First balance and further challenges for the euro
Eugenio Domingo Solans, Member of the Governing Council and the Executive Board of the European Central Bank, Speech at UNICE, Brussels, 10 June 1999
Thank you for inviting me to the meeting of the Economic and Financial Committee of UNICE. It is an honour for me to attempt to draw some lessons from first months of existence of the euro and the ECB, and to discuss future challenges with you.
Although it is obviously too early to make an accurate balance - the euro has been in existence for hardly six months and the ECB for hardly a year - I shall try to draw some conclusions on the ECB's objectives and its monetary policy strategy. I shall then continue with the implementation of the ECB's monetary policy, our statistics and the reaction of the markets.
THE OBJECTIVES OF MONETARY POLICY
I should like to draw your attention first to the word "objectives" in plural. The ECB certainly has a primary objective: "price stability". However, Article 105.1 of the Maastricht Treaty adds that "without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2."
Among other objectives, Article 2 states that the Community shall promote a "sustainable and non-inflationary growth" and "a high level of employment and social protection".
It seems clear that, as a matter of priority, the ECB must focus its decisions towards the objective of price stability. In addition, and without prejudice to this aim of stability, the ECB also has responsibilities as regards economic growth, employment and social protection. General, conditional and secondary responsibilities, if you like, but responsibilities nevertheless.
As to the relation between monetary policy and growth, there is an important question which needs to be analysed. Should the ECB consider economic growth only as a sub-product of stability? I am convinced that the best contribution that the ECB can make to economic growth is to create an environment for stability. I do believe that there is no better "fertiliser" for economic growth than price stability and that nothing is more refractory for economic growth than inflation. However, provided that stability exists, monetary policy should create the best economic conditions for exploiting the growth potential of the euro area.
ANALYSIS OF INFLATION AND MONETARY CONDITIONS
Analysing the current situation, we see no risks for the primary objective of the ECB. Inflation remains subdued in the euro area (1,1% in April 1999). Underlying inflation declined from 1,1% in March to 1% in April, and the medium-term prospects for inflation are satisfactory, well within our definition of price stability.
There is some divergence in the inflation of individual countries, but this is a normal characteristic of monetary unions. In the euro area the gap between the highest inflation rate and the lowest inflation rate has remained broadly stable in the last year at around 2.6 percentage points. This is mainly due to the differences in the economic cycle and to the different interest rate levels, which had prevailed in the euro-area economies before they were all merged to a single interest rate in December last year. To take another example of monetary union, the four main regions of the United States have maintained a gap of around 1.4 percentage points in their inflation rates in the last 30 years. To sum up, there will always be differences in inflation rates among regions or countries in a monetary union, but these differences will be limited in the long run.
The current monetary developments also show that there is no risk for price stability. The 5% increase in the three-month moving average of the 12-month growth rates of M3, covering the period from February to April 1999, is in line with the 4 ½ reference value for money growth (the first pillar of the ECB's monetary policy strategy), and is lower than its value last month (5.3%). Furthermore, the developments of M3 should be observed with care because of the general Lucas critique and the specific uncertainties surrounding the introduction of the euro. This is why there is not only one pillar for the ECB's strategy. The euro area yield curve has become steeper reflecting a partial spillover of the sharp increase in long-term bond yields in the U.S. Nevertheless, long-term bond yields in the euro area remain low by historical standards, signalling the markets' expectations of low inflation.
IMPLEMENTATION OF MONETARY POLICY
The instruments used by the ECB to conduct monetary policy are functioning correctly. Indeed, the wide range of monetary policy instruments at the ECB's disposal makes the system very versatile. The flexible choice of eligible collateral (government and private paper) also helps reduce the potential negative consequences of the relative heterogeneity of financial markets in the euro area. Indeed, the spread between the day-to-day interbank rate (EONIA) among participating countries has remained below 10 percentage points on average.
The actual implementation of monetary policy by the ECB during these first months has proven to be very market oriented, with a major use of open market operations (2/3 of the liquidity were injected through weekly fixed rate tenders and 1/3 through the monthly variable rate tenders) and a very limited-and decreasing-use of the marginal facilities.
As regards the infrastructure for monetary policy implementation, progress has been made in harmonising securities clearing and settlement systems and in introducing a new payments system for the whole euro area. As regards settlements, the ECB has created the Correspondent Central Banking Model (CCBM) in order to ensure that all collateral eligible for monetary policy operations is available to all market participants through cross-border transfers. As regards payments, the ECB has set up a real time single payments system for the 15 countries of the European Union, which facilitates cross-border payments at all levels.
The European money markets , which are most closely linked to the single monetary policy, have undergone a huge structural change because of the introduction of a common refinancing system in the Eurosystem. This has led to a rapid increase in cross-border transactions, not only in volume but also in the number of market participants (a large number of relatively small banks have opened lines with other EU counterparts after appropriate credit evaluation).
The former relatively segmented national bond markets are rapidly merging into a common Euroland bond market. Almost 2/3 of the international bond market in EMU currencies now belongs to the euro-area domestic market while the remaining 1/3 of the issuance is composed of issuers from industrial countries outside EMU and supranational institutions. New bond issuance in the international markets denominated in euro have increased substantially since January, practically reaching the level of dollar denominated issuance (49% to 50%, respectively, as compared to 42% and 58% in 1998).
The euro offers an interesting opportunity to diversify portfolios. The currently low interest rates in the euro area offer a very good opportunity to obtain funds through the issuance of euro-denominated bonds.
Fiscal consolidation is reducing the role of the European governments in bond issuance. Private companies, as well as local governments, are becoming more active in that market.
You will probably agree with me that nothing is more important for monetary policy than good statistics. The launch of EMU has increased interest in euro-area data. This has required substantial changes to statistics. At the same time, the adoption of the single currency implies such a massive structural change that it can only affect economic and financial relationships, and therefore statistics. What is clear, however, is that the ECB must take policy decisions and explain them publicly in terms of the data available. Co-ordination among statistical authorities in Europe is important, and is stressed in all the relevant legislation. The ECB and Eurostat work at it constantly.
THE EXCHANGE RATE
Since its launch last 31 December, the euro has depreciated against the US dollar by about 10% in nominal terms. However, its level in nominal effective terms in similar to that reached in mid-1997 and the early part of 1998.
The factors behind this depreciation trend are the cyclical divergence between the economies of the United States and the euro area, the different growth prospects, and the interest rate differentials between the two areas. Nevertheless, the fundamentals of the euro area are sound: the area enjoys low inflation, lower than the United States , and there are no risks for price stability in the foreseeable future. Furthermore, the euro area has an external current account surplus, compared to the large deficit of the United States . All this makes me believe that there is a clear potential for the appreciation of the euro.
Allow me conclude by saying that in this speech I have only attempted to describe general developments and draw general conclusions. But, of course, I shall leave it up to you to draw your own conclusions.