9 0.6 0.3 1.1 0.6 0.8* = Greece since 1997.

** = average of monthly inflation rates.

Inflation Differentials across Euro Area Countries


The Safety Margin“The Governing Council agreed that in the pursuit of price stability it will aim to maintain inflation rates close to 2% over the medium term. This clarification underlines the ECB's commitment to provide a sufficient safety margin to guard against the risks of deflation. It also addresses the issue of the possible presence of a measurement bias in the HICP and

the implications of inflation differentials within the euro area.”


the implications of inflation differentials within the euro area.”HICP inflation in selected euro area countries(y-o-y; non-seasonally adjusted)

0

1

2

3

4

5

6

Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07

DE

FR

IT

ES

PT

NL

GR

U2





Euro Adoption: The Euro Area Perspective

Benefits One Currency, One Europe

Improvements in production efficiency

Completion of Internal Market for Goods, Services, Labor, Capital

Euro Adoption: The Euro Area Perspective

Benefits One Currency, One Europe

Improvements in production efficiency

Completion of Internal Market for Goods, Services, Labor, Capital

Challenges Lack of Convergence Could Mean Lasting Divergences

in EMU

Persistent Divergences Mean Persistent Negative Spill-Overs

Euro Adoption: Individual Country Perspective

ECB

Benefits Faster Real Convergence: Trade Expansion, Lower

Interest Rates and Transaction Costs

Credible Policy Environment : Protection Against External Crises

Euro Adoption: Individual Country Perspective

ECB

Benefits Faster Real Convergence: Trade Expansion, Lower

Interest Rates and Transaction Costs

Credible Policy Environment : Protection Against External Crises

Challenges Suboptimal Policies if Business Cycles are Misaligned

Risk of Asymmetric Shocks

Loss of Monetary Autonomy and the Exchange Rate as Policy Tools: New Adjustment Channels

Euro Adoption: Convergence Criteria

ECB

Maastricht Criteria Price Stability

Fiscal Position: General Government Deficit and Debt

Exchange Rate

Long-Term Interest Rate

Other Factors: Market Integration and Current Account Positions

Legal Convergence Compatibility of National Legislation is Also Examined

Every Second Year (May 2008), ECB-EC Report on State of Convergence

Strict Interpretation and Application

No Hierarchy

To Be Met on Actual Data

Consistent, Transparent, Simple Application

To Be Achieved on a Lasting Basis

Euro Adoption: ECB’s Convergence Assessment

Euro Adoption: Two Polar Options

Source: ECB.

annual percentage change, sa

Inflation Targeting Regimes Achieve Real Appreciation through Low Domestic

Inflation And Nominal Appreciation

Czech Republic, Hungary, Poland, Romania, Slovakia


Source: ECB.





Hard Pegs Achieve Real Appreciation through Exchange Rate

Stability And High Domestic Inflation

Bulgaria, Estonia, Latvia, Lithuania


Source: ECB.





Hard Pegs Achieve Real Appreciation through Exchange Rate

Stability And High Domestic Inflation

Bulgaria, Estonia, Latvia, Lithuania

Is There a Better Way?

Hard Pegs Performed Better But Starting GDP-per-Capita Was Lower

Real GDP Growth

HARD PEGS FLOATERS

Lines: unweighted average. Shaded areas: maximum-minimum.

Real GDP growth (in %)

-10

-5

0

5

10

15

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

-10

-5

0

5

10

15

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

GDP per capita(PPP, % of euro area)

Hard pegs Floaters

1997 30.8 44.0

2006 49.3 54.3

Substantial Reduction and Less Dispersion in Hard-Pegs

Unemployment

HARD PEGS FLOATERS

Bulgaria included from 2000 onwards. Latvia, Lithuania, Czech Republic and Slovakia excluded in 1997.

Unemployment (% of labour force)

0

2

4

6

8

10

12

14

16

18

20

1997 1998 1999 2000 2001 2002 2003 2004 2005 20060

2

4

6

8

10

12

14

16

18

20

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Disciplinary Effect of Exchange Rate Regimes

Fiscal Performance

HARD PEGS FLOATERS

Romania excluded in 1997.

General government balance (% of GDP)

-12

-10

-8

-6

-4

-2

0

2

4

6

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

-12

-10

-8

-6

-4

-2

0

2

4

6

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Initially, Lower in Hard Pegs … But on a Rise

Inflation

HARD PEGS FLOATERS

Bulgaria excluded in 1997.

