Otmar Issing: The euro - a stable currency for Europe
Speech by Professor Otmar Issing, Member of the Executive Board of the European Central Bank, at
Euromoney Institutional Investor Plc, London, 21 February 2001.
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Introduction
Slightly more than two years ago the European Central Bank (ECB) assumed responsibility for the
second largest economic area in the world after the United States. The euro is now the currency for
300 million people. The transfer of monetary policy competence from 11 national central banks, many
of them characterised by a long history and impressive monetary policy results, was met with a great
deal of scepticism. All the more so, because the asymmetry between a self-contained central bank
and - in the meantime 12 - national governments brought with it an historically unique situation.
The single monetary policy has not experienced any significant accident so far in its short life: the
transition to the single currency has been quite smooth and the Governing Council of the ECB was
successful in fulfilling its mandate, namely in maintaining price stability in the euro area over the
medium term. Clearly, we are not satisfied with HICP inflation above 2 %, as we have seen since the
middle of last year. However, we have announced before we started to conduct our monetary policy
that the ECB could not precisely control inflation in the short-term and would not try to as, for example,
in the case of an oil price shock. But we have good reasons to expect that, if nothing comparable
happens again, HICP inflation in the euro area will fall back to below 2% in the course of this year.
You may ask why I am so confident about this. There are three main reasons. First, the institutional
set-up on which the ECB and the euro have been built is very sound. Second, the Governing Council
of the ECB managed to set up an efficient framework both as regards the monetary policy strategy as
well as monetary policy instruments. Finally, monetary policy in the last two years has rightly been
perceived by most observers as having been appropriate to maintain price stability in the medium
term. All this is reflected in a high degree of credibility of the ECB, as evidenced by low inflation
expectations.
The institutional design
Let me start with the institutional design. The Treaty establishing the European Community - which I
will refer to as the "Treaty" - and the mandate of the ECB provide a sound basis both for an effective
monetary policy and for the establishment and development of a good reputation and a high degree of
credibility for the ECB.
I will focus my attention on four aspects of institutional design which are of the utmost importance for
the ECB's reputation and credibility: (1) its mandate; (2) its independence from political interference;
(3) its transparency; and (4) provisions that contribute to fiscal discipline.
First, the Treaty establishes a clear hierarchy of objectives for the single monetary policy, giving
overriding priority to the maintenance of price stability in the euro area. This reflects the fact that the
best contribution that the ECB can make to long run sustained economic growth, employment creation
and raising standards of living, is maintaining price stability. The clear priority given to the price
stability objective also highlights the fact that the ECB itself does not have either the means or the
responsibility for ensuring a high level of employment and real growth, beyond the positive impact of
price stability just mentioned. Such a clear allocation of task and objective to different policy-makers
ensures efficiency, transparency and accountability.
Second, the Treaty has made the ECB one of the most independent central banks in the world. In this
way, political pressures can be avoided and European citizens can be assured that a long-term
euroarea wide perspective will be taken by the central bank in pursuing its mandate of maintaining price
stability.
Third, the Treaty recognises that the assignment of an important policy responsibility to an
independent institution has to be accompanied by transparent and accountable policy design and
implementation. Transparency and the accountability of the central bank add to its credibility by
imposing discipline on policy-makers. For these reasons, the ECB went significantly beyond the
statutory requirements regarding transparency.
Finally, let me emphasise that the Treaty, reinforced by the Stability and Growth Pact, contains
important provisions to facilitate the co-ordination of economic policies and ensure sound public
finances. The EU countries must regard their economic policies as a matter of common concern. The
ECOFIN Council is required to formulate broad guidelines for the economic policies of the Member
States and to monitor economic developments within a multilateral surveillance framework. EU
governments are also subject to a common code of conduct in fiscal matters, in particular imposing
limits on government deficits, as laid down in the Treaty. The Stability and Growth Pact, together with
the "no-bail-out clause" and other Treaty provisions, contributes to maintaining fiscal policy discipline.
In fact, fiscal discipline makes it easier for the central bank to maintain price stability and thus indirectly
contributes to keeping inflation expectations low.
To summarise, the institutional design of Economic and Monetary Union directly addresses the main
problems that a new central bank may face in establishing its credibility: overriding priority is given to
maintaining price stability, central bank independence is assured and various provisions go a long way
towards ensuring sound public finances. History has taught us that in these institutional features we
have laid the foundations of a safe currency.
Setting up a new central bank
Let me now make a few remarks about the experience we have gained in the first two and a half years
of setting up a new central bank, both in general terms and in particular with regard to the instruments
and monetary policy strategy.
It came, I suppose, as a surprise to those who had been very sceptical about the euro that the birth of
the new currency proceeded as smoothly as anyone could have hoped for. Indeed, it was a
resounding success. The process of the changeover to the euro was virtually free of technical faults.
