Andres Lipstok: Monetary policy will not become a prisoner
Article by Mr Andres Lipstok, Governor of Bank of Estonia, published in the newspaper
Postimees on 24 March 2011.
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Governor of Eesti Pank and member of the Governing Council of the European Central Bank
Andres Lipstok says that avoidance of excessive inflation in the euro area and alleviation of
inflation expectations are the best measures that the Eurosystem's central banks can take to
support the economy.
Estonia has been a full member of the euro area for almost three months now. The adoption
of the euro in Estonia was technically smooth and the society's approval of the changeover
has increased. The smooth changeover created suitable grounds for paying attention to what
really matters - how to help ensure the stability of the euro in the future. In other words, the
focus is now on the key issue - maintaining price stability in the euro area.
Euro-area price stability is not an abstract and foreign concern for us. We were aware of how
the reference interest rate on housing loans or the euro's exchange rate against the dollar
influence our daily lives already before the changeover. However, what people have not
realised is how much the general inflation developments in the euro area affect the society's
behaviour on the whole. Surveys indicate that general developments in the euro area have a
greater impact on the inflation expectations of people who live in the single currency area
than one might assume. For instance, in one year the inflation rate of Slovenia and Austria
may differ greatly due to changes in taxes or differences in the economic cycle, but the
longterm price expectations of people still remain quite similar in these countries.
This is logical. In the monetary union, it is natural that there occur differences in the inflation
rate across regions, but these cannot last very long. Otherwise, the competitiveness of the
country with the faster inflation rate will suffer: in the best case, the country's economic
growth will slow down gradually, but in the worst case the country will have to adjust through
a difficult crisis similar to the situation in Greece. One way or another - eventually, this
entails a decrease in demand and price growth will be forced back to its "correct" level.
For us, not much has changed after joining the monetary union. Inflation in Estonia was
affected by euro-area price stability already under the fixed exchange rate system. Though
for a short while, Estonia's inflation greatly exceeded that of Europe, long-term and
excessive deviations were corrected by the economy. Otherwise, it would have started
pressuring the credibility of the fixed exchange rate.
While in the previous monetary system, more fretful analysts might have speculated that the
economy would be adjusted through devaluation - the weakening of the currency's value -
which would have allowed inflation to remain higher, luckily this is not an option in the
monetary union.
There is a greater concern upon making long-term economic decisions in the monetary
union: whether the euro area's central banks (that is, the Eurosystem as a whole) are able to
keep the pan-European average inflation rate at a suitable level. This means that in the
medium term, the inflation rate has to remain below but close to 2%. While in Austria or
Slovenia, or in Estonia for that matter, inflation may temporarily differ from that of the euro
area, we have to look at the whole picture when making decisions.
The ability of the euro area to keep inflation close to 2% over the entire past decade has
inspired confidence. The average inflation rate has remained slightly below 2% throughout
the history of the single currency and annual inflation has mostly ranged within 1.5-2.5%.
However, we must not be distracted by our success. The euro area's inflation indicator was
over 2% at the beginning of this year, and, most recently 2.4%. This is worrying.
The more detailed picture is, of course, more diverse and future monetary policy measures
will also have to take that diversity into account.
On the one hand, the European economy is just recovering from a deep economic recession.
Unemployment is higher than usual, the relatively high debt burden is inhibiting borrowing
activity in many countries and the majority of the recent price hike stems from global factors,
such as the price growth of energy and food on the global market. The prices of other goods
and services, on the other hand, have been posting quite modest growth rates. Therefore,
the inflation expectations of entrepreneurs and consumers have remained close to the
historical average. If the price hike of commodities stops, the increase in the euro area's
prices could remain below 2% already next year.
However, looking at the data from another angle, we can find proof to arguments which insist
that the current euro-area interest rate level is not suitable for guaranteeing the low inflation
rate that corresponds to the price stability goal. Although the general public focuses on the
debt crisis of certain European countries, the developments of the economy itself have, on
the whole, exceeded expectations. Economic growth has remained above average and the
utilisation of production capacity no longer resembles a crisis situation. Though
unemployment is still high, it is decreasing and the indicators of the industrial and service
sectors are posting quite high results from the historical perspective.