Annual HICP inflation (in %)

0

5

10

15

20

25

1997 1998 1999 2000 2001 2002 2003 2004 2005 20060

5

10

15

20

25

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Hard Pegs Experience Easing of Monetary Conditions

Real Interest Rates

HARD PEGS FLOATERS

Bulgaria, Latvia, Lithuania and Romania excluded in 1997

1) Defined as nominal 3-month interest rates minus actual HICP inflation.

Real short-term interest rates (in %)1)

-10

-5

0

5

10

15

20

25

30

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

-10

-5

0

5

10

15

20

25

30

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Accelerating Growth in Hard Pegs

Credit Conditions

HARD PEGS FLOATERS

Czech Republic, Romania and Slovakia included from 2003, 2005 and 2000 onwards, respectively. Hungary and Latvia excluded in 1997.

Annual credit growth (to the private sector, in %)

0

10

20

30

40

50

60

70

1997 1998 1999 2000 2001 2002 2003 2004 2005 20060

10

20

30

40

50

60

70

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Stocks of credit(% of GDP)

Hard pegs Floaters

2005 54.8 33.8

Widening Deficits for Hard Pegs

External Imbalances

HARD PEGS FLOATERS

Current account balance (in % of GDP)

-25

-20

-15

-10

-5

0

5

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

-25

-20

-15

-10

-5

0

5

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

General Patterns

• Situation Differs from Country to Country

General Patterns


• But There Is a Pattern

General Patterns


• But There Is a Pattern Hard Pegs Catch Up Rapidly And Enjoy Fiscal

Sustainability

Monetary policy has more room to maneuver in floating regimes: nominal appreciation and lower inflation

Both strategies can lead to euro adoption: Slovenia (2007) and Slovakia (2009)

Free capital mobility within the EU constraints domestic policy options to address evolving instabilities

General Patterns


• But There Is a Pattern Hard Pegs Catch Up Rapidly And Enjoy Fiscal

Sustainability

Monetary policy has more room to maneuver in floating regimes: nominal appreciation and lower inflation

Both strategies can lead to euro adoption: Slovenia (2007) and Slovakia (2009)

Free capital mobility within the EU constraints domestic policy options to address evolving instabilities

• Reinforcing Policies Seem Necessary Fiscal

Structural

Supervision

Conclusions

• Price Stability is The Primary Objective of Monetary Union

• Current Definition Builds In Sufficient Margin To Account for Lasting Differentials

• But There Are Sizeable Risks If Convergence Is Insufficient

Conclusions

• Price Stability is The Primary Objective of Monetary Union

• Current Definition Builds In Sufficient Margin To Account for Lasting Differentials

• But There Are Sizeable Risks If Convergence Is Insufficient

• Convergence Has to Be Achieved Against High Capital Mobility

• This Is a Blessing But Can Become a Challenge If It Means Loss of Domestic Macroeconomic Control

• Reinforcing Policies Are Essential To Ensure Domestic Stability

Thank You

Inflation Differentials

Dispersion of annual inflation across euro area countries, the 14 US MetropolitanStatistical Areas (MSAs) and the 4 US census regions(unweighted standard deviation in percentage points)

Sources: Eurostat and US Bureau of Labor Statistics.

Euro area data up to Mar 2008. US 4 regions up to Feb 2008 and US 14 MSAs up to Dec 2007.

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

19901991

19921993

19941995

19961997

19981999

20002001

20022003

20042005

20062007

2008

Stage Iof EMU

Stage IIof EMU

Stage IIIof EMU

Euro area (12 countries)

United States(14 MSAs)

United States (4 census regions)

Euro area(13 countries, incl. Slovenia)

Euro area (15 countries, incl. Cyprus and Malta)

Productivity Growth Differentials

Labour productivity (GDP per person employed), average annual rates in percent.

Balassa-Samuelson for New Member States

High Investment and Low Savings

Current account balance(in % of GDP)

2005 2006 2007 Q1Bulgaria -11.9 -15.8 -17.3Estonia -10.2 -14.7 -15.7Latvia -13.1 -21.1 -23.5Lithuania -7.7 -10.8 -11.5

Investment, saving and current account, 2006(in percentages of GDP)

31.938.2 38.0

27.026.7

-15.6 -14.8-20.9

-11.5

-0.2

21.617.016.2 16.2

21.3

-30

-20

-10

0

10

20

30

40

Bulgaria Estonia Latvia Lithuania euro area

Investment Saving Current account

External Imbalances: Hard Pegs

High Level of Exposure

Exposure to Exchange Rate Risk: Hard Pegs

Selected New EU Member States: Foreign currency loans, 2004-06

2004 2005 2006

Foreign currency loans to private sector (share in total loans, percent)

