Vítor Constâncio: The performance of monetary policy during the past five
years
Speech by Mr Vítor Constâncio, Governor of the Bank of Portugal, at the dinner in honour of the
Governing Council of the European Central Bank, Queluz, 2 October 2003.
* * *
Prime Minister,
Minister of State and Finance,
President of the European Central Bank,
Colleagues,
Ladies and Gentlemen,
It gives me great pleasure to welcome you all in this place full of history on the occasion of a meeting
of the Governing Council of the European Central Bank. We meet twice a year outside Frankfurt and
this constitutes an important expression of the decentralized nature of the Eurosystem. It also
underlines the accountability of the ECB to all national constituencies and the importance we attach to
the need that our activity should be understood and supported by public opinion in all member states.
The decentralized system that we operate has worked well and it is therefore fortunate that the draft
Constitutional Treaty about to be discussed in the coming Inter-Governmental Conference, has left
untouched the basic principles and organization of the Eurosystem. I think this is wise in view of the
delicate balance that a major sharing of sovereignty among nations always requires and the need for
stability that monetary institutions always deserve.
European Monetary Union has been a great historical achievement and the past five years were
marked by several accomplishments: the smooth efficiency of its beginning, the building-up of a new
international institution, the successful introduction of euro notes and coins and, in particular, the
delivery of sound monetary policy. Many have contributed to make this possible but it is justifiable to
stress the importance of good leadership for the whole endeavour. So, I think it is appropriate to take
this opportunity to pay tribute and express our gratitude to Wim Duisenberg for his role as the first
President of the ECB. I am sure that time can only enhance the assessment of his contributions to
European monetary history. We were fortunate to have him as our leader but, at the same time, we
feel secure regarding the future as the Presidency passes into the experienced and competent hands
of Jean-Claude Trichet.
This is then a good moment to briefly take stock of the performance of monetary policy during the past
five years, both from a general perspective and from the point of view of a country such as Portugal.
With time and after the correction of an early depreciation of the euro with no basis in the
fundamentals, the public assessment of our monetary policy has become positive, both in the markets
and by academics. In fact, it has been impossible to ignore the good performance indicators. In the
first place, the overriding objective of price stability has been ensured with an average inflation for the
whole period of two per cent. This was accomplished in spite of supply shocks that negatively affected
the inflation rate, such as the sudden increase of oil prices from 1999 to 2001.
As important as the actual inflation rate achieved, stands the fact that we have managed to stabilize
the medium term expectations of markets regarding future inflation, at a value slightly below 2%. This
is a very important result as it means that the Eurosystem is seen as credible enough to deliver long
term price stability. This increases our margin of manoeuvre to reduce economic volatility and to better
ensure the overall objective of non inflationary growth. The Eurosystem, as the central bank of the
euro area, is now recognised as a credible institution and the euro as a robust and reliable currency.
Markets and economic agents in general have learned to understand the underlying framework of our
monetary policy with the important result that we have become a more predictable institution. This
implies that we can better manage expectations and implement monetary policy while maintaining
smooth functioning of money markets. At the same time, throughout this period, monetary policy has
been supportive of economic activity. Liquidity has been appropriate, as money supply and credit
growth were clearly favourable to economic expansion. Monetary policy cannot be made responsible
for the present weak economic conditions when the level of interest rates has been the lowest for
decades. In our case, we have to go back 45 years to find interbank market rates similar to the ones
now prevailing.
I stress this point not to contradict the idea that the best way for monetary policy to contribute to
longterm growth is by ensuring an economic climate of price stability. It is well known that monetary policy
is not able to directly affect the level or growth of potential output. The clear hierarchical mandate we
have to give priority to price stability, does not exclude the flexibility and pragmatism essential in the
implementation of policy in order to reduce short term volatility in an uncertain environment. Let me
recall just two examples. In April of 1999 our main refinancing rate was lowered to the then
unprecedented level of 2.5 per cent, when inflation was around 1 per cent and the economy was
showing signs of weakness. Focussed on avoiding possible deflationary risks, that decision meant that
the Governing Council was taking insurance against more negative developments which, although not
the most likely to occur, were nevertheless possible. The other example refers to the cut in rates
decided in May 2001 when headline inflation was above 3 per cent but the world economy seemed to
be on the brink of recession and there were no risks for medium term inflation.
This flexible approach was appropriate in both cases and was validated by subsequent events.
