Lucas Papademos: The economic outlook and the ECB's monetary policy -
some key issues
Speech by Mr Lucas Papademos, Vice-President of the European Central Bank, at the Nomura
annual Euro Conference "A challenging future for Europe", Tokyo, 11 November 2004.
* * *
Introduction
The annual Euro Conference in Tokyo, which is now well established, provides a useful forum for
examining various policy issues relating to the European economy, also from a global perspective. It is
a great pleasure to have the opportunity to address you today and I thank you for the invitation. In my
presentation, I would like to focus on two topics:
• First, the state of, and outlook for, the euro area economy and the current stance of the
ECB's monetary policy. Addressing this topic requires me to assess, in particular, the
implications of increased oil prices for the euro area economy and the single monetary
policy.
•
Second, I thought it might be of particular interest to you to also address the challenges
posed for monetary policy by large swings in asset prices, especially housing prices. Given
the Japanese experience in the 1990s, it is particularly appropriate to re-examine here in
Tokyo the impact that large asset price swings can have on macroeconomic stability and the
difficult choices for policy-makers confronting strong asset price dynamics. As you all know,
these issues are not only of interest for Japan; they are of increasing relevance worldwide.
The economic outlook and monetary policy in the euro area
I will start by discussing the current state of the euro area economy and the medium-term economic
outlook. The performance of the euro area economy this year is characterised by the ongoing recovery
of economic activity at a pace somewhat faster than previously envisaged. Inflation, however, has
remained above (though relatively close to) 2%. This outcome is not in line with our notion of price
stability and is higher than the average inflation expected a year ago for 2004. The sharp rise in oil
prices since the beginning of this year, by about 60% (in US dollar terms), has been the main reason
for the higher than earlier expected inflation.
Let me elaborate a bit on the pace of the economic recovery, the factors that have contributed so far to
the pick-up in growth, and the conditions and basic factors that are expected to influence the
mediumterm economic prospects.
Since the start of the economic recovery in the second half of 2003, we have seen robust growth rates
in the first half of 2004, with real GDP increasing by 0.7% and 0.5% in the first and second quarters,
respectively. The recovery in growth has so far been driven partly by buoyant external demand and
partly by domestic demand. Private consumption increased moderately but investment was subdued.
Although short-term indicators have become more mixed over the past couple of months, the
underlying determinants of economic activity remain favourable, and growth is expected to continue in
2005. On the external side, euro area exports should continue to benefit from positive global demand
conditions in 2005. I admit, we have seen some moderation in global growth rates following a period in
which the world economy has experienced its strongest dynamism in many years. We view this
moderation, however, as an orderly return to sustainable, and still robust, rates of growth. On the
domestic side, investment has thus far been subdued, partly due to weak construction investment.
Looking ahead, investment should be supported by the global environment and the continuing very
favourable financing conditions in the euro area. In addition, improved earnings and greater corporate
efficiency gained through business restructuring should support investment. As regards consumption,
we see scope for it to strengthen further, particularly once employment prospects have improved more
visibly.
As with any assessment of the future, this outlook is surrounded by some uncertainty. In particular,
there are risks to growth prospects stemming from unfavourable developments in oil markets. In this
respect, let me emphasise a number of characteristics of the recent rise in oil prices. First, it is evident
that recent oil price developments differ somewhat from previous oil price shocks, as they have been
partly driven by buoyant global demand, and not only by constraints on the supply side. Second, oil
prices, in real terms, have remained at a much lower level than in previous episodes. Third, the
oil-intensity of production is lower in the euro area than it was in the past. And finally, in percentage
terms, the oil price increase has not been as high as in previous oil price shocks. Despite this,
however, oil price increases constitute a significant adverse shock to the euro area economy - through
their direct impact on energy prices, their implications for global economic growth, and their adverse
effect on the euro area's terms of trade. If oil prices were to remain at close to USD 50 per barrel, or
even increase further, they would dampen the strength of the recovery.