Floaters

Czech Republic 11.2 10.0 10.4

Hungary 39.0 45.9 49.5

Poland 25.3 25.9 27.0

Slovakia 21.5 22.5 20.0

Romania 58.2 58.9 48.2Average (unweighted) 31.0 32.6 31.0

Hard pegs

Bulgaria 46.1 48.4 45.7

Estonia 80.0 79.3 77.6

Latvia 60.6 69.8 76.8

Lithuania 57.2 65.0 52.2Average (unweighted) 61.0 65.6 63.1

The state of economic convergence

HICP inflation(average annual percentage change)

1.5

4.3

1.22.2

2.73.5

4.3

6.77.4 7.5

8.39.4

12.3

5.54.4

2.23.2

2.0

0

2

4

6

8

10

12

14

Sweden Slovakia Poland Czech Rep. Romania Lithuania Hungary Estonia Bulgaria Latvia

0

2

4

6

8

10

12

14December 2006 CR May 2008 CR Reference value May 2008 (3.2%)

Source: Eurostat. For Lithuania the first observation is from the May 2006 Convergence Report. The reference value was 2.6% in May 2006 and 2.8% in December 2006.


General government surplus (+) or deficit (-)(percentage of GDP)

3.02.3

-0.5

-3.6-2.5

-3.1

-7.8

3.5 3.4

-1.6 -2.0 -2.2 -2.5

-5.5

0.1

2.8

0.0

-1.2

-10

-8

-6

-4

-2

0

2

4

Sweden Bulgaria Estonia Latvia Lithuania Czech Rep. Poland Slovakia Romania Hungary

-10

-8

-6

-4

-2

0

2

4

December 2006 CR May 2008 CR Reference value (-3%)

Source: Eurostat. The reference year in the 2006 Convergence Reports was 2005; in the May 2008 CR it was 2007. For Lithuania the first observation is from the May 2006 Convergence Report.


General government gross debt(percentage of GDP)

4.5

12.1

34.5

50.4

42.0

61.7

3.4

9.713.0

17.3 18.2

28.7 29.4

45.2

66.0

18.7

30.4

40.6

0

10

20

30

40

50

60

70

80

Estonia Latvia Romania Lithuania Bulgaria Czech Rep. Slovakia Sweden Poland Hungary

0

10

20

30

40

50

60

70

80December 2006 CR May 2008 CR Reference value (60%)

Source: Eurostat. The reference year in the 2006 Convergence Reports was 2005; in the May 2008 CR it was 2007. For Lithuania the first observation is from the May 2006 Convergence Report.


Participation in ERM II with effect from

Bulgaria -

Czech Republic -

Estonia 28 June 2004

Latvia 2 May 2005

Lithuania 28 June 2004

Hungary -

Poland -

Romania -

Slovakia 25 November 2005, revaluation on 19 March 2007

Sweden -


Long-term interest rates(in percentages, annual average)

3.7 3.84.3

3.7 3.9

5.2

7.1

4.24.5 4.5 4.6 4.7

5.4

7.1

5.7

6.9

0

1

2

3

4

5

6

7

8

Sweden Czech Rep. Slovakia Lithuania Bulgaria Latvia Poland Hungary Romania0

1

2

3

4

5

6

7

8December 2006 CR May 2008 CR Reference value May 2008 (6.5%)

Sources: Eurostat and ECB. Estonia does not have a harmonised long-term interest rate. For Lithuania the first observation is from the May 2006 Convergence Report. The reference value was 5.9% in May 2006 and 6.2% in December 2006.

Cross-country overview - key challenges

Further fiscal policy efforts are needed, in particular the implementation of credible fiscal consolidation paths.

Wage increases should not exceed labour productivity growth and should take into account labour market conditions and developments in competitor countries.

Continued efforts to reform product and labour markets are needed to increase flexibility and maintain favourable conditions for economic expansion and employment growth.

The conduct of a stability-oriented monetary policy is crucial to the achievement of lasting convergence towards price stability.

The ECBs Monetary Policy Strategy and the Euro Area Enlargement Massimo Rostagno European Central Bank The views expressed in this presentation are those.

Documents

countries inflation

objective of price stability

price stability binding

pursuit of price stability

price stability conducive

higher inflation

negative inflation

high inflation