John Hurley: Euro area monetary policy and EU enlargement
Speech by Mr John Hurley, Governor of the Central Bank and Financial Services Authority of Ireland,
to ACI Ireland, Dublin, 22 March 2004.
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First, let me say how pleased I am to have the opportunity to share some thoughts with you this
evening. I would like to begin by saying a little about the euro area monetary policy framework, which
was reviewed and clarified last year, before going to outline how monetary policy in the euro area has
been conducted in the first five years of EMU. I will then turn my attention to the current monetary
policy environment and recent exchange rate developments, before looking at some broader structural
and fiscal policy issues and, finally, speaking briefly about the imminent enlargement of the EU.
The euro area monetary policy framework
Turning on to euro area monetary policy, for just over five years now the euro area has had a single
currency and a single monetary policy conducted by the Governing Council of the ECB. The
introduction of the single currency has been an historical landmark. In twelve countries, the euro has
replaced the national currency and rapidly become part of everyday life. For the business community,
intra-euro area exchange rate volatility and the uncertainty it caused for trade and investment have
been eliminated. In the financial area, the role of the euro in global markets and the growth in the use
of the new currency outside the euro area over the past five years have also been impressive. The
euro has very quickly become an important part of the global financial system and the evidence of the
past five years is that its role will continue to grow for some time yet.
Within the euro area, the key challenge has been to formulate and implement the single monetary
policy. Since it is a "one size fits all" policy, many doubts were initially expressed about whether it was
possible or not to formulate a common monetary policy for such a diverse area. I think our experience
to date is that the policy is successful. In practice, the Governing Council formulates policy in much the
same way as many other central banks, that is, it focuses on controlling inflation. There are significant
benefits to be derived from keeping inflation low: it supports consumers purchasing power; it avoids
the misallocation of resources associated with inflation or deflation; it serves to reduce uncertainty and
risk premia in financial markets, ultimately facilitating lower medium and long-term interest rates, and it
is an important anchor for wage developments and for the enhancement of competitiveness in the
economy. In short, maintaining price stability is the key contribution that monetary policy can make to
achieving sustainable growth and job creation.
Being clear about its mandate, and how it fulfils it, helps a central bank to foster credibility. To ensure
that monetary policy firmly anchors inflation expectations from the very start the Governing Council
adopted a monetary policy strategy which is forward-looking, focussed on the medium-term and
broadly based. To be successful in maintaining price stability it is also important that the rationale for
decision-making is clearly understood. As I am sure you are aware, this is an area which had been the
subject of some criticism in the past. Reflecting this, after four years of experience, the monetary
policy strategy was reviewed and clarified in 2003.
Two important points of clarification emerged from this exercise, which address misunderstandings
which had emerged. First, as regards the definition of price stability, it has been clarified that the
objective is to maintain inflation, for the euro area as a whole, at a rate below but close to 2 per cent
over the medium-term. Second, as regards the assessment of the risks to price stability, the review
clarified the way in which the Governing Council integrates the signals coming from the economic
analysis, on the one hand, and the monetary analysis, on the other. In particular, it is made clear that
the monetary analysis mainly serves as a means of cross-checking, from a medium to long-term
perspective, the short to medium-term indications for inflation coming from the economic analysis.
The conduct of monetary policy since 1999
Having outlined how the Governing Council formulates and implements euro area monetary policy, I
would now like to make a short assessment of the conduct of that policy over the past five years. In its
early years, the single monetary policy has been conducted in a very testing environment,
characterised by a series of shocks. At various times in the past five years there have been periods of
exceptional economic, financial and geopolitical uncertainty. The first 18 months witnessed a tripling of
oil prices, the peak of the dotcom boom and a significant fall in the value of the euro. The subsequent
correction of the sizeable imbalances generated by the late 1990s boom, allied to heightened
geopolitical tensions, then triggered the most critical and sustained period of economic and financial
uncertainty witnessed in decades. This uncertainty persisted until last Spring, and while it has
unwound considerably since then, some of its effects still linger. On top of all this, we have also seen a
sharp appreciation of the euro, particularly against the dollar, which has taken it to a level that is higher
than at its initial launch. From that short outline, it is clear that the economic and financial environment
of the past five years has provided a stiff test of the single monetary policy.
Given this background, what has been the outcome? Over the past five years, the evidence indicates
that both inflation and inflation expectations, which signal the rate of price increase anticipated in the
future, have remained firmly under control. Since the beginning of 1999, indicators of long-term
inflation expectations in the euro area have remained below but close to 2 per cent. This suggests that
the new single monetary policy has been successful in anchoring long-term inflation expectations and
that the public and the markets are convinced about the determination to maintain price stability over
the medium-term. This has been a very significant achievement in a relatively short period of time and
has been an important factor in permitting euro area interest rates to fall to their lowest levels in
decades.