With regard to inflation, oil price developments have had a powerful direct impact on the year-on-year
change in the Harmonised Index of Consumer Prices (HICP), particularly in recent weeks. In October,
annual inflation increased to 2.5%, according to a provisional estimate, from 2.1% in September. The
oil price shock may feed through the economy and generate further indirect effects in the coming
months. This is indicated by developments in producer prices, which showed a year-on-year increase
of around 5% in September.
On the whole, however, the information available so far does not suggest that stronger underlying
inflationary pressures are building up in the euro area. Wages have grown at rates of around 2- 21⁄2%
over recent quarters. This trend should persist for some time in view of the high level of unemployment
in the euro area. Moreover, unit labour cost growth has been low (2.0 % in 2003, coming down to
around 0.7% in the first half of 2004) and it can be expected that it will be contained in the coming
quarters by moderate wage developments and labour productivity gains.
Notwithstanding these encouraging developments, there are still several upside risks to the outlook for
price stability. These risks are mainly associated with oil price developments, possible new increases
in indirect taxes and administered prices, and potential second-round effects stemming from wage and
price-setting behaviour. The rise in measures of long-term inflation expectations in the euro area in the
course of this year is also a cause of some concern.
In addition, our monetary analysis points to upside risks to price stability. Since mid-summer, the
dynamics of M3 have strengthened again, mainly reflecting continued strong demand for transaction
balances, which are included in the narrow aggregate M1, the most liquid component of M3. The
acceleration of money growth is driven by the stimulative effect of the historically low level of interest
rates in the euro area.
The low level of interest rates is also fuelling private sector demand for credit. In particular, the growth
rate of loans for house purchase continues to rise in the euro area and is now approaching double
digits. This goes hand in hand with relatively fast rises in real estate prices in many euro area
countries. In recent months, the annual rate of growth of loans to non-financial corporations has also
picked up.
Over the past few years, M3 growth has been very strong in the euro area, partly as a consequence of
flight-to-safety portfolio shifts out of stock markets in the period of heightened stock market volatility
between 2001 and 2003. As a consequence, there is now substantially more liquidity in the euro area
than is needed to finance non-inflationary growth. This excess liquidity could pose inflationary risks in
the future. Moreover, the persistently high excess liquidity and strong credit growth could become a
source of unsustainable asset price increases, particularly in property markets. I will elaborate on this
point later on in my presentation.
In summary, our assessment of the outlook for price stability, on the basis of the economic analysis
and cross-checking with the monetary analysis, leads to the following conclusions: underlying
inflationary pressures are still contained; there are still, however, a number of medium-term upside
risks to price stability that must be monitored carefully; and for this reason, strong vigilance is required
with regard to the materialisation of such risks. Against this background, the ECB's Governing Council
decided at its meeting on 4 November 2004 to leave the key ECB interest rates unchanged. On that
occasion, we again noted that the level of interest rates in the euro area remains very low by historical
standards. Indeed, at 2%, money market rates are the lowest since the end of the Second World War,
and at 4%, long-term government bond yields are also well below long-run averages. The low level of
interest rates, both in nominal and real terms, and the generally favourable financing conditions have
been lending support to the ongoing economic recovery in the euro area.
Fiscal imbalances in the euro area have not improved in 2004, while the current account balance
remained virtually unchanged. According to the European Commission, the average general
government deficit in the euro area increased to an estimated 2.9% of GDP in 2004 (from 2.7% of
GDP in 2003), while the current account is expected to record a surplus of close to 1% of GDP, slightly
higher than in 2003. Although the Commission is projecting a decline in the total euro area fiscal deficit
to 2.5% of GDP in the years 2005 and 2006, the slow pace of fiscal consolidation is a cause of
concern, especially in view of the expected growth in the coming year and given the underlying
imbalances associated with population ageing. Greater progress towards healthier public finances will
strengthen confidence and support, rather than hinder, the ongoing recovery.
