Mr. Wellink gives a central banker's view of price stability and monetary policy
Speech by the President of the Netherlands Bank, Dr. A.H.E.M. Wellink, on the Alumni Day of the
Tinbergen Instituut in Rotterdam on 23/10/98.
Introduction
It was only recently that some predicted that central bankers would soon be finding
themselves in never-never land. They alleged that the considerable technological advance made
since the Second World War would make for structurally higher growth and low inflation. The world
economy had supposedly landed in an age of no inflation. But here the question arises whether this
really is a new era, and if it is, how it was brought about. Before we go into these questions,
however, we need to look at the definition of price stability, as well as at the concept of prices as
such.
Price stability in central bank terms
It goes without saying that European monetary policy is concerned above all with
price stability within the euro area. That is after all the mandate given by the EC Treaty to the
European Central Bank. The euro's exchange rate against, let us say the US dollar or the Japanese
yen, is not targeted. The euro zone is a comparatively closed economy where, contrary to what we
have been used to in our open European economies, the exchange rate plays a relatively minor role
in price determination. The emphasis laid on the internal value of the euro is the greatest
contribution which the European System of Central Banks (ESCB) can make to the stability of the
international monetary system.
In their quest for internal price stability, the monetary authorities base their policies
notably on movements in the consumer price index (CPI). They do so for several reasons. To begin
with, there are various technical advantages to the CPI, such as its high publication frequency, timely
availability and transparency. The latter is reflected in its well-founded weighting scheme, which
covers a considerable proportion of final spending, viz. household consumption. This makes the CPI
a more attractive gauge than the broadest measure of inflation available, viz. the GDP deflator. The
GDP deflator is, however, no match for the CPI when it comes to monetary policy-making, because
its figures become available with a considerable lag and not as frequently. Moreover, price
movements over time lose some of their comparability because of shifts in the package of total
spending. But the CPI is useful for another, more basic reason as well. At the end of the day, central
banks are most interested in the ultimate net result of the gamut of price rises within the economy,
i.e. the increases in the prices paid by households for goods and services. In this context, the prices
of raw materials are, for instance, of a lesser importance. It must be kept in mind that price rises in
an earlier stage of the production process need not necessarily bring about tensions within the
economy, because they can be compensated for by other factors (such as increasing productivity or
competition).
However, this does not mean that central banks should not look at other price indices
as well. On the contrary. Movements in import prices may be barely relevant to the euro area, but
they are of importance to small, open economies. Because import prices in a small and open
economy are determined largely by exchange rate developments, the latter may have a considerable
influence on the general price level. That even goes for the euro zone, for example, when the
exchange rate of the US dollar - in which the prices of numerous commodities are expressed - is
subject to heavy fluctuations. Likewise, movements in the prices of non-final goods and services,
such as commodities and energy, can be relevant for central bankers because they may be an
indication of inflationary tensions.
It is becoming harder for central bankers to do their work because doubts have arisen
about the traditional gauges of inflation. What is going on? The measurement of inflation has drawn
the attention of the academic world, as well as that of the central banks. Take, for instance, the
Boskin Report published in the United States, and a comparable report published under the auspices
of the Deutsche Bundesbank. These studies indicate that the CPI has been systematically overstated,
in the United States by about 1 percentage point, and in Germany by three-quarters of a percentage
point. It is worthwhile taking a closer look at this matter, because, from the point of view of
monetary policy, the importance of any distortions of the CPI increases in a world where inflation
has dropped to low levels. After all, the lower the rate of inflation, the greater the relative
significance of any statistical distortion. With inflation in the euro zone coming out at 1.2% over the
last twelve months, measurement errors of the magnitude which I mentioned earlier suggest that
Europe is currently wavering between inflation and deflation.
