Jean-Claude Trichet: Overview of recent euro area developments and the
effects of globalisation on prices and real estate
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the meeting
of the Management Board of the CDU, Wiesbaden, 5 January 2008.
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It is a great pleasure for me to be invited as a guest speaker here today.
Let me briefly sketch out the main topics I want to address. First, I will present to you our
views on the current economic situation in the euro area. Then, I will explain the ECB's
liquidity operations following the tensions in the money markets since August last year as
well as our views on the stability of the euro area financial system. To conclude, I will say a
word upon the effects of globalisation on price developments and on developments in the
real estate sector.
Economic and monetary developments
Let me first say that we are presently in the purdah period, namely within a week before the
next decision meeting of the Governing Council. Nothing in what I will say should be
interpreted in terms of our future decision next Thursday. I will stick to explaining what has
been our diagnosis and judgment on the occasion of our last meeting.
All recent incoming information had fully confirmed our view that, in a context of vigorous
money and credit growth and sound economic fundamentals in the euro area, the risks to
price stability over the medium term are clearly on the upside, as I said, on behalf of the
Governing Council, after our meeting on Thursday, 6 December 2007. The recent substantial
increase in oil and food prices, together with unfavourable base effects from energy prices,
owing to the marked decline in oil prices a year ago, are having a strong upward impact on
inflation in the current context. Looking ahead, the inflation rate is expected to remain
significantly above 2% in the near future, and it is likely to moderate only gradually in the
course of 2008. Hence the period of temporarily high inflation rates would be somewhat more
protracted than previously expected.
Looking further ahead, the December 2007 Eurosystem staff macroeconomic projections
foresee annual HICP inflation to be between 2.0% and 2.2% in 2007, to then rise to between
2.0% and 3.0% in 2008, before moderating to a range of 1.2% and 2.4% in 2009. Compared
with the September 2007 staff projections, the ranges for 2007 and 2008 have shifted
upwards. These staff projections are based on two key assumptions. The first is that recent
oil and food price dynamics and their impact on HICP inflation will not have broadly-based
second-round effects on wage-setting behaviour. The second key assumption is that growth
in profit margins will moderate over the projection horizon. These two assumptions imply, in
the context of the staff projections, a continuation of overall contained domestic cost
pressures, which contributes to the moderation in inflation projected in 2009.
It has been the view of the Governing Council that the risks to this medium-term outlook for
price developments are fully confirmed to lie on the upside, mainly relating to possible further
rises in oil and agricultural prices, and increases in administered prices and indirect taxes
beyond those foreseen thus far. In addition, against the background of sound economic
fundamentals, stronger than currently expected wage dynamics may emerge, while an
increase in pricing power in market segments with low competition could materialise.
As regards economic activity, incoming information had confirmed the sustained nature of
economic expansion in the euro area, with real GDP growing by 0.7% quarter-on-quarter in
the third quarter, while indicating some moderation in the fourth quarter. Overall, the
economic fundamentals in the euro area remain sound. Looking ahead, Eurosystem staff
projects annual real GDP growth to lie between 2.4% to 2.8% in 2007, between 1.5% and
2.5% in 2008, and between 1.6% and 2.6% in 2009. In comparison with the September 2007
ECB staff projections, the range projected for real GDP growth in 2008 has been revised
slightly downwards, whereas for 2007 the new range lies within the upper part of the
previous one.
This scenario is based on the expectation that the global economy will remain resilient, with
the slowdown of economic growth in the United States partly offset by the continued strength
of emerging market economies. However, in view of the potential impact of ongoing financial
market volatility and re-pricing of risk on the real economy, this assessment remains
surrounded by a high level of uncertainty. And in the Governing Council's view, the risks
surrounding this outlook for economic growth lie on the downside.