Economic effects and policy implications of higher oil prices
In this presentation of our assessment of the economic outlook and of our decision on the monetary
policy stance, one aspect stands out which is of particular interest to investors, consumers and the
financial markets at large - the recent sizable rise in oil prices. This is an important issue, and one on
which clear and convincing communication from the central bank is warranted.
Oil prices, which reached historical highs in nominal US dollar terms in the last week of October, are a
key factor determining near-term prospects for economic activity and inflation, both globally and in the
euro area. As I noted earlier, persistently high and rising oil prices have had a visible direct impact on
consumer prices in the euro area, and inflation is likely to remain above the upper limit of our definition
of price stability of 2% in the coming months. This is a worrisome development, although there is little
indication that medium-term inflationary pressures are building up in the euro area.
What would be the potential impact of a sustained rise in oil prices on key macroeconomic variables in
quantitative terms? For purely illustrative purposes, and using a variety of macroeconomic models,
ECB economists have estimated the potential impact of a hypothetical permanent oil price increase of
50% on both inflation and output. According to these calculations, such an increase would add 0.3 to
0.6 percentage points to overall inflation in the euro area in the first year and 0.1 to 0.4 percentage
points in the second year, before petering out in the third year (0.0 to 0.1 percentage points). The
estimated impact on output would be, of course, negative, dampening real GDP growth by 0.1 to 0.8
percentage points in the first year; in subsequent years, the average cumulative impact suggested by
these models would be roughly neutral (-0.3 to 0.2 percentage points in the second year; -0.1 to 0.4
percentage points in the third year).
Needless to say, these estimates are surrounded by a high degree of uncertainty related to the model
specifications and other factors, for instance, the assumed initial cyclical position of the economy, the
nature of the oil price shock, and the possible existence of non-linearities in the transmission of the oil
price shock to the economy. More importantly, these (and other comparable) simulations are based on
the assumption that the monetary policy stance is given; that is, the central bank's interest rates are
assumed to be kept constant and not to be adjusted in response to the impact of the oil price shock on
inflation. Of course, this assumption is made for the purpose of isolating the "pure" impact of the oil
price shock. In reality, monetary policy has an important role to play in influencing the effects of oil
price shocks on the economy.
Oil price shocks present policy-makers with difficult choices as they simultaneously pose upside risks
to inflation and downside risks to growth. In responding to oil price shocks, it is essential to understand
that policy-makers cannot offset the real effects of oil price increases. An oil price increase triggers a
loss in the economy's terms-of-trade and implies a transfer of wealth from oil-importing countries to oil
exporters. This change in the terms-of-trade (in relative prices) requires an adjustment of the real
economy and must be absorbed by markets. The policy-makers' aim should be to facilitate this
adjustment by minimising inflationary pressures and aggregate output losses.
In reacting to oil price shocks, it is, therefore, important that policy-makers do not repeat the mistakes
of the past by attempting to stabilise output growth at unrealistic levels. In the 1970s, such attempts
led to a prolonged period of high and costly inflation, rising unemployment and sizeable fiscal deficits.
Monetary policy should aim to ensure that inflation expectations are not adversely affected by the
unavoidable "first-round" direct and indirect effects of an oil price shock on the price level and that they
remain anchored to price stability. By preventing oil price shocks from having "second-round" effects
on inflation expectations and on wage and price-setting behaviour, monetary policy can contain the
unfavourable consequences of these shocks on both inflation and growth. It can prevent the fuelling of
an inflationary spiral and the persistence of inflationary pressures, it can facilitate the real economy's
adjustment to the change in relative prices implied by the oil price shock, and it can thus help to
minimise the associated output losses. This is why we at the ECB stress the need to be extremely
vigilant against the materialisation of second-round effects that may result from a rise in oil prices. The
ECB's commitment to maintaining price stability in the euro area over the medium term implies that it
will react promptly if there are indications that second-round effects are likely to emerge.
