Ladies and Gentlemen,
I should like to begin by saying what a great honour and pleasure it is for me to be here in Murcia and to address such a distinguished audience. At the same time, I would like to thank the Economics and Social Council of the Region of Murcia for this invitation.
In my speech today, I will concentrate on the issue of inflation differentials in the euro area, a topic closely related to the interesting book on “Labour Costs and Productivity in the Economy of the Region of Murcia” that has been presented earlier.
The question on how to deal with heterogeneity in a diversified single currency area has been an issue at the heart of the debate in Europe all along the road towards deeper economic integration and already well before the single currency was introduced.
The terms of the debate are very familiar. Economic and Monetary Union (EMU) has created the conditions necessary for sizeable gains in terms of prosperity and welfare for the European people. At the same time, monetary policy in EMU is being conducted by the Governing Council of the ECB with the primary objective of maintaining price stability in the euro area as a whole. Monetary policy does not, therefore, directly address differences in inflation rates or other national economic developments that may emerge across the euro area.
While inflation differentials are a normal phenomenon in any monetary union, their occurrence in the euro area context is combined with institutional and economic characteristics that are, to a large extent, unique, such as limited labour mobility, rigidities in labour and product markets, a lack of significant centralised fiscal transfer mechanisms and decentralised responsibility for fiscal and other economic policies. Under these circumstances, differences in macroeconomic performance, in general, and price developments, in particular, across the countries of the euro area have attracted substantial public attention since the introduction of the euro.
I would today like to address the main features and possible causes of inflation differentials in the euro area and to discuss their implications for economic policies and the single monetary policy. Let me start with recent developments in inflation differentials in the euro area.
The dispersion of inflation across the euro area countries has broadly stabilised since the inception of the euro. Looking back towards the beginning of the 1990s, the degree of inflation dispersion, measured as the (unweighted) standard deviation among the 12 euro area Member States, was characterised by a strong downward trend. The high degree of dispersion, of around 6 percentage points, observed in the early 1990s was mainly the result of very high levels of inflation in a few countries. Between 1994 and 1998, inflation dispersion continued to decline, reaching its lowest level since the start of the Stage Three of EMU, namely less than 1 percentage point, around the second half of 1999. Since then, with the exception of a modest increase over the period from 2000 to 2002, the level of inflation dispersion across the euro area has changed very little. By way of comparison, since 1999, inflation dispersion across the euro area has been fluctuating close to the level observed across the 14 metropolitan statistical areas in the United States.
At the same time, inflation differentials in the euro area appear to be very persistent, in the sense that many countries have systematically maintained either a positive or a negative inflation gap against the euro area average since the introduction of the euro. This persistence of inflation differentials seems to be a feature specific to the euro area, where seven of the 12 economies have recorded annual inflation rates that have remained either consistently above or consistently below the euro area average since 1999.
A first insight into the possible causes of the persistence of inflation differentials in the euro area can be gained by studying their underlying determinants, namely internal factors – such as the unit labour costs, profit margins and net indirect taxes – and external factors – such as the import prices. In 9 of the 12 countries, internal factors were the most important contributors to the inflation differentials in relation to the euro area average. Import costs also played a major role in a few cases (Belgium, France and Luxembourg). As regards the internal sources of inflation differentials, the main contributions to the differentials came from unit labour costs and the gross operating surplus. In Germany, France and Finland, in particular, below-average dynamics in terms of both unit labour costs and the gross operating surplus contributed significantly to the negative inflation differentials of those countries in relation to the euro area average. By contrast, the positive gaps for Greece, Ireland, Italy and Spain were the result of dynamics above the euro area average in both unit labour costs and profits.
The diversity of inflation rates among euro area countries also has an important sectoral dimension. Overall, the degree of dispersion in the upward movement of services prices across the euro area countries remained higher than that observed for the Harmonised Index of Consumer Prices (HICP) as a whole. By contrast, the rates of increase in non-energy industrial goods prices converged significantly throughout the 1990s and levelled off at a low level of dispersion from 1999 onwards. The low level of dispersion in this sector is likely to have been the result of the process of convergence in price levels observed in the countries of the euro area. This process was given significant impetus by the implementation of the Single Market Programme in the first half of the 1990s and continued with the introduction of the single currency.