If we add here the fact that global price rise pressures have been annoyingly enduring and
do not show any signs of abatement, the risk of a persistently higher inflation rate in the euro
area has increased. Therefore, at the press conference after the most recent meeting of the
Governing Council of the European Central Bank it was pointed out that, to withstand this
threat, the Eurosystem might increase the price of money in the markets earlier than
expected, maybe already in April. The mandate of the euro area's central banks is clear on
this subject and there is no reason to think that some other stray thoughts would let us
deviate from our key goal. It should be stressed that the Governing Council of the European
Central Bank is monitoring the economic situation very carefully and will not commit to future
decisions in a form that would render the Council a prisoner of their own words.
Public discussions include two extraneous arguments, based on which it has been claimed
that the hands of the euro area's central banks are tied and therefore they cannot fulfil their
primary goal properly.
Firstly, it has been presumed that banks' situation in Europe is so weak that we cannot
abandon the extraordinary monetary policy measures that made money supply easier for
banks during the crisis. Secondly, it is claimed that until the fiscal situation of some euro area
countries is not firmly under control and the new financial control mechanisms have not been
implemented, central banks do not dare to focus on the threat of inflation.
I do not wish to underestimate either argument. The situation in global money markets,
including Europe, is not entirely risk-free yet and the leaders of Europe's public financing are
struggling to ensure that the amended fiscal framework would help avoid crises in the future.
However, upon fulfilling their main goal, the euro area's central banks are not limited by
these concerns to the extent that they could or should ignore the price stability goal. The
prevention of excessive inflation and the alleviation of inflation fears is the best that a central
bank can do to support long-term economic growth.
As for money market liquidity and extraordinary crisis measures, they do not hinder the
pursuance of the necessary interest rate policy. If it is necessary to continue fixed rate tender
procedures with full allotment to guarantee the normal operation of the money market, it may
also be a reasonable move when the monetary policy interest rates are already on the rise.
In this case, one does not hinder the other.
It must also be pointed out that contrary to the popular misbelief, general monetary growth in
Europe has not been very rapid after the introduction of extraordinary measures. Recent data
indicate that it amounts to only a couple of per cent a year, which is too little rather than too
much. Meanwhile, extraordinary instruments in the market do not mean that the money
market environment is too lenient, because the European central banks have performed
monetary policy transactions to curb liquidity according to need. Naturally, if the arrangement
principles of such tender procedures become obsolete, they should be reviewed
immediately.
The same principle applies to the impact of the state budget on monetary policy. The
situation of the state budget undoubtedly has a great influence on economic developments
and it plays a great role in the analysis of the economic situation. However, this analysis
does not give the Governing Council of the European Central Bank cause to worry
excessively about the debt servicing costs of the whole euro area or its member states.
Instead of monetary policy interest rates, the debt servicing costs of countries are still
primarily influenced by the credibility of their fiscal policies - this is also reflected by the very
different interest rates of public debts within the euro area.
The government bond purchase programme that started last spring may understandably
cause concern regarding the goals of central banks. However, that step had a specific goal,
which was related to the situation in the financial market and not to fiscal policy. Central
banks are not allowed to finance the state budget and no such financing has occurred within
the Eurosystem during the crisis. It must also be emphasised that the liquidity provided to the
markets as a result of these purchases has been eliminated by opposite transactions
throughout the entire period. This also indicates that the euro area's central banks regard the
key monetary policy goal - price stability - as superior. Although the reorganisation of the
state budget is a serious challenge for many European countries, there are other people and
measures for solving this problem. Monetary policy will not be imprisoned by it.
In conclusion, the containment of inflation is the only goal of the euro area's central banks in
shaping their monetary policy. Adhering to this principle is the key to how monetary policy
can support the correction of economic discords.