Monetary policy cannot be transformed into a dogmatic and mechanical science and it will always be
necessary to use good judgement to properly assess the balance of the risks regarding inflation
prospects. The same assessment of risks that is also essential to good communication with markets
which has become such a crucial part of the activity of central banks. The recent clarification of our
monetary strategy, in particular concerning the goal of price stability now defined as implying an
inflation rate «below but close to two per cent», was thus important to improve communication and to
ensure the continuation of good monetary policy for the euro area.
Turning now to our own national perspective, it is clear that Portugal has been a net beneficiary as a
participant in the European economic and monetary union. Among other things, we have taken
advantage of our trade interdependence with Europe through currency stability; we imported a low
inflation regime that is good for long-term growth and we have benefited from financial integration that
granted us lower bond rates and a lower cost of capital. There are obviously risks involved and the
need to adopt new and rigorous discipline concerning public finance and flexibility of markets in order
to achieve timely adjustment of wages and prices. In view of a past history of high inflation, Portugal
could be considered a good candidate to illustrate what some critics underline as the great difficulty of
a single monetary policy in dealing with a group of heterogeneous economies. In our case, however,
the performance of the economy throughout this period does not confirm these possible causes of
concern. Since 1999 Portugal has had an average positive inflation differential with the euro area of
only 1.2 per cent and an average annual output growth of 0.5 per cent higher than the one of our
partners. Considering the overall picture, the dispersion of inflation in the euro area, after only four
years, is remarkably similar to the one verified in much older monetary unions like the USA or Canada.
What some critics seem to forget is that monetary union itself contributes to the deepening of
economic and financial integration, by promoting the medium term convergence of inflation and the
synchronization of the business cycle. These developments contribute to dispel the risks of
asymmetric shocks in the future. What does not disappear is the risk of an initial period of excessive
expansion of expenditure and debt after joining a monetary union that guarantees a regime of low
inflation and low interest rates. We have felt the consequences of this hazardous development. The
economy, however, has automatic correcting mechanisms as economic agents soon have to begin
restraining their indebtedness and adjusting their spending. In spite of the restrictive nature of this
mechanism we could have achieved a gradual soft landing of the economy if two new factors had not
made their appearance: the strong deceleration of the world economy and the budget crisis that
emerged in 2001. The Government had to adopt difficult measures of budget consolidation to reduce
the structural deficit from -4.6 per cent of GDP to -2.5 per cent last year. The recession we are now
going through, with annual growth this year around -1 per cent, is making things more difficult for
fiscal policy. More than others, we would have justification not to comply exactly with the present fiscal
rules. However, as small nations always have to try harder, we still hope to be able to cope with the
situation, in spite of being very much dependent on developments of the world economy.
An economic recovery is definitely coming, even if some doubts remain about its intensity or duration.
In fact, uncertainties remain in connection to the large unbalances existing in some economies. It is
deceptive to think that everything can be solved by exchange rate adjustments. The problem is one of
saving rate insufficiency and will require internal financial adjustments.
In the process of global economic adjustment Europe should not bear the main burden of exchange
rate corrections. The responsibility of Europe is to implement the necessary reforms in order to
increase its rate of potential growth. We need to deal with the very serious consequences of negative
demographic developments, of technological shortfalls and the requirements to flexibly adjust markets
to the demands of the new international environment. We need good structural policies to restore
confidence in the future. These reforms are a condition to preserve the basic features of the European
model, that particular combination of stability, growth and social cohesion that has made Europe a
beacon of civilization. It is indeed in Europe that one can find the most humane and progressive
societies compatible with the human condition. But, in the present world environment, like in the
hegelian "aufhebung", we have to transform in order to maintain. What we have to preserve comes
from our common cultural heritage. If by society we mean a community of men living under a system
of «opinions, norms, desires and beliefs», then Ortega y Gasset was right to say that «the European
society has historically preceded all European nations». The reality of nations cannot, of course, be
ignored as they are our main form of socialization and the place where predominantly we exercise our
rights. But they are now part of a wider community. The euro is the more important manifestation of
our common bond and a great rampart that defends our economic and social autonomy. But more is
needed. A recent large inquiry organized by the German Marshall Fund showed that 71 per cent of
Europeans want the European Union to become an international power. The new Constitution, now in
preparation, is an opportunity to give form to what the present european consciousness expects of our
Union. Let us hope that, as a result of our endeavours, we will be able to say about the near future of
Europe what Ortega said about the role of culture: «a moment of clarity in the confusion of the world».