Overall, several elements can be identified as being important in accounting for the persistence of euro area inflation differentials, such as wage dynamics, the role of the services sector and the different degrees of openness of national economies to international trade. However, the evidence available indicates that there is no single factor that explains the persistence of inflation differentials across euro area economies. Let me now focus on the origins of inflation differentials.
In order to ascertain the potential policy implications of persistent inflation differentials, it is necessary to properly identify their underlying causes. However, this is not an easy task because, in a large monetary union like the euro area, a number of factors may contribute to inflation divergence. I will focus on the main factors that have been put forward to explain the existence of long-lasting inflation differentials in the euro area. It is useful to make a distinction between: (i) transitory factors related to the convergence process; (ii) factors related to long-lasting or permanent differences in national economic structures; and (iii) policy-induced factors related to the conduct and operation of national fiscal and structural policies or to the various regional responses to euro area-wide policies.
Starting with inflation differentials that were caused by the process of convergence prior to Stage Three of EMU, the one-off convergence of nominal interest rates towards the low rates prevailing in the best-performing countries in terms of credibility was an important temporary factor shaping inflation differentials in the first years of the euro area’s existence. The adoption of the euro led to a significant reduction in both nominal and real interest rates and in financial costs in countries that had experienced higher inflation rates in the past, as well as a higher degree of integration with the capital markets of the rest of the euro area. This contributed to a surge in domestic demand in those countries, exerting sustained upward pressure on prices, particularly in the non-tradable goods and services sectors.
A second important factor was the implementation of the Single Market Programme in the first half of the 1990s and the subsequent introduction of the euro in 1999. Both contributed to a marked decline in price level dispersion, mainly for tradable goods, which has also contributed to generating some of the inflation differentials observed in the first years of the euro. Looking ahead, the importance of this type of price level convergence for euro area inflation differentials should diminish over time.
While market integration and increased cross-border price transparency has led to convergence in the price of traded goods, a large proportion of consumer price inflation is accounted for by prices of goods and services that are not traded between countries. In this respect, the Balassa-Samuelson effect has often been discussed in relation to persistent inflation differentials in the euro area. At the centre of the Balassa-Samuelson hypothesis are differences in productivity growth in countries’ tradable and non-tradable goods sectors. In essence, this theory states that countries with large differences between their labour productivity growth rates in the tradable and non-tradable goods sectors – due, for instance, to a process of catching-up in income levels – will tend to also experience a higher overall inflation rates. The Balassa-Samuelson effect reflects an equilibrium phenomenon: while international competition ensures downward pressure on prices in the tradable goods sector, price pressures arise only in the non-tradable sector and there is no need to reabsorb the resulting inflation differentials across countries. Opinions differ as to the extent to which the Balassa-Samuelson hypothesis is relevant to the euro area, partly because it is difficult to quantify the effect with any precision. Overall, there is a growing consensus that this effect constitutes only a partial explanation for the persistent inflation differentials observed in the euro area. Moreover, the size of the Balassa-Samuelson effect for countries currently in the euro area is likely to diminish over time, given that there has already been substantial convergence among those countries in terms of GDP per capita.
Turning to inflation differentials that have their origins in structural differences, and are thus of a more long-lasting nature, one factor that may contribute to lasting inflation and output differentials in a single currency area relates to the differences across countries in households’ preferences regarding consumption. This heterogeneity is reflected in the fact that the shares of the various goods and services in national consumption differ from country to country, and thus have different weights in the respective national HICP. However, empirical evidence has shown that this factor contributes relatively little to the inflation dispersion observed in the euro area.
The divergence in inflation rates within the euro area may also have an external dimension related to member countries’ exposure to changes in the exchange rate of the euro and in prices of raw materials. In particular, fluctuations in the exchange rate of the euro, coupled with differences in the degree of openness, in the composition of international trade and in trade links with non-euro area partner countries, might be relevant factors behind inflation differentials.