It should also be recalled that, before the establishment of the euro and the single monetary policy,
there were significant differences in long-term interest rate levels across countries. A key
achievement, and also an indication of the credibility of European Monetary Union, has been the
convergence of long-term interest rates to the lowest level prevailing in the area and not just to the
average level. This has helped to improve financing conditions in many parts of the euro area. Allied to
the fact that intra-euro area exchange rate volatility is also now a thing of the past, this has created a
much more favourable environment for consumers, the business community and investors.
Recent developments and background
In recent years, the main influence on monetary policy, both in the euro area and globally, has been
the heightened economic and financial uncertainty which persisted until mid-2003, and the
after-effects of which have still not fully dissipated. Against this background, already exceptionally low
global interest rates were reduced further. In the euro area, with inflation and inflation expectations
under control, the Governing Council lowered interest rates on two occasions, March and June 2003,
effectively bringing rates to levels equivalent to post-World War II lows.
For the euro area, 2003 was the third successive year in which economic growth decelerated. For the
year as a whole, the euro area economy grew by only 0.4 per cent, a most disappointing performance,
considering that the economy had already registered below potential growth in both 2001 and 2002.
However, these average figures mask the fact that, after several years of below par growth, a gradual
recovery in activity has been underway since around the middle of last year. The main impetus to the
euro area recovery has come from the improvement in the global economic performance, which, in
turn, reflects a number of factors. Initially, there was the unwinding of geopolitical uncertainties, which
facilitated a rebound in confidence, especially business confidence, over the second-half of last year.
More fundamentally, however, the recovery, particularly in the US, has acquired considerable
momentum from the sizeable policy stimulus put in place in recent years; indeed the scale of this
stimulus itself poses some medium-term risk to the continuation of the recovery there. Further
contributory factors were the performance of equity markets, which rallied considerably over the
course of last year, and also the unwinding of the investment overhang created during the late 1990s
boom, which removed an important headwind to growth. The improvement in the global economic
environment, however, does not simply reflect developments in the US. Growth has also resumed in
Japan, and accelerated in both the UK and East Asia, where, in both instances, the slowdown had
been less pronounced.
The current euro area monetary policy environment
In the case of the euro area, the recovery clearly has lagged that of most of the other major
economies. As was the case elsewhere, the strong gains in euro area business confidence, from last
summer onwards, suggested that growth was going to gather momentum. While third quarter data
seemed to confirm that recovery was taking hold, activity was being driven by a solid pick-up in
exports, with domestic demand remaining weak. Notwithstanding the rise in the value of the euro, the
stimulus from a more strongly growing global economy was driving euro area growth.
The scenario which appeared to be unfolding at that stage was one where stronger export growth
would generate a recovery in production. This would stimulate investment and would be followed, in
turn, by a pick-up in consumer spending.
Although this recovery scenario remains broadly in place, progress has been slow. While we have
seen an externally-led rebound which has boosted industrial production and helped generate some
rebound in investment, the recovery has not yet become broadly based. In particular, domestic
demand remains subdued. To a large extent, this reflects the weakness of consumer spending, which
has yet to show much sign of improvement. There has been only a modest recovery in consumer
confidence since the middle of last year. Continuing uncertainty about labour market prospects and job
security have not helped and may be leading households to maintain savings at somewhat higher
levels for precautionary motives. Moreover, more recently, the signals with regard to the nature of the
recovery have become somewhat mixed. They continue to point to expansion, but at a gradual pace.
For example, neither the level nor composition of recent fourth quarter GDP growth, where sluggish
consumption and net trade were offset by a strong inventory build-up, suggest that the momentum of
recovery is likely to accelerate in the near term.
Notwithstanding this, many of the conditions needed for a recovery in private demand are in place.
Most of the headwinds that have held back economic activity in the past couple of years have
dissipated. Real short-term and long-term interest rates are very low, making financing conditions very
favourable. In addition, the strong global recovery should help offset some of the drag resulting from
the strengthening of the euro.
However, while this should help ensure that the recovery continues, the pace of improvement seems
set to be slow. Against this background, there is likely to be little upward pressure on inflation and the
outlook for price stability in the medium-term is favourable.
That the recovery is taking so long to gain traction reflects the fact that there are still uncertainties and
risks to the outlook. In the near term, as I have mentioned already, these relate to the prospects for
euro area consumer spending. Until there is some improvement on this front, the euro area recovery
will continue to be unconvincing. The longer-term risks relate to concerns about the sustainability of
economic growth at the global level given the persistence of, both internal and external, imbalances in
some parts of the world. Both sets of risks suggest that a sustainable recovery cannot yet fully be
taken for granted, though it still remains the most likely prospect. While our view is that the current
stance of monetary policy remains appropriate, I can assure you that the Governing Council remains
vigilant and will closely watch developments in coming months.
