Challenges to ECB Credibility
Part 1: Fundamentals of ECB credibility Since its inception, the ECB’s price stability promise has been credible from the point of view of financial markets. This achievement can be ascribed to a large extent to the institutional framework governing monetary policy in the euro area, that is, for instance, the independence of the ECB, its price stability mandate and the requirements of the European Stability and Growth Pact (“Pact”). Some of the pillars of ECB credibility seem to be increasingly challenged: the structural weaknesses in the euro area economies, resulting in low growth, high unemployment and unsound fiscal balances, run the risk of eroding the consensus for price stability oriented monetary policy. In particular, a continuation of the lack of persistent fiscal policy discipline is likely to pose a serious threat for a stable currency going forward. That said, it is of the utmost importance for governments to adhere to the Pact’s requirements, e.g. achieve balanced budgets, and not only to continue but intensify reform efforts to improve economic growth perspectives. Part 2: ECB strategy review – the problem of the “open flank” An important outcome of the ECB’s strategy review was the de facto downgrading of the role of money. In view of the fact that (i) the ECB’s interest rate policy has been largely driven by actual rather than future inflation and (ii) inflation projections have been based on (real) economic rather than monetary developments, the rearrangement of the “two pillar strategy” appears to be a straightforward decision. However, it is certainly not supported by empirical evidence analysing the factors driving inflation in the euro area. Money – as measured through the “price gap” or “real money gap” – outperforms alternative measures, such as the “output gap”. Thus, it would have seemed rational to strengthen – rather than weaken – monetary analysis in the ECB strategy concept. As long as money demand is stable and the M3 price gap is a valid indicator for future inflation, M3 should be used – together with other variables – to derive the ECB’s inflation projections and play a greater role in the bank’s interest rate setting. Moreover, the rearranged “new strategy” runs the risk of increasing the bank’s open flank vis-à-vis political pressure, and provoking a more discretionary monetary policy, which could ultimately negatively affect the bank’s credibility. Part 3: Uncertainty – provoking pressure for easy monetary policy In the current low growth environment, accompanied by a high degree of uncertainty, calls for an even easier ECB monetary policy have gained momentum. However, our model approach – which rests on the so-called theory of the “option value of waiting” – shows that the impact of monetary policy on growth and employment is strongly diminished in an environment of high (revenue) uncertainty. This finding is actually based on the existence of sunk investment, e.g. hiring, costs. Against the background of the currently prevailing uncertainty, our model provides at least three important implications for ECB monetary policy: (1) cutting interest rates is not effective as long as high uncertainty continues to prevail; (2) by cutting rates under high uncertainty, the ECB reduces the option value of waiting, thereby reducing its effectiveness in future periods; and (3) a hectic ECB monetary policy, that is frequent interest rate changes, induces additional uncertainty to the economy which is likely to aggravate the weakness of investment and consumer goods demand. Part 4: ECB policy review and outlook Since December 2002, the ECB’s rate cuts appear to have been largely motivated by the decline in the HICP inflation and short-term business cycle considerations. The medium- to long-term inflation indicators, such as the “real money gap”, did not play an important role in the bank’s decisions. In the euro area, deflationary pressure is not discernible. Liquidity is very high with the “real money gap” having risen to more than 6%, representing a substantial inflation potential. Bank loan expansion, though having declined since 2000-Q3, does not suggest any supply side restrictions but seems to be in line with the cyclical position of the euro area. As things stand, the ECB is widely expected to lower rates further towards 1.5% until the end of this year. However, in view of the already very high money overhang and our inflation forecast of 1.8% for 2003 and 2.2% for 2004, such a policy might deteriorate the price stability outlook in the euro area. In the current economic environment, further monetary policy easing could run the risk of causing an “asset price inflation” and, in addition, reduce the economic incentives to bring about structural reforms in the euro area.
European Central Bank