The monetary analysis had confirmed the prevailing upside risks to price stability at medium
to longer-term horizons. On the basis of latest available data, covering the period to the end
of November 2007, the underlying money and credit expansion remains vigourous, even
taking temporary factors into account, such as the flattening of the yield curve, the financial
market turmoil and specific transactions associated with the restructuring of certain banking
groups. Therefore, monetary and credit developments continue to require very careful
monitoring, not least with a view to better understand the response of the private sector to
increased financial market volatility.
Thus far, there has been little evidence that the financial market turbulence since early
August 2007 had strongly influenced the dynamics of broad money and credit aggregates.
Indeed, the expansion of loans to households and non-financial corporations has remained
robust, which may suggest that the supply of credit has not been impaired. To develop a
more complete view of the impact of financial market developments on bank balance sheets,
financing conditions and money and credit growth, further analysis will be required.
The ECB's Governing Council stands ready to counter upside risks to price stability, in line
with its mandate. Against this background, on 6 December 2007 we decided to leave the key
ECB interest rates unchanged. The Governing Council will monitor very closely all
developments. In particular, as I said on behalf of the Governing Council after our last
meeting, for the recent increase in inflation to remain temporary, it is essential that the price
and wage-setting behaviour remains unaffected by current inflation rates, so as to avoid the
emergence of second-round effects. By acting in a firm and timely manner on the basis of its
assessment, the Governing Council will ensure that such second-round effects and risks to
price stability over the medium term do not materialise. To firmly anchor inflation
expectations in line with price stability is even more important at times of financial market
volatility and increased uncertainty. In this respect, the Governing Council has decided to
continue to pay great attention to financial market developments.
Liquidity operations
Ladies and gentlemen, once the Governing Council has defined the monetary policy stance
necessary for maintaining price stability in the medium term, in line with its mandate as
defined by the Treaty, the ECB has the responsibility to also ensure the smooth functioning
of the segment of the money market that we influence. I should like to underline - once again
- that these two responsibilities are clearly distinct and should not be mixed.
Since early August last year, tensions have been observed in money markets and during the
last months banks expressed particular concerns about their liquidity needs over the
yearend. The year-end period is traditionally a period of scarce liquidity, as market activity is
subdued and banks are preparing their year-end balance sheets.
In its open market operations, the ECB therefore pursued its endeavour to contribute to the
smooth functioning of the euro money market. In early August, we responded to the sudden
upward pressures on the overnight interest rate by lending significant amounts of liquidity
through overnight fine-tuning operations. We also carried out, and later renewed, two
supplementary longer-term refinancing operations in order to reduce banks' concerns over
their longer-term funding during a period when the longer-term repo and deposit markets
turned illiquid. In the main refinancing operations the ECB has allotted larger amounts of
liquidity than under normal circumstances with an aim to limit the volatility of very short term
rates around the ECB's minimum bid rate. These large amounts of liquidity have always
been absorbed later on during the maintenance period, so that the ECB has only provided
banks with the liquidity needed for the fulfilment of their reserve requirements on average
over the maintenance periods. Let me also underline that we only provide such operations
against solid collateral, as always.
Just before Christmas we lengthened the maturity of the second last main refinancing
operation from one to two weeks, thus facilitating the coverage of the year-end liquidity
needs of banks. For this specific operation, we announced that we would satisfy all bids
received at 4.21 percent or above, the 4.21 percent level being the weighted average rate of
the previous main refinancing operation one week before. This action, combined with our
liquidity-absorbing operations until 4 January, contributed to a smooth end of the year in the
euro area by keeping short-term interest rates close to the ECB's minimum bid rate.
Overall, the ECB's actions permitted to maintain very short-term rates close to the ECB's
policy rate. The tensions, which have been observed in the longer term money market rates
in euro, are due in particular to the persistence of uncertainties surrounding the financial
health and liquidity needs of financial institutions as well as the impact of the ongoing global
financial market correction, with a general re-appreciation of risks. These tensions have
receded whilst remaining significant. By reducing the volatility of the very short-term rates
around the key policy rate of the ECB and by containing pressures in the interbank term
money market, the ECB's liquidity operations have contributed to a better resilience of the
European financial system without - of course - eliminating the causes of the tensions,
originating outside the money market.