An important structural factor relates to rigidities in wage and price-setting. The process of adaptation to changing economic conditions typically requires the continuous adjustment of relative prices across regions and sectors. Such a mechanism, which is a normal and desirable feature of a market-based economy, may give rise to short-lived inflation differentials across the regions and sectors of a monetary union in the face of demand and supply shocks. However, the presence of rigidities affecting the price and wage formation mechanism delays the necessary adjustment and gives rise to distortions in relative prices after such shocks, thereby contributing to lasting inflation differentials. Recent provisional evidence from the Eurosystem Inflation Persistence Network – a research network of the Eurosystem studying the pricing behaviour of firms – helps to shed light on the importance of rigidities in the price-setting behaviour of firms in the euro area. For instance, the Network calculates that average consumer price duration – the time elapsing between two successive price changes – in the euro area is between four and five quarters, compared with an estimate of around two quarters for the United States. This seems to indicate that, on average, there is greater rigidity in price-setting in the euro area than in the United States. Looking at the sectoral pattern, energy and unprocessed food prices seem to change most frequently, while services prices appear to be modified less frequently. If services prices are indeed characterised by a systematically longer adjustment process, this could, given the large weight of this sector in the economy, generate significant and persistent inflation divergence.
This conclusion would seem to sit well with the evidence I have cited earlier that the services sector (which accounts for most of the price dynamics of the non-tradable sector) contributes significantly to overall inflation dispersion. It is also corroborated by the evidence on the importance of unit labour costs in explaining differentials in changes in inflation across the euro area. Overall, this suggests that a substantial part of the persistent divergence of price developments may stem from differences in wage developments and in wage-setting mechanisms across euro area countries, including – in some countries – the automatic indexation of nominal wages to prices.
Finally, both area-wide and regional policies may themselves shape the degree of heterogeneity in a currency union. Fiscal policies in particular may be one of the sources of inflation and output differentials in the euro area. First, changes in administered prices, which account for around 6% of the HICP, and indirect taxes can add to inflation dispersion, at least in the short to medium term. More importantly, fiscal policy can also help to create or reinforce inflation differentials through the inappropriate use of fiscal instruments. In this respect, there is some evidence that the pro-cyclical effects of the fiscal policies of euro area countries may have helped to increase cyclical differences among euro area countries in the recent past.
Monetary policy in a currency union can also add to inflation dispersion via its differentiated transmission across countries, particularly in the presence of differing degrees of nominal rigidities. In this respect, however, there is no conclusive evidence of systematic differences in the transmission of monetary policy impulses across euro area countries. The effects of monetary policy depend critically on the monetary policy regime in place, and the change in policy regime due to the introduction of the euro may have modified the transmission mechanism of monetary policy across euro area countries, making it more difficult to properly extrapolate from historical experience.
Furthermore, in the public and political domains, it has been often argued that the combination of uniform interest rates and inflation differentials imply different “real” interest rates across countries. Such a difference may have a destabilising impact on national economies because, for example, countries with above-average inflation experience lower real interest rates, which would, in turn, fuel domestic demand and inflation. And countries with below-average inflation would register higher real interest rates, resulting in further downward pressure on domestic demand and inflation and, thereby, adding further to the original inflation differentials.
In my opinion, these views are, to a large extent, misleading, and they do not take all the underlying factors into account.
First of all, the aforementioned argument is generally made with reference to ex post measures of the real interest rate, calculated by subtracting the currently observed level of inflation from nominal interest rates. By contrast, what matters for investment and consumption decisions are ex ante measures of real interest rates, namely the difference between market interest rates and economic agents’ expectations with regard to inflation developments over the relevant horizon. In this respect, the dispersion across countries of ex ante measures of real interest rates is significantly lower than that of ex post measures. In the case of long-term interest rates, the dispersion of ex ante measures of real interest rates has been approximately half that of real interest rates measured using realised inflation since 1999. Furthermore, again since 1999, the dispersion of ex ante measures of real interest rates has been about one-third of that prevailing before the inception of the euro.
Second, and perhaps even more fundamentally, the consequences of inflation differentials – and thus of different real interest rates – obviously depend on the underlying causes, which – as mentioned earlier – are manifold. For example, if a country’s lower-than-average inflation rate is due to higher-than-average productivity growth, this would be an indication that the country in question has strong investment prospects, even if its observed real interest rate is higher than that of other countries.
Finally, in a monetary union, where exchange rates among countries are fixed by definition, there are strong market-based forces that work in a stabilising manner. In particular, if a country has below-average inflation on account of weak demand, it will become more competitive in relation to other countries. This tends over time to increase demand in that country (and to reduce it in others). As shown in a number of recent studies, the competitiveness (“real exchange rate”) channel, although slow to build up, eventually becomes the dominant adjustment factor. In this respect, it must be noted that, as a consequence of the prolonged inflation differentials observed, the euro area countries have experienced marked differences in terms of the evolution of the indicator of national competitiveness.