Exchange rate developments
I would now like to say a few words about exchange rate developments, which, of course, the
Governing Council takes into account as part of the overall economic analysis. In the early years of
EMU, the relatively weak exchange rate of the euro placed exporters to markets outside the euro area
in a relatively favourable position. This is no longer the case. While exchange rate appreciation helps
to dampen inflation and ultimately improve purchasing power, it also obviously impacts on the net
trade position. So far, the positive effect of stronger global growth has outweighed the negative impact
of exchange rate appreciation on euro area exports. More recently, however, there has been some
evidence from sentiment indicators of a moderation in export orders, and industrial production fell in
January.
The euro has been trending upwards, both against the dollar and in overall terms, for just over two
years now, and there have been sizeable movements in exchange rates over the past six months. In
particular the appreciation of the euro accelerated considerably against the dollar and also Asian
currencies in late 2003 and the first half of January 2004. These movements were linked with
imbalances at the level of the global economy, such as the US current account deficit. They also
reflected the fixity of some Asian currencies vis-à-vis the US dollar, which led them to depreciate in
line with the US currency. The speed and strength of the appreciation of the euro over this period
raised concerns and, while the gradual and smooth correction of global imbalances is an important
medium-term issue for the global economy, it must be achieved in an appropriate manner. Viewed in
this way, excess volatility and disorderly movements in exchange rates are undesirable. The G-7
statement issued in Florida on 7 February recognised this risk. The statement emphasised that greater
flexibility in exchange rates is desirable for major countries or economic areas that lack such flexibility
to promote smooth and widespread adjustment in the international financial system, based on market
mechanisms. While I recognise that there have also been other factors at work, I am encouraged by
the fact that since the recent G-7 meeting, we have seen greater stability in foreign exchange markets.
The importance of an appropriate policy mix
I will now briefly touch on the issue of the euro area policy mix. There is sometimes a misconception
that the single monetary policy is in some way anti-growth. I can assure you that the single monetary
policy is not anti-growth. Not only has it had the positive effects I have described earlier - anchoring
long-term inflation expectations, thus, facilitating low short and long-term interest rates - the ethos of
the policy is not in any way opposed to growth. In fact the opposite is true. The aim is to support
growth. The Maastricht Treaty makes it clear that, while the primary objective of monetary policy is
price stability, the Eurosystem should, without prejudice to this objective, also take into account the
broader economic goals of the European Community. Sometimes it is overlooked that monetary policy
operates in tandem with other policies and there are strong complementarities between them.
Monetary policy has been successful in ensuring price stability and delivering low short and long-term
interest rates. However, other elements such as a sound fiscal policy, a stable macroeconomic
framework and sufficiently flexible labour and product markets are also necessary to achieve strong
and sustainable growth.
Structural Reform
Reflecting this, an important commitment of the Irish Presidency of the EU is to progress the structural
reform agenda. As a member of the Governing Council, I welcome this initiative. Why is structural
reform an issue for a central bank? There are a number of reasons. Increasing the efficiency with
which markets operate raises potential growth. Importantly, also, a more efficiently functioning
economy will utilise the resources available to a greater extent and, in doing so, will be less prone to
inflation. This extends the boundaries within which all economic policies, including monetary policy,
can operate without generating inflation. In effect, the economy will have a higher growth "speed limit"
i.e. it will be able to grow faster before inflation is likely to become a problem.
The structural reform agenda, set out in the Lisbon Strategy of 2000, aims to improve the functioning
and flexibility of euro area product and labour markets. This is to be achieved through raising
employment rates, education and skills levels and promoting technological innovation. While, in terms
of time, we are nearly halfway through the Lisbon process, progress in meeting targets has been slow.
While most EU countries have undertaken initiatives for labour market reforms in recent years,
achieving the target employment rate of 70 per cent of the working age population is still far off.
Moreover, further reforms are needed to allow wages to reflect more strongly regional and sectoral
productivity differences and also to improve education and training systems. The emphasis placed on
these issues is to be welcomed and their achievement has the potential to contribute materially to
boosting the long run sustainable growth rate of the euro area.