Asset prices and monetary policy
As has become clear from the previous discussion, monetary policy-makers may face very difficult
choices in the event of large swings in important economic variables - like the price of oil and other
raw materials - that can have a significant impact on the state of the economy. The same is true for
large movements in asset prices, especially when markets - notably equity and housing markets - are
seen to be moving out of line with what could be considered fundamentals. Such asset price
misalignments, or "bubbles", and their eventual correction, can potentially have severe economic
costs.
Asset prices are important for monetary policy, not just because abrupt changes in asset prices may
have severe implications for macroeconomic stability, but also because asset prices play a key role in
the transmission of monetary policy. Through balance sheet effects and through their influence on the
cost of capital, wealth, and confidence, asset prices affect spending decisions by households and
companies. In addition, asset prices provide useful information to monetary policy-makers, notably
about private sector expectations.
Over recent years, central banks and economic research have paid increasing attention to these
issues. Indeed, the experience in Japan over the past two decades underscores how harmful bursts in
asset price bubbles can be for macroeconomic stability, and how difficult it is for policy-makers to
mitigate these costs. Indeed, there are quite a number of historical episodes when a collapse in asset
prices triggered sustained deflationary trends and problems of financial instability.
When discussing asset prices and monetary policy, four questions come to mind:
• First, is it possible to identify the emergence of an asset price bubble in the markets? And if
so, how?
•
Second, assuming that a bubble has been identified, what can policy-makers do about it?
What are their choices and dilemmas?
•
Third, what is the concrete situation in equity and housing markets in the euro area at
present?
•
Finally, what role do asset prices play in the ECB's monetary policy and what challenges
could they pose?
How to identify a bubble?
Answering the first question is both easy and tricky at the same time: I think, we can all agree that it is
very difficult to identify bubbles, not least since we need to distinguish asset price changes that are
justified by changes in fundamentals, such as technological advances or changes in risk preferences,
from those that are due to misalignments or "irrational exuberance" - to quote a prominent central bank
colleague. For these reasons, central banks need to be - and they are - very cautious in identifying
and pointing to the existence of a bubble. However, a number of indicators may help us to form an
assessment about whether an asset price misalignment or a bubble is under way. A widely used
indicator to gauge major stock price misalignments - which I am sure many of you employ in your
professional activities - is to compare price-earnings ratios with historical averages. In the housing
market, one method is to look at trends in the price-rent ratio relative to the historical averages, or at
affordability (price-income) measures. All these indicators can be informative in judging the
sustainability of asset price valuations.
In addition, a number of researchers have stressed that important complementary information for
assessing the sustainability of asset price movements can be derived from monetary and credit
developments. In particular, it has been shown that periods of high money and credit growth often give
rise to boom-bust cycles in stock and property prices, which then causes high costs in terms of
macroeconomic stability. Overall, we have several tools which could help us to detect bubble
phenomena. While individual tools are subject to caveats, applying a broad range of methodologies
should help limiting the risk of making mistakes in the assessment of asset prices.
What can central banks do about bubbles?
Coming to my second question, how should central banks react if they see the risk of an emerging
asset price bubble? The options range from not reacting at all to consciously trying to prick an
emerging bubble. Obviously, attempts to deflate an asset price bubbles are likely to require substantial
interest rate increases which, in turn, could adversely affect economic activity and inflation. In view of
the difficulties in identifying a bubble, it seems established wisdom today that central banks should be
exceedingly careful in dealing with asset bubbles.
There is, however, a more subtle way: to cautiously consider "leaning against the wind" when an asset
price bubble is developing. Indeed, some academics have argued that, by accepting some short-term
deviation from the pursuit of its stated objective of price stability, a central bank may improve the
conditions for maintaining price stability over the medium to long-term. If a potentially costly bubble is
firmly under way, then a somewhat tighter monetary policy stance than would otherwise be needed
could be warranted.
