The ECB’s Monetary Policy Strategy and the Euro Area Enlargement

1. The ECB’s Monetary Policy Strategy and the Euro Area Enlargement Massimo Rostagno European Central Bank The views expressed in this presentation are those of the speaker and do not necessarily represent those of the European Central Bank or the Eurosystem Skopje 30 May 2008

2. 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

3. Comparison: The Fed • Dual Mandate • “To furnish an elastic currency [and] to afford means of re-discounting commercial paper” [Federal Reserve Act, 1913] • * * * • “Maintain the growth of monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates” [Full Employment and Balanced Growth Act, 1978] • Primary Objective • “The primary objective of the ESCB shall beto 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]

4. Why Price Stability in the Medium Term? • Price stability boosts Potential in the long term • Reduces uncertainty regarding the level of future prices and encourages the formation of productive capital • Minimizes noise by which high inflation erodes price signals • Reduces the distortion of the fiscal system (fiscal drag) • Minimizes the inflation tax on small savings  Evidence (Benati, 2007): 1% permanent increase in inflation now would cut GDP level 10 years from now by 1.3%-2.3%

5. The Quantitative Definition of Price Stability • Year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2% over the medium term • Clarification of the Strategy (8 May 2003) • The Governing Council will aim to maintain inflation rates close to 2% over the medium term

6. Comparison: The Fed 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

7. The Quantitative Definition of Price Stability • Was price stability conducive to macroeconomic stability? • Low inflation volatility … • … did not de-stabilize real activity Source: ECB calculations. See J.C. Trichet (2007): “The euro and is Monetary Policy” (speech delivered at the Conference “The ECB and its Watchers”, Frankfurt, 7 September) UPDATED 20.5.2008

8. The Quantitative Definition of Price Stability • Why “inflation below but close to 2%”? • ... Below 2% • The costs of inflation are minimised at below 2% • ... Close to 2% • Measurement Bias in HICP • Zero inflation restricts Central Bank room for manoeuvre in case of negative demand shocks (Zero Lower Bound problem) • Inflation Differentials across countries: if average inflation is too low it brings zero or negative inflation to richer countries

9. Inflation (and Growth) Differentials across Countries The Quantitative Definition of Price Stability • … 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

10. Inflation (and Growth) Differentials across Countries The Quantitative Definition of Price Stability • … 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

11. Inflation Differentials across Euro Area Countries The Quantitative Definition of Price Stability

12. 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.”

13. 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.”

14. 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.”

15. 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.”

16. Euro Adoption: The Euro Area Perspective • Benefits • One Currency, One Europe • Improvements in production efficiency • Completion of Internal Market for Goods, Services, Labor, Capital

17. 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

18. Euro Adoption: Individual Country Perspective • Benefits • Faster Real Convergence: Trade Expansion, Lower Interest Rates and Transaction Costs • Credible Policy Environment : Protection Against External Crises ECB

19. Euro Adoption: Individual Country Perspective • 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 ECB

20. Euro Adoption: Convergence Criteria • Maastricht Criteria • Price Stability • Fiscal Position: General Government Deficit and Debt • Exchange Rate • Long-Term Interest Rate • Other Factors: Market Integration and Current Account Positions • Legal Convergence • Compatibility of National Legislation is Also Examined ECB

21. Euro Adoption: ECB’s Convergence Assessment • Every Second Year (May 2008), ECB-EC Report on State of Convergence • Strict Interpretation and Application • No Hierarchy • To Be Met on Actual Data • Consistent, Transparent, Simple Application • To Be Achieved on a Lasting Basis

22. Euro Adoption: Two Polar Options • Inflation Targeting Regimes • Achieve Real Appreciation through Low Domestic Inflation And Nominal Appreciation • Czech Republic, Hungary, Poland, Romania, Slovakia annual percentage change, sa Source: ECB.

23. Euro Adoption: Two Polar Options • Inflation Targeting Regimes • Achieve Real Appreciation through Low Domestic Inflation And Nominal Appreciation • Czech Republic, Hungary, Poland, Romania, Slovakia • Hard Pegs • Achieve Real Appreciation through Exchange Rate Stability And High Domestic Inflation • Bulgaria, Estonia, Latvia, Lithuania annual percentage change, sa Source: ECB.

24. Euro Adoption: Two Polar Options • Inflation Targeting Regimes • Achieve Real Appreciation through Low Domestic Inflation And Nominal Appreciation • Czech Republic, Hungary, Poland, Romania, Slovakia • Hard Pegs • Achieve Real Appreciation through Exchange Rate Stability And High Domestic Inflation • Bulgaria, Estonia, Latvia, Lithuania annual percentage change, sa  Is There a Better Way? Source: ECB.

25. Real GDP Growth Hard Pegs Performed Better But Starting GDP-per-Capita Was Lower

26. Unemployment Substantial Reduction and Less Dispersion in Hard-Pegs

27. Fiscal Performance Disciplinary Effect of Exchange Rate Regimes

28. Inflation Initially, Lower in Hard Pegs  … But on a Rise

29. Real Interest Rates Hard Pegs Experience Easing of Monetary Conditions

30. Credit Conditions Accelerating Growth in Hard Pegs

31. External Imbalances Widening Deficits for Hard Pegs

32. General Patterns • Situation Differs from Country to Country

33. General Patterns • Situation Differs from Country to Country • But There Is a Pattern

34. General Patterns • Situation Differs from Country to Country • But There Is a Pattern • Hard Pegs Catch Up Rapidly And Enjoy Fiscal Sustainability • Monetary policy has more room to maneuver in floating regimes: nominal appreciation and lower inflation • Both strategies can lead to euro adoption: Slovenia (2007) and Slovakia (2009) • Free capital mobility within the EU constraints domestic policy options to address evolving instabilities

35. General Patterns • Situation Differs from Country to Country • But There Is a Pattern • Hard Pegs Catch Up Rapidly And Enjoy Fiscal Sustainability • Monetary policy has more room to maneuver in floating regimes: nominal appreciation and lower inflation • Both strategies can lead to euro adoption: Slovenia (2007) and Slovakia (2009) • Free capital mobility within the EU constraints domestic policy options to address evolving instabilities • Reinforcing Policies Seem Necessary • Fiscal • Structural • Supervision

36. 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

37. 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

38. Thank You

39. Inflation Differentials

40. Productivity Growth Differentials Labour productivity (GDP per person employed), average annual rates in percent.

41. Balassa-Samuelson for New Member States

42. External Imbalances: Hard Pegs High Investment and Low Savings

43. Exposure to Exchange Rate Risk: Hard Pegs High Level of Exposure

44. The state of economic convergence

45. The state of economic convergence

46. The state of economic convergence

47. The state of economic convergence

48. The state of economic convergence

49. 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.