Testimony before the Committee on Economic and Monetary Affairs of the European Parliament
Introductory Statement by Jean-Claude Trichet,President of the European Central Bank,Brussels, 21 November 2005
Madame la présidente, Mesdames et Messieurs les membres de la Commission économique et monétaire, je me réjouis de paraître devant votre Commission aujourd’hui et de poursuivre ainsi notre dialogue régulier. Nos rencontres trimestrielles sont très importantes pour la Banque centrale européenne, comme vous le savez. Je commencerai mon intervention par une évaluation de la situation économique et monétaire.
Anschließend möchte ich einige Ausführungen zum Stand der Finanzintegration im Euroraum machen. Die EZB hat ein großes Interesse am Integrationsstand des europäischen Finanzsystems. Da die in der öffentlichen Diskussion hierzu genannten Argumente oftmals qualitativer Natur sind, hat die EZB vor kurzem erstmals eine Reihe von (quantitiativen) Indikatoren für den Stand der Integration der Finanz- und Bankenmärkte im Euroraum veröffentlicht. Die Ergebnisse hiervon werde ich zusammenfassend darstellen.
Economic and monetary issues
At the time of my last appearance before the European Parliament, we expected the underlying trend in real economic growth to remain modest in the short term. I said that the conditions were also in place for positive fundamental factors to influence the outlook and for economic activity to pick up beyond the short term. The most recent data and indicators available have confirmed our working assumption of a gradual ongoing strengthening of economic activity. According to Eurostat’s flash estimate, released on 15 November, euro area GDP rose by 0.6% quarter-on-quarter in the third quarter of 2005, after increasing by 0.3% quarter-on-quarter in the second quarter of 2005. Notably, the euro area economy has shown a marked degree of resilience to the increase in oil prices.
Looking ahead, on the external side, it is projected that ongoing growth in global demand will continue to support euro area exports. And on the domestic side, it is projected that investment will benefit from continued favourable financing conditions and from the robust growth of corporate earnings. Consumption should gradually recover, broadly in line with expected developments in real disposable income. At the same time, the outlook for economic activity remains subject to downward risks, relating mainly to oil prices, concerns about global imbalances and weak consumer confidence.
Turning to price developments, recent increases, mainly in energy prices, have pushed headline inflation rates to levels significantly in excess of 2% and along a path higher than previously expected. According to Eurostat’s release on 16 November, annual HICP inflation was 2.5% in October 2005, compared with 2.6% in September and 2.2% in the two preceding months. It is likely that HICP inflation will remain elevated in the short term. In interpreting current inflation rates, it is important to make a distinction between temporary, short-term factors and factors of a more lasting nature. While some developments might prove to be transitory, markets still expect oil prices to remain at historically high levels, driven mainly by buoyant global demand and also, to some extent, by fragilities on the supply side. This suggests that the impact of energy prices on overall price developments may be more lasting than in the past.
Whilst our scenario is based upon the preservation of price stability, in line with our definition, beyond the short term concerns exist about the medium-term upside risks to this scenario. Upside risks relate to ongoing uncertainties surrounding oil market developments, to a potentially stronger pass-through than has so far been observed – on account of higher oil prices being passed on to consumers via the domestic production chain – and to potential second-round effects in wage and price-setting behaviour. In addition, possible further increases in administered prices and indirect taxes have to be taken into account.
The monetary analysis also points to increased upside risks to price stability over the medium to longer term. Liquidity in the euro area is very ample in terms of all plausible measures. Moreover, the strengthening of monetary growth observed since mid-2004 has gained further momentum over the past few months, driven by the increasingly dominant impact of the low level of interest rates. Furthermore, the growth of credit, especially mortgage loans, remains very robust at the level of the euro area as a whole.
In conclusion, the economic analysis indicates that energy price increases, in particular, imply upward revisions to the outlook for short-term price developments. Some of the contributing factors can be expected to be temporary, but others are likely to be more lasting. Domestic inflationary pressures over the medium term still remain contained in the euro area, but significant upside risks have to be taken into account. Moreover, the monetary analysis identifies increased risks to price stability over the medium to longer term. Overall, cross-checking the information from the two pillars confirms that strong vigilance is warranted to keep inflation expectations in line with price stability.
After two and a half years of maintaining interest rates at a level historically exceptionally low, I would consider that the Governing Council is ready to take a decision to move interest rates, and to moderately augment the present level of ECB rates in order to take into account the level of risks to price stability that have been identified. We would thus withdraw some of the accommodation which is embedded in the present monetary policy stance, while the policy would remain accommodative.
This move would aim at coping with inflationary risks in order to maintain and preserve full confidence in price stability and to continue solidly anchoring inflation expectations. This move would therefore contribute to sustainable growth and job creation in the euro area.
As regards fiscal policies, a number of countries have presented their budget plans for 2006 and the European Commission has presented its autumn forecasts. No significant progress has been made in fiscal consolidation, and the outlook for countries with excessive deficits is a matter of great concern, as there is a high risk of commitments for this year and the next not being met. All parties involved in the forthcoming decisions have an important responsibility to ensure the proper functioning of the overall fiscal framework in the future. This would be the most effective way of contributing to enhance the growth prospects of the euro area and building confidence in public finances before the challenges of population ageing set in. Countries with fiscal imbalances should give priority to the timely correction of these and should implement the revised Pact rigorously.