Certainly, there are also risks involved in "leaning against the wind". First, as I mentioned already,
there can never be full certainty as to whether an asset price bubble is under way. Second, by
influencing market psychology, a monetary policy tightening could trigger dynamics that are difficult to
foresee and may be hard to control ex post.
Effective communication, as always, is crucial, especially in situations of heightened uncertainty. The
central bank can consider adjusting its communication pre-emptively in order to discourage the
formation of overly optimistic expectations regarding future returns and/or in order to signal concerns
about too low risk premia. In any case, monetary authorities, through their communication, should
avoid appearing complacent, thus possibly contributing themselves to unrealistic expectations and
asset-price dynamics that are not in line with fundamentals.
Finally, central banks should not be seen as reacting asymmetrically to asset price movements; that is,
as only reacting to mitigate the consequences of a fall in asset prices. Obviously, such asymmetric
behaviour can lead to moral hazard in the market, with the central bank becoming a potential
contributor to excessive asset price fluctuations, if its actions induce private agents to take higher risks
than would otherwise be the case.
What is the situation in the euro area housing and equity markets?
After these rather general considerations, let us look at the current situation in the euro area? What
are the underlying factors fuelling recent developments in asset prices? Are these developments a
cause for concern and what are the associated risks? Let me first focus on residential property
markets. As already noted, growth rates in euro area property prices have been rather dynamic in
recent years. After relatively modest price increases of less than 3% between 1993 and 1998,
residential property prices on average for the euro area as a whole have been rising at annual rates of
around 6-7% in each of the past four years. In real terms, this corresponds to growth rates of 4-5%,
which is relatively high by historic standards. Differences across euro area countries have been
considerable: while in Spain, France, Ireland and Italy, residential property prices were rising on an
annual basis by between 11% and 17% in 2002 and 2003, they have been falling slightly in Germany
and Austria in the last four years.
The dynamism of property prices in several euro area countries is very much related to the very low
levels of interest rates brought about by the introduction of the euro. For several euro area countries,
the adoption of the euro marked a significant fall in real interest rates, as it implied a "regime change"
towards a more stable macroeconomic environment. The fall in interest rates, in turn, allowed
households to borrow more and accumulate more debt. As a consequence, household indebtedness
in the euro area has increased significantly in recent years. In 2004 it is estimated at 54% of GDP, up
from 46.5% in 1998 and 43% in 1995.
The rise in household debt has not, however, been accompanied by higher interest payments as a
ratio of disposable income in the euro area as a whole. This ratio amounted to 4.6% in 2003, similar to
the 4.8% observed in 1998. However, the strong rise in house prices and the substantial increase in
household indebtedness have raised some concerns. Given the differentiated path of house price
increases across countries, this concern is obviously more relevant and stronger in some countries
than in others.
The concern relates in particular to the likelihood that some households may be underestimating the
risks they face. These risks are associated first, with the higher sensitivity of households to changes in
interest rates. In this regard, we have seen a tendency in some euro area countries to increasingly
focus on borrowing at conditions which are linked to short-term interest rates. For many households
this seems to be an attractive option as it implies a rather low interest rate burden notably at the
beginning of the contract. What is often overlooked, however, is the fact that the currently low interest
rates could well change over time.
A second risk relates to future house price changes. Some valuation measures for property prices,
such as the price-to-rent ratio, are now 10-15% higher than their average levels during the period
1995-2003 in the euro area as a whole. These valuation measures have even reached levels as high
as 17%. Against this background, concerns have been expressed that substantial house price
increases in some countries entail risks of a reversal of this trend that may currently be
underestimated.
It is not the first time we have been confronted with pronounced movements in asset prices in the euro
area. Indeed, current movements in house prices are small when compared to some swings in stock
market prices over the last six years. We have witnessed rather substantial share price fluctuations
resulting from the new economy euphoria and the subsequent disillusionment. And we have, of
course, tried to assess the impact of the dramatic stock market decline from the peaks in 2000 on
macroeconomic conditions and financial stability.