In conclusion of this long list of possible determinants, let me add that I tend to view inflation differentials across countries as a normal feature and as an integral part of the adjustment mechanism of relative prices in a single currency area and, as such, they are not only unavoidable, but also desirable. At the same time, we need to be aware of the fact that such re-equilibrating mechanisms sometimes appear slow to operate in the euro area, and some of the persistent divergences observed may indeed be harmful if not seriously addressed by policy-makers.
Would it be wise for policy-makers to ignore these concerns? I do not think so, but what can policy-makers do to take divergence into account? I will try to give an answer to this question in two steps. First, I will briefly consider the role of structural and fiscal policies. Then I will focus on the implication of inflation differentials for the ECB’s monetary policy.
Starting from structural policies, it is widely recognised that two elements are crucial to the smooth adjustment to changing economic conditions and the efficient functioning of the labour and product markets of a single currency area: first, the mobility of factors of production and, second, the flexibility of wage and price-setting behaviour.
On the mobility of factors of production, a clear dichotomy can be observed in the euro area. On the one hand, the process of integrating financial markets has already come a long way. Although further action is needed to remove the remaining market segmentation and regulatory impediments to free competition, a continuous increase in cross-border financial and capital flows is being observed, as well as increasing competition in the provision of financial services. On the other hand, the other main factor of production – labour – appears either to be too slow to react to wage and demand signals or is prevented from doing so by persistently distorted price signals, leading to relatively low labour mobility between countries and regions, as well as between sectors and professions. This points towards a need for more flexible labour markets in the context of EMU, particularly at the national and regional levels. In this respect, while some discernible progress with regard to labour market reform has been seen in almost all countries of the euro area over the past decade, labour markets there still appear to be too rigid and unresponsive to economic conditions – as indicated by the persistently high level of structural unemployment and the low labour force participation rates observed in most countries.
On the flexibility in wage and price-setting, it is crucial to continue the process of strengthening effective competition, for instance through liberalisation and deregulation, in order to improve the efficiency of price signals in the goods and services markets, thereby enhancing the efficiency of resource allocation in the economy.
Turning to fiscal policies, it is clear that proper fiscal reforms can also help to enhance the ability of individual countries to respond to economic shocks and reduce the potentially damaging effects of prolonged inflation differentials. In particular, sound government finances are crucial in order for individual countries to be able to let automatic stabilisers work fully without running the risk of excessively high deficits. This represents an important mechanism in the process of macroeconomic adjustment in response to regional divergence. Historical experience shows that discretionary fiscal policies are – especially in view of the implementation and impact lags involved – a blunt instrument when it comes to responding to cyclical fluctuations. It is particularly important in this respect that governments prevent discretionary policy measures from acting pro-cyclically over the business cycle, thereby exacerbating divergence across countries after asymmetric shocks.
All in all, structural and fiscal policies that are aimed at fostering a greater mobility of production factors, in particular labour, and more flexibility in price and wage-setting can increase the power of those re-equilibrating mechanisms that sometimes appear too slow to operate in the euro area.
Moving to the side of monetary policy, I must say that the establishment of the euro area spurred a far-ranging academic, but also political, debate on the proper design and conduct of monetary policy in a monetary union. More recently, these discussions have also tended to highlight more direct implications of inflation differentials for the formulation of monetary policy in a single currency area, particularly where such differentials are coupled with, or are the product of, nominal and real structural rigidities. For this whole debate, some important general conclusions can be drawn.
First, there is a broad consensus among academics, observers and policy-makers that monetary policy should focus on maintaining price stability in the single currency area as a whole. Thus, monetary policy should anchor inflation expectations and increase market transparency, thereby facilitating the necessary adjustment of relative prices across different countries or sectors in the presence of economic shocks. By contrast, it is widely recognised that assigning to monetary policy the additional role of directly addressing the relative balance between the sectors or regions of the single currency area in the process of adjustment to shocks would overburden monetary policy to the detriment of its primary role.
Second, the presence of long-term equilibrium inflation differentials across countries may constitute an additional reason – together with other prominent reasons – for the central bank to aim for maintaining the inflation rate in the currency area as a whole at a very low level, but not too close to zero.