During this tumultuous period, the Eurosystem remained, as usual, in close contact with
other major central banks. In this context, on 12 December the ECB, the Federal Reserve,
the Bank of England, the Bank of Canada and the Swiss National Bank announced
measures designed to address elevated pressures in short-term funding markets. In
particular, the ECB participated in joint action with the Federal Reserve and the Swiss
national Bank. The ECB provided a total of 20 billion US dollar in two auctions to Eurosystem
counterparties against ECB-eligible collateral.
Through its own actions as well as the joint efforts with other central banks, the Eurosystem
as well as the community of central banks have shown their capacity to cope with a number
of challenges that euro and global money markets are currently facing. More than ever, in
these periods of tensions, lucidity in the diagnosis, rapidity in the decision, and absence of
complacency are of the essence. This total absence of complacency is particularly necessary
as regards financial stability.
Financial stability
I would now like to share with you our assessment of the financial stability situation, as
described in the recent Financial Stability Review. I will discuss briefly the role of financial
institutions and supervisory authorities in coping with the present financial market correction.
With financial systems undergoing a process of de-leveraging and re-intermediation,
uncertainty surrounding the financial stability outlook for the euro area has heightened and
may persist until it becomes clear how the potential balance sheet effects of the turbulence
will be spread across individual financial institutions. Clarity is also needed concerning
liquidity commitments to off-balance sheet vehicles, and the magnitude of assets that may be
re-intermediated back onto the balance sheets of euro area financial institutions. The
process of improving clarity, which started when Q3 2007 financial statements became
available, will be advanced further when institutions publish their annual audited accounts for
2007 as a whole.
Given the uncertainties, the adjustment process in the financial system in the coming period
may be challenging, and we have to be prepared to the materialisation of risks at any time.
That being said, there are mitigating factors, including a broadly favourable economic
outlook, the largely sound balance sheets of households and firms, and the generally sound
capital positions of core financial firms. This should not, however, provide any grounds for
complacency given the heightened uncertainties. In a fluid environment where financial
system conditions may unexpectedly change, prudence is of the essence both for
policymakers and financial institutions.
Concerning the role of financial institutions and supervisory authorities in coping with the
financial turmoil, I would submit three observations. First, given the underlying factors of the
financial stress, and in order to re-establish confidence within the financial system, it is
crucial to promote a widespread consistent valuation of complex structured products as well
as an adequate disclosure by banks of all their exposures, in particular related to the US
subprime mortgage sector. Second, I would welcome the efforts of the supervisory community,
namely through the Basel Committee on Banking Supervision and the Committee of
European Banking Supervisors, in keeping each other abreast of developments and in
considering jointly possible measures to contain the potential effects of the turmoil. Third, I
would underline the importance in stress situations, like the current one, of effective and
smooth cooperation and exchange of information between the supervisory authorities and
central banks.
As to the policy lessons to be learned in order to avoid the recurrence of similar disruptions in
the future, I would say that, while it is still too early to draw definitive conclusions, there is a
common understanding on the key issues requiring further analysis. In this respect, let me
recall a few topics. First, the need for the financial industry to provide significantly more
public information about securitisation, credit risk transfer and complex structured products.
Transparency appears to be of the essence in order to restore trust and confidence. Second,
the need for rating agencies to review their methodologies for complex structured products
and to address very seriously potential conflicts of interest. Third, the need for investors to
review their investment behaviour excessively reliant on ratings. Fourth, the need for
supervisors to implement the new capital framework under Basel II as rapidly and effectively
as possible and to reflect on possible improvements of the framework, including the
enhancements of the supervisory regime for liquidity risk. In this context, I should mention
that the ECB with the assistance of the Banking Supervision Committee is carrying out work
on banks' stress-testing and contingency funding plans.