In this regard, it mattered that, partly linked to the introduction of the euro, the outstanding amount of
shares substantially increased in the euro area. For non-financial corporations in the euro area, the
annual net issuance of shares increased from 1.7% of GDP in 1995 to 7.3% of GDP in 2000. At the
same time, during the late 1990s, the distribution of shares across the euro area population
broadened significantly, implying that more households invested in shares in the late 1990s than
before. Corrected for valuation effects, the amount of household's holdings of shares and mutual fund
shares increased between 1995 and 2003 by 78%.
Against this background, stock prices have become more relevant to economic conditions in the euro
area in recent years. And indeed, when stock prices started to fall, we could see that this had a
notable dampening effect on the euro area economy in the period 2001-2003.
What role do asset prices play in the ECB's monetary policy?
After this description of the current situation, the crucial question is: how do asset price developments
enter into the assessment of the outlook for price stability and how they influence the
policy-formulation of the ECB. Recently, much attention has been devoted to the question of which
monetary policy strategies are optimal in an environment of strong asset price fluctuations. With
regard to inflation targeting strategies, it has been acknowledged that if financial imbalances
accumulate and there is, for example, substantial uncertainty about the sustainability of asset price
movements, it is not advisable to strictly pursue an inflation forecast for consumer prices over a
horizon of one to two years. In such circumstances, it may be better instead to set interest rates with a
view to a time-frame extending well beyond conventional forecast horizons. The ECB's monetary
policy strategy has some features that can become quite useful in this respect:
•
First, from the beginning, the ECB has adopted a "medium-term orientation". This implies
that policy is not set for a time horizon of one or two years. Rather, the ECB pays due
attention to the need to take into account the entire horizon over which monetary policy and
macroeconomic shocks impact on the state of the economy. This lengthening of the policy
horizon helps to trace out the likely macroeconomic impact of a financial misalignment.
•
Second, the monetary policy strategy of the ECB is broad-based implying that a whole range
of several indicators and models are employed and cross-checked, thus making the
assessment and policy response to financial imbalances robust. In particular, the
commitment to monitor and assess money and credit developments - besides being
instrumental in identifying longer-term risks to price stability in general - may help to guard
against ignoring asset price bubbles. Indeed, growth rates of money and credit which are
persistently in excess of those needed to sustain non-inflationary economic growth may,
under certain circumstances, provide early information on emerging, and potentially
destabilising, asset price bubbles. In this respect, they act as a permanent admonition for
vigilance in the face of unusual movements in asset prices.
From what I have said, it has become clear that it is important to monitor asset prices and to try to
avoid the emergence of unsustainable, pronounced movements in asset prices which may
subsequently lead to sharp recessions. Obviously, there cannot be a mechanical link between asset
prices and monetary policy instruments. Central banks, however, should take asset price movements
into account, especially if large swings in asset prices imply long-term risks to financial and economic
stability.
Concluding remarks
As you can see, there are a number of key concepts which I have emphasised in my speech today:
"strong vigilance"; "careful monitoring and analysis"; "medium-term orientation"; "prompt reaction".
These are central elements of our approach to monetary policy-making, both at the current juncture
and in connection with the specific topic of asset price developments that I discussed in the second
part of my address. We live in a world of considerable uncertainty, not just in terms of economic
shocks - which by definition are impossible to predict - but also in terms of our knowledge of how the
economy functions, how economic agents form expectations and react to events and changing
conditions. Under such circumstances, the central bank's unambiguous commitment to attaining its
objectives is an indispensable anchor. A credible central bank with a clear commitment to price
stability can, and must, provide such a haven of trust and confidence within the complex and uncertain
web of interrelations in a modern economy. This is precisely what the ECB is seeking to do. Our track
record over the past, almost six, years shows that we have been rather successful.
Thank you very much for your attention.