The errors made in measuring inflation are due, first of all, to the (fortunately)
progressing increase in product quality. This is known in academic circles as the quality bias. It is
not easy to distinguish between the price rises and quality improvements of sophisticated products
such as computers and telecommunications equipment. For marketing reasons, technological
innovations may be very highly priced, for one thing because the development costs need to be
recovered. Later generations of IT tools, by then mass-produced, are invariably much cheaper than
their predecessors. Falling prices and an impressive expansion of investment and profitability then
go hand in hand, which is a fairly unusual phenomenon macroeconomically. The variety of products
and their ever-shorter life cycle add to the risk that distortions in price indices increase over time.
The second cause of statistical distortions in inflation is the growing importance of
services; this is known as the services bias. In 1997, more than 65% of the nominal value added
within the Dutch economy was accounted for by the services sector. In 1950, it had still been less
than 50%. The shares of the agricultural sector and manufacturing industry have shrunk accordingly.
Within the services sector, the greatest expansions are accounted for by business services, banking
and telecommunications. The problem is that it is not easy to determine the output volume of
services, which can usually only be calculated in a roundabout way. Because the growth of output is
underestimated, price movements in the services sector are systematically overestimated because of
these measurement problems. This (unduly) low estimation of output growth is corroborated by
studies made by the Netherlands Bureau for Economic Policy Analysis. According to them, the total
productivity of business services in the Netherlands between 1991 and 1995 came out at minus
1.5%. Compared to the increase in productivity in manufacturing industry in the same period, of
1.75%, this figure is implausibly low. The problems inherent in measuring the CPI are compounded
further by the fact that services have come to make up an increasingly large share of the national
product.
The third factor causing measurement problems with regard to inflation may be
termed the substitution bias. In practice, the composition of the package of goods and services
purchased by consumers changes fairly rapidly. That is especially true in this day and age, with new
and improved products being marketed all the time. The package composition underlying the CPI is
adjusted for such changes only once every five years. The basket of goods and services used to
calculate the CPI has recently been harmonised within the European Union. This harmonised CPI
will be used by the ESCB as a measure of inflation in their monetary policy-making. This means that
the differences between the national definitions used by statistical agencies have declined. However,
the process of harmonisation has not yet been completed. The harmonised CPI in fact covers too
narrow an area in terms of goods and services. Several components which are relevant to the general
price level are not included. Take, for example, rent increases.
Consequences for monetary policy
In view of the problems attending the measurement of inflation, people are right to
question whether central bankers still have sufficient insight into inflationary developments. And
subsequently, whether central bankers are still capable of conducting adequate monetary policies.
Such concerns are valid notably in times of low inflation, when the statistical distortions that we are
speaking about carry extra weight.
In a market economy, any difficulties encountered in the calculation of the index of
the general price level need not necessarily give rise to problems right away. An entrepreneur who
has decided to purchase new computer hardware will not be swayed by possible statistical distortions
in the CPI. Neither will you or I, when we visit the supermarket on Saturdays to stock up our larders.
The essential thing is that entrepreneurs, consumers and other economic agents have proper insight
into the value of individual goods.
But there is a catch. An inflation gauge which is closely monitored by a central bank
may influence the behaviour of economic agents. Contracts and labour agreements often refer
explicitly to an officially published inflation figure. Via this route, distortions in measured inflation
can thus affect functioning of the economy. In other words, it is of the utmost importance, not just
for the monetary authorities, that price rises be gauged as accurately as possible.
In spite of the uncertainties inherent in measuring inflation, the monetary authorities,
in formulating their policies, make use of a gauge that seeks to encompass the general price level.
How otherwise can one ascertain whether price stability has been achieved. Moreover, monetary
policy should in principle take effect at the macroeconomic level. However, in order to allow for
possible measurement errors, price stability - as indicated by the inflation measure used - is defined
more broadly by the central bank. The Governing Council of the European Central Bank has recently
defined price stability as a rise in the (harmonised) consumer price level of less than 2%. On the one
hand, this definition, which is in line with that used in most countries of the euro area, implies that
measurement errors occur while, on the other, it stresses that it is one of the tasks of the European
System of Central Banks to prevent deflation. Some caution is in order when it comes to using the
word "deflation". In purely technical terms, deflation may be defined as a fall in prices, but it
conjures up much more than that, viz. the depression of the 1930s. A slight decrease of the general
price level need not of course be attended by an overall collapse of demand. In 1987, for instance,
consumer prices in the Netherlands dropped by around 0.5%, a development which had a positive
impact on the economy because disposable income in real terms grew more than expected.