Third, it is important for the central bank to take into account regional and sectoral information on the source and nature of economic shocks, including monitoring and understanding the underlying reasons for inflation differentials, even if it formulates its policy with a view to maintaining price stability for the currency area as a whole.
Finally, by maintaining a medium-term orientation in the conduct of its monetary policy, a central bank is able to facilitate the necessary adjustment of relative prices across regions and sectors in the presence of asymmetric shocks.
Let me say that those principles are indeed present in the ECB’s monetary policy strategy.
First, as laid down in the Treaty, the primary objective of the ECB is to maintain price stability for the euro area as a whole. By keeping price levels stable, monetary policy contributes to the adjustment of relative prices and facilitates their role in guiding the allocation of resources across the sectors and countries of the euro area. This is the best contribution that monetary policy can make to economic welfare and the attainment of high levels of economic activity and employment. In May 2003 – as part of its review of the ECB’s monetary policy strategy – the Governing Council of the ECB clarified its price stability objective, explaining that, in pursuing price stability, it aims to maintain inflation rates “below but close to 2%” over the medium term. In aiming to keep the inflation rate close to the upper bound of its definition of price stability, the Governing Council made it clear that this also takes into account the implications of inflation differentials across the countries of the euro area, in particular by providing an adequate safety margin to avoid that some regions have to structurally operate at negative inflation rates. It was thus recognised that inflation differentials could pose a risk for regions with structurally lower inflation rates in terms of the potential costs of adjustment associated with the possible presence of downward nominal rigidities.
Second, while the ECB’s internal work, analysis and assessment of economic information, its policy deliberations and its decisions are directed at the goal of maintaining price stability, as defined, for the euro area as a whole, this does not mean that the ECB looks exclusively at area-wide information. In order to achieve its objective and, in particular, in order to conduct its broad-based analysis of the risks to price stability over the medium term, the ECB regularly reviews and analyses all relevant information relating to the various sectors and countries of the euro area. Thus, we closely monitor sectoral and national developments in order to better formulate our assessment of the economic situation and its possible evolution for the euro area as a whole. Indeed, it is essential that the monetary policy-maker is able to understand the source and nature of economic shocks – whether demand or supply-related, whether permanent or temporary – and to assess their effects on the economy as a whole in order to formulate the best possible monetary policy response. In this respect, the analysis of disaggregated information is crucial, as many shocks of area-wide relevance originate in specific countries or sectors.
Finally, a key element of the ECB’s monetary policy strategy is its medium-term orientation, that is to say the fact that it does not attempt in the wake of economic changes to maintain or restore price stability in the very short term. This allows the ECB to formulate the best possible monetary policy with due account for the nature of economic shocks and, at the same time, to provide flexibility for individual economies or sectors to adjust gradually after localised or asymmetric shocks.
Ladies and Gentlemen,
It is time for me to conclude and I would like to do so by asking whether our strategy has been successful in conducting monetary policy in the euro area and in coping with the challenge posed by the differentials in inflation observed among euro area countries.
My answer to this question can only be affirmative. The ECB’s clear and unambiguous quantitative definition of price stability, its high degree of credibility and its strong focus on the attainment of its primary objective have allowed inflation expectations in the euro area to be maintained in line with its definition of price stability. This has resulted in low interest rates and extremely favourable financing conditions to the benefit of all euro area economies. Moreover, by anchoring inflation expectations and increasing transparency, monetary policy is contributing to the adjustment of relative prices, as well as to facilitating their role in guiding the allocation of resources across countries and sectors. Furthermore, an important positive effect of our strong focus on achieving price stability in the euro area is also to be found in the fact that inflation expectations at the level of the individual countries are very similar to one another, as proven by the very low dispersion of inflation expectations across euro area countries. Given the importance of expectations for future developments in wage and price-setting behaviour, this implies that a powerful mechanism has been put in place that is helping to keep price developments across the individual countries of the euro area closely bound together. To me, these are the best contributions that monetary policy can make to economic welfare and the attainment of high levels of activity and employment in our economies.
At the same time, lasting inflation differentials that are the product of misaligned national policies and/or deep-seated structural inefficiencies may be damaging for the national economics and need to be addressed by national policies. In particular, suitable structural policies aimed at enhancing the relevant countries’ flexibility and adaptability to continuously changing conditions in the monetary union are of the essence.
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