As regards structural reforms, I would again like to stress the need to increase the flexibility of labour and product markets in order to achieve a more dynamic and competitive European economy, to increase its resilience to shocks and to help foster the adjustment processes within the euro area.
Structural reforms are also of relevance to the speed and smoothness of adjustment mechanisms within the euro area. Competitiveness patterns across the euro area countries are depending on developments in unit labour costs within the euro area. Since the start of EMU, cumulative increases in unit labour costs have posted significant differences across euro area countries. It must be stressed that part of the differences in such cumulative increases in unit labour cost rates are a natural feature of a well-functioning monetary union. As such, they may reflect welcome catching-up processes or necessary adjustments to past shocks. In this respect, the degree of flexibility within the euro area may well have been underestimated in its early phase of existence. At the same time, however, there is no room for complacency. In some euro area countries, wage developments have substantially and persistently exceeded labour productivity growth, leading to relatively strong and sustained increases in unit labour costs, higher inflationary pressures and losses in competitiveness. This may be due, at least partially, to wage rigidities, such as an explicit or de facto indexation of nominal wages to prices, or high reservation wages determined by the level of unemployment benefits, as well as to a lack of competition in some sectors. Structural reforms aimed at addressing these issues would support unit labour cost developments that are conducive to price stability and would further smooth the functioning of adjustment mechanisms in the euro area, thereby strengthening the foundations for sustained growth in output and employment.
Indicators of financial integration in the euro area
Let me now say a few words on the issue of financial integration in Europe.
The ECB has a keen interest in this area as financial integration enhances the smooth and effective transmission of monetary policy impulses throughout the euro area financial system and is an important factor in safeguarding financial stability. Financial integration also enhances the efficient functioning of payment and settlement systems. Furthermore, under Article 105 of the Treaty, the Eurosystem supports, without prejudice to the objective of price stability, the general economic policies in the Community. Financial integration, which is a priority Community objective, can promote the development of the financial system, thereby raising the potential for economic growth. The ECB supports this process through various activities. For example, it acts as a catalyst for private-sector initiatives that foster financial integration, such as the Short-Term European Paper (STEP) initiative.
A prerequisite for any action by the ECB is an analysis of the state of financial integration in the euro area and an assessment of the progress of financial integration over time. Because the relevant arguments in discussions on this topic are often of a qualitative nature, the ECB sought to devise a way of capturing, in quantitative terms, the state of financial integration in the euro area.
On 30 September 2005, the ECB published its first annual report and a first set of 20 indicators on financial integration in the euro area. Based on these statistics, the report provides an overall assessment of the degree of financial integration in the main segments of the euro area financial market, namely the money market, the government bond market, the corporate bond market, the equity market and the banking markets. The main conclusion is that the degree of integration varies greatly depending on the market segment, with integration being more advanced in those market segments that are closer to the single monetary policy.
An integrated interbank market ensures an even distribution of central bank liquidity and a homogeneous level of money market interest rates across the euro area, which is a prerequisite for the smooth implementation of the single monetary policy. Our indicators show that the unsecured interbank money market has been fully integrated since early 1999. For example, the cross-country standard deviation of the average overnight lending rates among euro area countries, that one year before the start of Monetary Union was still higher than 130 basis points, stood as low as three basis points in early 1999, and has since decreased even further to only one basis point this year. As regards the repo market, while it has a lower degree of liquidity, in particular in the longer-term segment, the indicators also suggest a high degree of integration.
Government bond markets have also achieved a very high level of integration, mainly due to the disappearance of (intra-euro area) exchange rate risk and the convergence of inflation expectations across countries when the euro was introduced. Another notable feature is the emergence since 1999 of a euro corporate bond market. Our studies suggest that this market segment is fairly integrated in the sense that the country of issuance is only of marginal importance in explaining yield differentials.
In other market segments, there is potential for further advances in integration. Our indicators for the euro area equity market show that the degree of integration is rising, although room for further integration remains. The assessment of gradually progressing equity market integration is based inter alia on evidence that the elimination of (intra-euro area) currency risk has encouraged a significant reduction of the “home bias” in the equity holdings of institutional investors since 1999. In addition, stock prices across the euro area also seem to react increasingly to euro area-wide developments and news.
Finally, in this first report we also put forward a first set of indicators related to banking markets. Our findings confirm that retail banking markets, for example mortgage markets, are generally far less integrated, whereas the euro area interbank (or wholesale) market and capital market-related activities show signs of increasing integration.
In order to extend the assessment of financial integration in the euro area, the coverage of the indicators will be further enhanced next year, in particular by adding indicators relating to the integration of financial institutions and financial market infrastructures.
In conclusion, with its first publication of indicators of financial integration in the euro area, the ECB has initiated a regular monitoring of the progress of financial integration in the euro area.
I am now ready to answer your questions.
 The ECB provides the outcome of its euro area-wide financial stability monitoring in its Financial Stability Review, which has been published since December 2004. For the June 2005 issue see: Press briefing on the Financial Stability Review June 2005. The next Financial Stability Review will be published at the start of December 2005.
 See for example London Economics (2002), “Quantification of the macro-economic impact of integration of EU financial markets”, Report to the European Commission.
 The ECB’s report and the statistics underlying the financial integration indicators can be accessed under Statistics > Indicators of financial integration on the ECB’s website.