On all the issues mentioned above, work is already under way at both the international and
European level. The ECB is strongly supportive of the work of the Financial Stability Forum,
as well as of the European initiatives discussed in the ECOFIN Council. In this context, I
would like to once again stress the importance of effective cooperation in any policy actions
to be taken at the international level.
The impact of globalisation on price developments
Ladies and gentlemen, let me turn to the impact of globalisation on price developments. As a
preface, let me say that while globalisation could influence aggregate prices in several ways,
such impacts are limited to the short term given that inflation is ultimately a monetary
phenomenon.
The direct, and perhaps most visible effect of globalisation for consumers, is its implication
for relative prices. On the one hand, globalisation has dampened increases in euro area
import prices of manufactured goods given a rising share of imports from lower-cost
countries such as China and the new EU Member States. On the other hand, rising demand
associated with globalisation has contributed to the significant increases observed in world
energy and other commodity prices. Although such relative price shocks do not necessarily
affect inflation, prolonged short term impacts of sizeable relative price shocks could result, for
instance, from adjustment frictions in the economy. Empirical studies for the euro area have
tended to suggest a small dampening influence of trade openness on prices in the early part
of this decade, though globalisation's contribution to recent movements in commodity prices
- particularly energy and food - has had a significant offsetting upward impact on prices.
This warrants close monitoring, in particular given the risks of second round effects. In case
of food related commodities, it also underlines the importance of efficient supply side
adjustment in agricultural commodity markets.
A separate but nonetheless potentially equally important channel through which globalisation
can affect inflation involves the indirect price impact of increased competitive pressures, with
two main aspects. First, in principle it could contribute to compressing firms' price-cost
markups as competitive forces resulting from trade openness would depress profit mark-ups of
domestic firms competing with international firms. In practice, however, such effects have
been hard to identify and, indeed, aggregate profitability has remained high. Second, in
principle competition associated with globalisation could alter the responsiveness of prices to
costs or measures of economic slack, or imply a greater role for foreign conditions in the
inflation process. In practice, it would appear that such responsiveness has not increased
over the last decade, while empirical evidence supporting a growing role of global measures
of economic slack in the inflation process of the euro area and other advanced economies
has been limited.
On balance, not only is the net effect of globalisation on euro area prices difficult to
accurately gauge, but it may also be changing through time. For this reason, the ECB
continues to actively monitor possible ongoing changes in the inflation process. At the same
time, efficient adjustment can be best facilitated by focusing on price stability and continuing
to solidly anchor inflation expectations in the face of considerable relative price shocks.
Developments in the real estate sector
Let me conclude with some remarks on residential property prices. As with other asset
prices, residential property prices are closely monitored by the ECB in terms of our economic
analysis. Within this context, while we take the euro area real estate sector into account in
assessing risks to price stability, we certainly do not target house prices, or for that matter,
any other asset prices. We do monitor asset prices closely because of the potentially high
costs for price stability and for the economy as a whole that are associated with strong
appreciations and rapid reversals in asset prices. Also, our monetary analysis covers the
monitoring of money and credit which often reflect the evolution of prices and house
purchases. In this sense, a strategy which on top of our economic analysis regularly
assesses money and credit developments has an important benefit on the monitoring side in
that it can contribute to identifying and limiting the emergence of unsustainable
developments in asset prices.
In terms of recent developments in the euro area real estate sector, the latest available data
on house prices appears to support the notion of a cooling in euro area housing market
developments after a prolonged period of unusually high growth rates in many euro area
countries. That said house price growth generally remains relatively elevated in the euro area
on average when seen in historical perspective - notwithstanding considerable heterogeneity
in underlying country developments. The outlook for the euro area as a whole - I insist, for
the euro area as a whole - remains that of a relatively soft landing. Within this context, a
continued moderation of residential investment would also be likely.
I thank you for your attention.