Nicholas C. Garganas

Governor of the Bank of Greece

Does One Size Fit All? Monetary Policy and Integration in the Euro Area

2

Introduction

The euro created new challenges for monetary policy:

• How to build credibility: the ECB’s Monetary Policy Strategy would be crucial.

2. Does One Size fit all?

Traditional OCA view overlooks endogeneity of criteria used to judge optimality.

Argument here: creation of a monetary union can itself create the conditions favourable to its operation

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The ECB’s Monetary Policy Strategy

• Adopted in 1998 and confirmed with clarifications in 2003.

• Drew on decades of central bank policy experience and the strategies of the most successful central banks in the euro area.

• Three key elements:

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Price Stability Objective

• Monetary policy contributes to economic welfare by focusing on price stability.

• defined as a year-on-year increase in consumer prices for the euro area of “below, but close to, 2 percent”.

• to be maintained in the medium term, in light of the long lags involved in the transmission of monetary policy.

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The two analytical pillars

• Economic analysis: assessment of economic and financial developments from the perspective of the interplay between supply and demand in the product and factor markets; provides short-to-medium-term indications of inflation.

• Monetary analysis: a cross-check to the economic analysis focuses on monetary developments in recognition of the link between monetary growth and inflation in the medium to long run.

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Independence counterbalanced by Accountability, Transparency

• The Maastricht Treaty granted full political independence to

the ECB in its pursuit of price stability.

• Central bank independence needs to be counterbalanced by

accountability.

• Accountability requires transparency with respect to both

objectives and decision-making.

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ECB’s record over the last 9 years

• Low levels of inflation– Average inflation of 2.03 percent in the euro area

since its inception

• Low inflation expectations

• Low interest rates

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Figure 1: Annual inflation (HICP) and Main Refinancing Operations (MRO) rate(January 1998 - August 2007) (in percent)

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HICP excluding unprocessed food and energy

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Source: ECB

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• Inflation expectations remarkable close to ECB’s definition of price stability.

• Long-term interest rates at historically low levels.

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Figure 2: Indicators of long-term inflation expectations in the euro area(January 1999 - September 2007) (monthly averages)

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SPF (4)

Consensus Economics (5)

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Notes to Figure 2(1) The ten-year break-even inflation rate reflects the average value of inflation

expectations over the maturity of the index-linked bond. It is calculated as the difference between the nominal yield on a standard bond and the real yield on an inflation index-linked bond, issued by the same issuer and with similar maturity.

(2) Issued by the French Government linked to the French CPI excluding tobacco.

(3) Issued by the French Government linked to the euro area HICP excluding tobacco.

(4) Survey of Professional Forecasters conducted by the ECB on different variables at different horizons. Participants are experts affiliated with institutions based with the European Union. This measure of long-term inflation expectations refers to an annual rate of HICP expected to prevail five years ahead.

(5) Survey of prominent financial and economic forecasters as published by Consensus Economics Inc. This measure of long-term inflation expectations refers to an annual rate of inflation expected to prevail between six and ten years ahead.

Sources: ECB and Consensus Economics Inc.

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Does One-Size Monetary Policy Fit All?

• While the success of monetary union in delivering low inflation and a credible monetary policy is beyond dispute, the issue of whether a single monetary policy can “fit” all members states of the euro area continues to be hotly debated.

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EMU: an Optimum-Currency-Area perspective

• EMU brought unique challenges to monetary policy.

• Critical observers took the view that EMU was doomed to failure – euro area is not an OCA:– Lack of labour mobility– Absence of centralised fiscal transfer mechanism.

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• Shocks lead to widening inflation differentials;

• Single nominal interest rate + widening inflation differentials = diverging real interest rates;

• High inflation countries have low real interest rates which further fuels inflation;

• Low inflation countries have high real interest rates which puts downward pressure on inflation;

Conclusion: one-size does not fit all.

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OCAs – the new view

• Participation in monetary union may itself induce changes in economic structure and performance.

• This is what academic research shows.

• This is what the experience of the euro area shows – two channels have helped.

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Channel 1: Enhanced Credibility

• Credibility gain derived from eliminating the inflationary bias of discretionary monetary policy:– No devaluation risks hence interest rates are lower;– Low and stable inflation and inflationary

expectations lengthen economic horizons.

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Channel 2: trade and financial integration

• Trade creation effects of a common currency:– Single currency removes costs of conversion;– Future competitive devaluations are precluded;– Foreign direct investment is facilitated.

• Promotion of reciprocal trade, economic and financial integration and the accumulation of knowledge.

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Channel 2: trade and financial integration cont.

• Euro area experience:– Intra-euro-area trade in goods has grown;– Intra-euro-area trade in services has grown;– Intra-euro-area foreign direct investment has more

than doubled.

• Increased trade integration leads to more highly-correlated business cycles.

