Nicholas C. Garganas

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Does One Size Fit All? Monetary Policy and
Integration in the Euro Area

• Nicholas C. Garganas
• Governor of the Bank of Greece

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Introduction

• The euro created new challenges for monetary
  policy
• How to build credibility the ECBs Monetary
  Policy Strategy would be crucial.
• Does One Size fit all?
• Traditional OCA view overlooks endogeneity of
  criteria used to judge optimality.
• Argument here creation of a monetary union can
  itself create the conditions favourable to its
  operation

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The ECBs Monetary Policy Strategy

• Adopted in 1998 and confirmed with clarifications
  in 2003.
• Drew on decades of central bank policy experience
  and the strategies of the most successful central
  banks in the euro area.
• Three key elements

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Price Stability Objective

• Monetary policy contributes to economic welfare
  by focusing on price stability.
• defined as a year-on-year increase in consumer
  prices for the euro area of below, but close
  to, 2 percent.
• to be maintained in the medium term, in light of
  the long lags involved in the transmission of
  monetary policy.

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The two analytical pillars

• Economic analysis assessment of economic and
  financial developments from the perspective of
  the interplay between supply and demand in the
  product and factor markets provides
  short-to-medium-term indications of inflation.
• Monetary analysis a cross-check to the economic
  analysis focuses on monetary developments in
  recognition of the link between monetary growth
  and inflation in the medium to long run.

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Independence counterbalanced by Accountability,
Transparency

• The Maastricht Treaty granted full political
  independence to the ECB in its pursuit of price
  stability.
• Central bank independence needs to be
  counterbalanced by accountability.
• Accountability requires transparency with respect
  to both objectives and decision-making.

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ECBs record over the last 9 years

• Low levels of inflation
• Average inflation of 2.03 percent in the euro
  area since its inception
• Low inflation expectations
• Low interest rates

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• Inflation expectations remarkable close to ECBs
  definition of price stability.
• Long-term interest rates at historically low
  levels.

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Notes to Figure 2

• (1) The ten-year break-even inflation rate
  reflects the average value of inflation
  expectations over the maturity of the
  index-linked bond. It is calculated as the
  difference between the nominal yield on a
  standard bond and the real yield on an inflation
  index-linked bond, issued by the same issuer and
  with similar maturity.
• (2) Issued by the French Government linked to the
  French CPI excluding tobacco.
• (3) Issued by the French Government linked to the
  euro area HICP excluding tobacco.
• (4) Survey of Professional Forecasters conducted
  by the ECB on different variables at different
  horizons. Participants are experts affiliated
  with institutions based with the European Union.
  This measure of long-term inflation expectations
  refers to an annual rate of HICP expected to
  prevail five years ahead.
• (5) Survey of prominent financial and economic
  forecasters as published by Consensus Economics
  Inc. This measure of long-term inflation
  expectations refers to an annual rate of
  inflation expected to prevail between six and ten
  years ahead.
• Sources ECB and Consensus Economics Inc.

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Does One-Size Monetary Policy Fit All?

• While the success of monetary union in delivering
  low inflation and a credible monetary policy is
  beyond dispute, the issue of whether a single
  monetary policy can fit all members states of
  the euro area continues to be hotly debated.

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EMU an Optimum-Currency-Area perspective

• EMU brought unique challenges to monetary policy.
• Critical observers took the view that EMU was
  doomed to failure euro area is not an OCA
• Lack of labour mobility
• Absence of centralised fiscal transfer mechanism.

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• Shocks lead to widening inflation differentials
• Single nominal interest rate widening inflation
  differentials diverging real interest rates
• High inflation countries have low real interest
  rates which further fuels inflation
• Low inflation countries have high real interest
  rates which puts downward pressure on inflation
• Conclusion one-size does not fit all.

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OCAs the new view

• Participation in monetary union may itself induce
  changes in economic structure and performance.
• This is what academic research shows.
• This is what the experience of the euro area
  shows two channels have helped.

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Channel 1 Enhanced Credibility

• Credibility gain derived from eliminating the
  inflationary bias of discretionary monetary
  policy
• No devaluation risks hence interest rates are
  lower
• Low and stable inflation and inflationary
  expectations lengthen economic horizons.

