ECB Observer

Part 1: A case against ECB FX market interventions We argue against ECB FX market interventions. Our most important considerations are: (1) To support the US dollar against the euro, the ECB would have to pursue an expansionary policy, thereby causing inflation to rise in the future. (2) Empirical evidence shows that appreciations of the euro exchange rate do not cause the negative effects on (German) exports that are widely put forward as an argument for an ECB intervention. (3) Assuming forward-looking market agents, monetary policy cannot influence the real exchange rate – which is the relevant variable for ex-ports – at will and on a systematic basis. (4) FX market interventions run the risk of becoming destabilising. (5) Reducing economic incentives to bring about structural reforms and process and product innovations, thereby damages growth and thus employment in the euro area. Part 2: “Price gaps” and US inflation Empirical analyses on the relationship between money and inflation in the US suggest that the so-called “price gap” – that is the stock of money which has not yet been absorbed by increases in output and prices – has considerably power for explaining US consumer price inflation; “money matters,” even in the US. However, the income velocities of monetary aggregates do not show a “deterministic trend stationarity”. As a result, the US Federal Reserve (Fed) cannot – like, for in-stance, the ECB – make its interest rate decisions solely dependent on money growth. A careful interpretation of the current US monetary developments suggests that inflation is going to accelerate (slightly) going forward; deflationary tendencies are not discernible from the point of view of monetary conditions. Part 3: “Price gaps” and euro area inflation In the euro area, the price gap on the basis of M3 is an inflation indicator par excellence; it outperforms alternative indicators such as, for instance, the output gap, the exchange rate and unemployment. The price gap M3 is particularly useful when it is calculated on the basis of the trend path of M3. Alternative specifications such “Divisia” monetary aggregates are no better than M3 for inflation-forecasting exercises. Against this background it would be rational for the ECB to focus on the price gap M3 (“monetary analysis”) rather than other indicators (“economic analysis”) when setting rates. That said, the bank’s decision to downgrade the role of M3 in its policy, as happened in the last strategy revision, is hard to understand. The actual price gap M3 indicates considerable inflation potential: the liquidity built up would be sufficient to increase the euro area price level by around 7.0% on a persistent basis. Part 4: ECB rate and euro inflation outlook Money and credit supply in the euro area suggests a need for higher central bank interest rates to reduce (the increase in) the price gap M3; it is hard to see that currently prevailing real short-term interest rates will be compatible with low inflation. It is unlikely that the excess liquidity, which has been built up in the past, will be fully absorbed by higher production. On the basis of our forecast model, euro area inflation will start to rise, being, on average, 2.1% in 2004 and 2.2% in 2005. – In particular, we see the risk that excess liquidity in the US as well as in the euro area could cause, in a first wave, asset price inflation (on the stock, bond and housing markets) before driving up consumer prices. The inevitable correction of such a development could prove highly costly as far as output and employment are concerned, and thus warrants attention by monetary policy makers. This is why we conclude: “Too much money is chasing too few goods.”