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Figure 3: Euro Area Rolling Business Cycle Correlations and Logarithmic Trend Line (1997-2008)

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Log. (business cyclecorrelations)

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Notes to Figure 3:

• The rolling business cycle correlations are constructed by calculating the pairwise correlation coefficients between all euro area countries for the various 4-year periods (1997-2000, 1998-2001, etc). The average of these coefficients is calculated for each time period.

• Data source: EU AMECO database

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Channel 2: trade and financial integration cont.

Additional reasons why monetary union reduces incidence of country-specific shocks:

• Principle cause of asymmetric shocks – divergent monetary policies – no longer exists;

• Deeper financial market integration.

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Channel 2: trade and financial integration cont.

Introduction of euro helped make financial markets more integrated:

• Money market – almost perfectly integrated since start of EMU;

• Corporate bond market – significant growth;

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Figure 4: International Corporate Bonds by Country of Nationality: Amounts outstanding (millions USD)

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Narrowing of spreads on government bonds…Figure 5: Spreads between 10-year benchmark european sovereign

bond yields and the German benchmark (per cent)

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Higher correlation of equity market returns…

Figure 6: Correlations between German and other European returns -on composite stock indices - Rolling 24-month window

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Forces for further financial integration

• Market participants will increasingly exploit the new environment.

• A number of initiatives supported by Eurosystem/Commission: eg TARGET2.

• Monetary transmission mechanisms will continue to converge.

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• To the extent that countries continue to experience asymmetric shocks or asymmetric responses to common shocks, financial integration can help members of a union insure against the effect of such shocks.

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Inflation and Growth Differentials

• Despite increased trade and financial integration, divergences in economic performance continue to exist.

• How significant are these divergences?

• How concerned should we be?

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Inflation dispersion in the euro area

• Between 1990 and 1999, inflation dispersion fell from 6 percentage points in early 1990s to 1 percentage point in the second half of 1999.

• Subsequently it has remained at around 1 percentage point.

• It does not differ that much from dispersion across the US.

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Figure 7: Dispersion of annual inflation rateswithin Euro Area (13 countries), US (14 Metropolitan Statistical Areas) and US (4 regions)

(unweighted standard deviation in percentages)

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Inflation dispersion in the euro area cont.

• Where the euro area does differ from the US is that the observed differentials seem to be more persistent.– Balassa-Samuelson effect?– Adjustment mechanisms in the euro area not

functioning as smoothly as they might.– Non-monetary policies are not consistent with

inflation rates close to euro area average.

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Inflation dispersion in the euro area cont.

• Other factors contributing to inflation differentials include:– Misaligned fiscal policies;– Wage dynamics not linked to productivity

developments;– Structural inefficiencies such as rigidities in

product and factor markets.

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Figure 8: Cumulative Deviation of Inflation and ULCs Relative to Euro Area Average(1999-2006, in percentage points)

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inflation ULCs

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Dispersion of real GDP growth

• The process of nominal convergence was not accompanied by a greater dispersion of real GDP growth rates.

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Figure 9: Dispersion of real GDP growth rateswithin Euro area (13 countries), US (50 states and D. Columbia) and US (8 regions)

(unweighted standard deviation in percentages)

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Figure 10: Scatter Plot of Inflation and Growth in Euro Area Countires (1999-2006)

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Inflation and growth rates seem to move together…..

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Dispersion of real GDP growth cont.

Countries with higher than average growth rates have higher than average inflation.

This suggests that the dampening effect of the loss of competitiveness has been offset by:

- interest rate falls in run-up to EMU;

- inflows of EU structural funds;

- immigration;

- financial liberalisation.

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Conclusions

• The single-size monetary policy has worked extremely well in the euro area.

• This is the result of endogenous changes brought about by the very existence of the monetary union:– Increased trade and financial integration;– Credibility of ECB which has delivered low

interest rates and inflation.

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Conclusions cont.

• This is not sufficient alone to increase economic growth and raise living standards.

• Need to increase flexibility of product and labour markets.– 2001-2005: euro area growth weak; dispersion of

inflation and growth rates persistent.

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Conclusions cont.

• A number of countries undertook structural reforms.

• Fruits of reforms began to emerge in second half of 2004:– Unemployment began to fall.

• Structural impediments, however, still exist:– Reflected in high unemployment and low

participation rates.

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Conclusions cont.

• Fiscal developments have been favourable in recent years.

• However, only a small part has been due to policy measures.

• Need to sustain the momentum and accelerate the pace of fiscal consolidation in the euro area.

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Conclusions cont.

• The euro area has come a long way – the success of the single currency has demonstrated that one size can fit all.

• Much more needs to be done to ensure that the euro area becomes a more dynamic force for growth.– Need for more flexibility in factor and product

markets– Need for greater competition.