Almost overnight a unified money market was created, which - notwithstanding a formidable
transactions overload - functioned from the very start without any major complications. Short-term
interest rate volatility remained well contained, and the main refinancing operations, along with the
standing facilities and the reserve requirement system with its averaging provisions, have since
guaranteed money market developments closely in line with the ECB's intentions.
The operational framework of the ECB is very market oriented, i.e. it relies on tender procedures,
leaving the initiative to banks, and lets automatic stabilisers, through the averaging provision in the
reserve requirements system, work. While the ECB sets the framework and the rules, it is up to banks
to best exploit the incentives set under this framework.
On this issue, let me add a few remarks on the increase in money market rates which has occurred
over the past few days. These developments have occurred following the low amount of bids
submitted in the main refinancing operation of 13 February. The recent increase in money market
rates should not be seen as reflecting a change in the stance of monetary policy, which continues to
be signalled by the minimum bid rate.
Also the monetary policy strategy of the ECB has proven successful from the start. The recognition
that monetary policy will always have to cope with a changing and imperfectly known world has been a
key consideration in the design of the ECB's monetary policy strategy. In addition, we had to bear in
mind the fact that the mere establishment of the ECB as a totally new institution marked a historical
discontinuity, with potentially profound implications for economic behaviour and measured structural
relationships.
In these circumstances, the Governing Council chose to equip itself with an internally consistent and at
the same time comprehensive and appropriately flexible approach to policy analysis. It was decided
that the best way we could serve the lasting objective of guaranteeing a stable measure of value in a
non-discretionary manner was to adopt a robust analytical framework well-suited to informing
policymakers in a changing world. Developing and refining this framework was our main challenge.
This tension was resolved - and in my view this is the optimal solution - by announcing a quantitative
definition of price stability and by adopting an encompassing approach to analysing and assessing
information relevant to detect risks to price stability.
Defining price stability as "a year-on-year increase in the Harmonised Index of Consumer Prices of
below 2%", along with the emphasis on the medium term, was designed to enhance clarity, to anchor
expectations and to provide a yardstick against which the new independent institution could be held
accountable.
Likewise, the eclectic but systematic approach to the processing of information relevant for assessing
risks to price stability, which we call our two-pillar strategy of monetary policy, was intended to
guarantee that no piece of evidence relevant to policy decision-making would be excluded from the
Governing Council's information set. The prominent role assigned to money, as the first pillar of our
strategy, ensures that monetary developments are always part of the picture, and receive the attention
that they deserve, given the monetary nature of inflation beyond the immediate horizon. In parallel, the
second pillar of the strategy ensures that other forms of analysis, such as the investigation of the
interplay between supply and demand and cost-push dynamics, are also incorporated into the policy
process. Together, the two pillars ensure that information and analysis produced on the basis of one
methodological perspective are always cross-checked against information and analysis produced on
the basis of the other.
Analysis under the two pillars provides the Governing Council with all crucial information regarding the
nature of the shocks within the euro area economy and the resulting risks to price stability. The
complementing viewpoints of the two pillars have served us well as a comprehensive framework for
analysis in the past two years. The strategy has provided the basis for a thorough and timely
explanation of monetary policy decisions to the general public.
The current situation
Since November 1999, the Governing Council raised the main ECB interest rates by a total of 225
basis points in reaction to a perspective of upward risks to price stability. These rises have been
appropriate. Recent developments point towards increasingly balanced risks to price stability in the
medium term. However, the analysis of the information relating to the two pillars of the monetary policy
strategy showed that there are still factors which might pose upward risks to price stability and as such
will need to continue to be closely monitored.
Starting with the first pillar, monetary and credit growth have slowed down in the course of 2000. The
growth of M3 has gradually approached the reference value of 4 1/2% confirming that the risks to price
stability stemming from the monetary side have become more balanced in comparison to the situation
in early 2000. In fact, the short term dynamics of M3 growth in the second half of 2000 were clearly
weaker than in the first half of 2000. This will become visible in the annual growth rate of M3 in the
coming months which will be affected downwards by base effects resulting from the strong growth of
M3 in the first quarter of 2000.
Turning to the second pillar, several developments have recently changed somewhat the outlook for
the euro area. Most notably, the slowdown in the US economy and recent developments in Japan
have increased the uncertainty surrounding the prospects for world growth. It is now clear that the
international outlook is no longer as positive as it has been for almost two years. World real GDP
growth, which in 2000 posted its strongest performance for many years, may moderate in 2001, but is
expected to remain solid.
However, whereas the euro area is not immune to external developments, it is a relatively closed
economy. While the more moderate prospects for world growth might end up being associated with
some further slowdown in economic activity in the euro area, the dynamics of domestic demand
suggest that, overall, the outlook for sustained euro area growth remains positive. This
notwithstanding, real GDP growth in 2001 might turn out somewhat lower than expected earlier.