Returning to our measurement problem, we cannot conclude, on the basis of the
information now available, that the distortions in the official price indices have increased
substantially over time. That would have landed the monetary authorities with real problems. If, for
example, inflation had been increasingly overstated, monetary policy would have been unduly
tightened, with negative effects for economic growth and the employment situation. However, we
cannot but admit that it has become more difficult over the past few decades to measure output and
price developments in the services sector in particular.
A brave new world?
Now let us take a look at actual inflation. We can see from the various inflation rates
in Europe, and even throughout the world, that there are few factors which could make for rising
inflation. In the European Union and the United States, inflation has been structurally reduced since
the early 1980s, thanks to budgetary consolidation in both these areas, the deregulation of labour and
product markets, and a further liberalisation of international trade and capital markets, boosting
international competition. In those - large - parts of the world which have been affected by the
financial and economic crisis, deflation is in evidence.
This brings me back to the question which I posed at the beginning of this address:
what indications are there that we now find ourselves in a new era of permanently higher growth and
lower inflation, or to cite Alan Greenspan, in a new economy. This question is prompted notably by
the developments in the United States where - so far - high growth has been attended by low
inflation.
But one swallow does not make a summer, as the saying goes. And that is true of the
United States, too. Those who feel that high growth and low inflation have come to form a
permanent fixture may be suffering under some delusion. After all, viewed over the longer term,
neither the duration of the upswing in the United States, nor the increase in productivity nor the rate
of inflation are unique. In fact, if the signs are not misleading, the American economy would seem to
be over the hill. Since the early 1950s, the expansion phases of the American business cycles have
on average lasted five years, two of them lasting longer than the current phase. Though accelerating,
the rise in labour productivity over the past few years (of 1-1.5%) still compares unfavourably with
the 3% average recorded during the first two decades following the Second World War. And, where
inflation is concerned, it may be noted that it was low until the mid-1960s, averaging 1.3%. The
current developments in the United States, which are now beginning to tarnish somewhat, therefore
have much more in common with the situation in the first half of the post-war period (though there
are also quite a few differences), and can hence hardly be called exceptional. It is all the more
imperative to exercise caution when averring that inflation has been banned forever, because the
current low rate of inflation in the United States and Europe is accounted for largely by a fall in
commodity prices, which is temporary in nature. Obviously a role is also played by the collapsing
demand in South-East Asia in particular and its repercussions elsewhere. That is why there is no
telling what the underlying inflation rate would be if there were greater economic equilibrium
worldwide. For example, suppose oil prices in 1998 and 1999 continued to be at their 1997 level
($19.2 per barrel UK Brent). That is 30% more than the current price. Inflation in the European
Union would then come out at 1.8% this year, instead of the current estimate of 1.5%. In 1999,
inflation would then rise to 2.4% (according to the Netherlands Bank's EUROMON model).
Conclusion
Let me conclude. Central bankers will never be at a loss for something to do. Just
look at the current financial and economic crisis. And although the inflation genie will not emerge
from the bottle for the time being, central banks will need to keep an eye on price movements all the
time. Monetary policy is not asymmetrical, as some might feel, in the sense that a central bank only
takes action when prices soar. Falling prices, too, may be detrimental to the economy, and call for
some reaction from the central bank.
It is under these very conditions - low inflation worldwide and even deflation in some
areas - that measurement problems with regard to price movements, though not insurmountable, may
prove a nuisance. Although the central banks still have at their disposal sufficient monetary and
economic beacons by which to steer their course, there is work to do for the statistical agencies, the
ESCB and the academic world. If problems with measuring inflation mean that inflationary tensions
may be hard to assess reliably, we must do all we can to ensure that the quality of the price indices
published is at least maintained and, where possible, improved.