lucas papademos : the economic outlook and the ecb ’ s monetary policy some key issues speech by mr lucas papademos, vice - president of the european central bank, at the nomura annual euro conference “ a challenging future for europe ”, tokyo, 11 november 2004. * * * introduction the annual euro conference in tokyo, which is now well established, provides a useful forum for examining various policy issues relating to the european economy, also from a global perspective. it is a great pleasure to have the opportunity to address you today and i thank you for the invitation. in my presentation, i would like to focus on two topics : • first, the state of, and outlook for, the euro area economy and the current stance of the ecb ’ s monetary policy. addressing this topic requires me to assess, in particular, the implications of increased oil prices for the euro area economy and the single monetary policy. • second, i thought it might be of particular interest to you to also address the challenges posed for monetary policy by large swings in asset prices, especially housing prices. given the japanese experience in the 1990s, it is particularly appropriate to re - examine here in tokyo the impact that large asset price swings can have on macroeconomic stability and the difficult choices for policy - makers confronting strong asset price dynamics. as you all know, these issues are not only of interest for japan ; they are of increasing relevance worldwide. the economic outlook and monetary policy in the euro area i will start by discussing the current state of the euro area economy and the medium - term economic outlook. the performance of the euro area economy this year is characterised by the ongoing recovery of economic activity at a pace somewhat faster than previously envisaged. inflation, however, has remained above ( though relatively close to ) 2 %. this outcome is not in line with our notion of price stability and is higher than the average inflation expected a year ago for 2004. the sharp rise in oil prices since the beginning of this year, by about 60 % ( in us dollar terms ), has been the main reason for the higher than earlier expected inflation. let me elaborate a bit on the pace of the economic recovery, the factors that have contributed so far to the pick - up in growth, and the conditions and basic factors that are expected to influence the mediumterm economic prospects. since the start of the economic recovery in the second half of 2003, we have seen robust growth rates in the first half of 2004, with real

of course, this assumption is made for the purpose of isolating the “ pure ” impact of the oil price shock. in reality, monetary policy has an important role to play in influencing the effects of oil price shocks on the economy. oil price shocks present policy - makers with difficult choices as they simultaneously pose upside risks to inflation and downside risks to growth. in responding to oil price shocks, it is essential to understand that policy - makers cannot offset the real effects of oil price increases. an oil price increase triggers a loss in the economy ’ s terms - of - trade and implies a transfer of wealth from oil - importing countries to oil exporters. this change in the terms - of - trade ( in relative prices ) requires an adjustment of the real economy and must be absorbed by markets. the policy - makers ’ aim should be to facilitate this adjustment by minimising inflationary pressures and aggregate output losses. in reacting to oil price shocks, it is, therefore, important that policy - makers do not repeat the mistakes of the past by attempting to stabilise output growth at unrealistic levels. in the 1970s, such attempts led to a prolonged period of high and costly inflation, rising unemployment and sizeable fiscal deficits. monetary policy should aim to ensure that inflation expectations are not adversely affected by the unavoidable “ first - round ” direct and indirect effects of an oil price shock on the price level and that they remain anchored to price stability. by preventing oil price shocks from having “ second - round ” effects on inflation expectations and on wage and price - setting behaviour, monetary policy can contain the unfavourable consequences of these shocks on both inflation and growth. it can prevent the fuelling of an inflationary spiral and the persistence of inflationary pressures, it can facilitate the real economy ’ s adjustment to the change in relative prices implied by the oil price shock, and it can thus help to minimise the associated output losses. this is why we at the ecb stress the need to be extremely vigilant against the materialisation of second - round effects that may result from a rise in oil prices. the ecb ’ s commitment to maintaining price stability in the euro area over the medium term implies that it will react promptly if there are indications that second - round effects are likely to emerge. asset prices and monetary policy as has become clear from the previous discussion, monetary policy - makers may face very difficult choices in the event of large swings in important economic