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Channel 2 trade and financial integration

• Trade creation effects of a common currency
• Single currency removes costs of conversion
• Future competitive devaluations are precluded
• Foreign direct investment is facilitated.
• Promotion of reciprocal trade, economic and
  financial integration and the accumulation of
  knowledge.

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Channel 2 trade and financial integration cont.

• Euro area experience
• Intra-euro-area trade in goods has grown
• Intra-euro-area trade in services has grown
• Intra-euro-area foreign direct investment has
  more than doubled.
• Increased trade integration leads to more
  highly-correlated business cycles.

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Notes to Figure 3

• The rolling business cycle correlations are
  constructed by calculating the pairwise
  correlation coefficients between all euro area
  countries for the various 4-year periods
  (1997-2000, 1998-2001, etc). The average of these
  coefficients is calculated for each time period.
• Data source EU AMECO database

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Channel 2 trade and financial integration cont.

• Additional reasons why monetary union reduces
  incidence of country-specific shocks
• Principle cause of asymmetric shocks divergent
  monetary policies no longer exists
• Deeper financial market integration.

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Channel 2 trade and financial integration cont.

• Introduction of euro helped make financial
  markets more integrated
• Money market almost perfectly integrated since
  start of EMU
• Corporate bond market significant growth

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Narrowing of spreads on government bonds
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Higher correlation of equity market returns
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Forces for further financial integration

• Market participants will increasingly exploit the
  new environment.
• A number of initiatives supported by
  Eurosystem/Commission
• eg TARGET2.
• Monetary transmission mechanisms will continue to
  converge.

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• To the extent that countries continue to
  experience asymmetric shocks or asymmetric
  responses to common shocks, financial integration
  can help members of a union insure against the
  effect of such shocks.

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Inflation and Growth Differentials

• Despite increased trade and financial
  integration, divergences in economic performance
  continue to exist.
• How significant are these divergences?
• How concerned should we be?

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Inflation dispersion in the euro area

• Between 1990 and 1999, inflation dispersion fell
  from 6 percentage points in early 1990s to 1
  percentage point in the second half of 1999.
• Subsequently it has remained at around 1
  percentage point.
• It does not differ that much from dispersion
  across the US.

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Inflation dispersion in the euro area cont.

• Where the euro area does differ from the US is
  that the observed differentials seem to be more
  persistent.
• Balassa-Samuelson effect?
• Adjustment mechanisms in the euro area not
  functioning as smoothly as they might.
• Non-monetary policies are not consistent with
  inflation rates close to euro area average.

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Inflation dispersion in the euro area cont.

• Other factors contributing to inflation
  differentials include
• Misaligned fiscal policies
• Wage dynamics not linked to productivity
  developments
• Structural inefficiencies such as rigidities in
  product and factor markets.

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Dispersion of real GDP growth

• The process of nominal convergence was not
  accompanied by a greater dispersion of real GDP
  growth rates.

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Inflation and growth rates seem to move
together..
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Dispersion of real GDP growth cont.

• Countries with higher than average growth rates
  have higher than average inflation.
• This suggests that the dampening effect of the
  loss of competitiveness has been offset by
• - interest rate falls in run-up to EMU
• - inflows of EU structural funds
• - immigration
• - financial liberalisation.

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Conclusions

• The single-size monetary policy has worked
  extremely well in the euro area.
• This is the result of endogenous changes brought
  about by the very existence of the monetary
  union
• Increased trade and financial integration
• Credibility of ECB which has delivered low
  interest rates and inflation.

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Conclusions cont.

• This is not sufficient alone to increase economic
  growth and raise living standards.
• Need to increase flexibility of product and
  labour markets.
• 2001-2005 euro area growth weak dispersion of
  inflation and growth rates persistent.

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Conclusions cont.

• A number of countries undertook structural
  reforms.
• Fruits of reforms began to emerge in second half
  of 2004
• Unemployment began to fall.
• Structural impediments, however, still exist
• Reflected in high unemployment and low
  participation rates.

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Conclusions cont.

• Fiscal developments have been favourable in
  recent years.
• However, only a small part has been due to policy
  measures.
• Need to sustain the momentum and accelerate the
  pace of fiscal consolidation in the euro area.

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Conclusions cont.

• The euro area has come a long way the success
  of the single currency has demonstrated that one
  size can fit all.
• Much more needs to be done to ensure that the
  euro area becomes a more dynamic force for
  growth.
• Need for more flexibility in factor and product
  markets
• Need for greater competition.