Stability and Growth Pact
The link between monetary and fiscal policy is, I think, readily appreciated. The Stability and Growth
Pact, together with the Maastricht deficit and debt objectives, constitutes the euro area's fiscal
framework. There are two main reasons why we need such a framework. First, given the divergent
structure between centralised monetary and exchange rate policy, on the one hand, and decentralised
fiscal policies (i.e. at the national level), on the other, a rule-based fiscal framework is necessary to
avoid conflicts between monetary and fiscal policy. By adhering to fiscal rules, within a broad
framework, divergent fiscal behaviour of individual Member States can be contained. This fiscal
discipline, in turn, supports low interest rates, which is essential for good long-term economic
performance. Secondly, and this will become increasingly important in the years ahead, low public
debt will help Member States to prepare for the budgetary impact of ageing populations.
As you are aware, however, there have been difficulties in the application of these rules. The recent
budgetary experiences of some large Eurozone countries demonstrate clearly the problems that can
arise in relation to the 3% deficit limit, especially when insufficient provision is made during economic
upturns. The decision by ECOFIN on November 25th to "hold in abeyance for the time being" the
excessive deficit procedure against these countries has given rise to much talk about the status of the
Pact. Clearly the Governing Council is concerned about this situation, because of the impact such an
action can have on the ECB's core mandate to attain and maintain price stability, and it respects the
Commission's decision to seek legal clarity in this regard. But, it is important to emphasise that, while
the Governing Council does not see a need for change in either the Treaty or the Pact, it does,
however, agree that it is possible to improve its implemention in certain respects. For instance, the
analysis of structural balances and the incentives to pursue sound fiscal policies in good times could
be strengthened and improved. And there si also scope to enhance the clarity and enforcability of the
framework overall. These are undoubtedely issues that will be considered in the future.
Enlargement
On 1 May, we look forward to having ten new members of the European Union. While the immediate
contribution (5 pre cent) to the level of output may be relatively modest, at a stroke the area of the EU
will expand by 25 per cent and its total population by 20 per cent.
In due course, also, enlargement could have major implications for the governance of the ECB.
Several acceding countries have signalled their intention to adopt the euro within the next few years,
and, most, if not all, may well be part of the euro area by the end of this decade. In the meantime,
there is much ground to be covered. The starting point for the acceding countries is that, once a
country joins the EU, it is obliged to treat its exchange rate policy as a matter of common interest and
it is in that context that the question of participation in the exchange rate mechanism arises. An
acceding country is not obliged to participate in ERM II, but is expected to do so and it can join the
mechanism at any point, subject to agreement on the central rate and fluctuation margins. Economic
conditions among the acceding countries differ greatly, as far as nominal and real convergence are
concerned: to give just one example, GDP per capita, as a percentage of the euro area average,
ranges from 37% in Latvia to 80% in Cyprus; but there are also significant differences in
unemployment, inflation rates, and fiscal positions. It, therefore, makes sense that, throughout the
process leading to the adoption of the euro, assessment be carried out on a case-by-case basis.
Participation in ERM II is something to which we in the Governing Council attach considerable
importance, as a preparation for the rigorous regime that lies ahead. For the acceding countries,
however, the focus is on the adoption of the euro, which will bring considerable benefits in terms of
greater policy credibility and the absence of exchange risk for much of their external trade. But,
ultimately, in the interests of the acceding countries themselves and in the interests of a successful
euro, the bottom line is that all those adopting the euro must be able to live with its constraints. Hence
the need for adequate preparation before adopting the euro and, indeed, joining the exchange rate
mechanism.
We in Ireland may have something to offer from our experience. Some of you will recall in the early
1980s, we had 20% inflation and twin deficits well into double figures. We resolved these difficulties by
the late 1980s, but still experienced pressure on exchange rate and monetary policy through most of
the wide band period as we tried to achieve nominal convergence, while containing some of the
pressures generated by real convergence. Some acceding countries are facing similar issues. Our
experience underscores the need for policy makers to be aware of the changes needed to help them
prepare for EMU. But, having said that, these are essentially short-term matters. Over the longer term,
the positive impact of accession on the EU economy could be immense. In particular, I would expect
the energy and dynamism released by the catching-up process to percolate through to the rest of the
EU, not least as a catalyst in creating a more competitive environment and in hastening structural
reform. Enlargement on this scale is unique, and we in Ireland, who currently occupy the presidency of
the EU, are privileged to have enlargement on our agenda.
Conclusion
The first five years of EMU can be considered a success. More than three hundred million consumers
and investors in the euro area have enjoyed the benefits of price stability, low nominal interest rates in
a single money market and the convenience of dealing in a single currency over a wide geographic
area. By maintaining price stability, monetary policy provides the basis for sustainable growth in output
and employment. But, for growth to materialise, the active support of fiscal policy and structural reform
is also required. I believe that there is a growing awareness across the euro area of the need for both
to play their part in addressing current problems and to prepare for the coming challenge, especially
that of ageing populations. I expect these issues to be centre stage over the next five years.