However, all in all, realistic optimism is justified.
Turning to consumer price developments, the euro area has seen HICP inflation above 2% for some
months now. This was mainly due to the unexpected increases in oil prices and the depreciation of the
euro. In December 2000 the annual rate of increase in the HICP declined to 2.6%, from 2.9% in
November. It is expected that this trend continues in this year although it may take some time for HICP
inflation to fall again below 2%. The moderation in oil prices and the appreciation of the euro exchange
rate would, if sustained, contribute to a faster decline in overall HICP inflation over the course of this
year.
The evolution of external inflation forecasts and of inflation expectations as derived from the analysis
of long-term interest rates is reassuring. It suggests that financial markets and economists expect
price developments in the medium to long term to be in line with the ECB's definition of price stability.
In spite of the assessment that the risks to price stability in the medium term are now more balanced,
there are still factors posing upside risks which require continued attention. One risk is related to the
evolution of wages in the period ahead. It is important that wage moderation continues. This should be
facilitated by the decline in consumer price inflation which is expected to occur over the coming
months. However, the increase in some labour cost indicators in 2000 warrants close scrutiny. A
second important factor will be fiscal policy in the euro area. The relaxation of consolidation efforts at
this juncture will lead to an undesirable pro-cyclical impact. In order not to threaten the progress in
fiscal consolidation, the reduction in the tax burden has to be accompanied by a structural reduction of
expenditure.
When evaluating the current situation, I would like to emphasise the obvious, namely that the
monetary policy decisions of the ECB are based on the assessment formulated under both pillars of
the monetary policy strategy of the ECB and nothing else. The outcome of this assessment is not least
reflected in the level of the minimum bid rate on the main refinancing operations. This assessment
which is transmitted to the public by the ECB's well-known instruments of communication, and not
short-term oriented expectations in financial markets on decisions in the next meeting of the
Governing Council, is decisive for the monetary policy stance of the ECB.
Challenges for the euro area
In the context of the recent US slowdown, the following question is often raised: Who might take
responsibility over from the United States for "global growth"? I would contend that this question is
misleading from the outset. Indeed, the US economic policy has, in my view, always been conducted,
and rightly so, with a clear focus on domestic objectives. It is important to note in this regard that the
periods of success of the US economic policy from a domestic point of view, i.e. the periods of
sustainable non-inflationary growth in the US, have actually coincided with the periods when
significant contributions to both growth and stability in the whole world were made by the US.
In principle, the same logic should also hold for the euro area. The euro area is the second largest
economic area in the world. Therefore economic developments in the euro area are significant for
developments and prospects elsewhere. The mandate of the ECB clearly states that price stability in
the euro area is its primary objective. Price stability is indeed a key element of an overall environment
leading to sustained growth at domestic level.
In such a context, the best contribution which a large economy as the euro area can provide to
support sustainable non-inflationary growth in the world economy is to pursue policies maintaining
price stability "at home". This is the only reasonable allocation of responsibilities across world
policymakers. Anything else risks blurring responsibilities and diluting accountability. This, in turn, would
distort incentives in a perverse way.
It goes without saying that exchange of information and views, for instance in the context of
international fora, may in such a context further help the policy-makers of large economies assume
their global responsibilities by providing them with a better understanding of the economic
environment.
Notwithstanding the clearly positive outlook for the euro area, a lot has still to be done. While monetary
policy will have to remain focused on its commitment to maintain price stability -thereby providing a
credible anchor for expectations, the challenge for the euro area will be to best exploit and enlarge its
growth potential in the coming years.
Structural reforms have taken place but are far from being satisfactory in most countries. Their
implementation is of crucial importance to foster the supply of labour and capital and the innovation
and diffusion of new technologies and production methods. More flexibility in labour markets and
reforms aiming to encourage labour force participation are necessary to offset the low growth in the
working age population. Fostering a knowledge-driven economy, removing barriers to investment and
creating the institutional structures needed for a rapid and efficient adoption of new technologies, will
strengthen the process of capital accumulation. The ongoing current regulatory reform process will
create the conditions to enhance competition and is expected to have important economic benefits.
Overall, sound economic policies designed to avoid the appearance of economic imbalances and
structural reforms will allow the euro area to better exploit its growth potential, thereby also
contributing to growth and economic stability worldwide.
Conclusion
To conclude, let me recall what I said at the beginning of my address. While I am not satisfied with
HICP inflation of above 2% as we have at present, price stability will be maintained over the medium
term. What I regard as most important is the fact that medium-term inflation expectations are still in
line with price stability and, in my view, rightly so. We are convinced that we are well equipped to
pursue a stability-oriented monetary policy and thus gain the trust of the public. The euro has proven
to be a stable currency for Europe and the world economy, and the best contribution the ECB can do
to sustain this achievement is to maintain price stability in the euro area.