Public Information Notice No. 00/26

Public Information Notice: IMF Executive Board Discusses the Monetary and Exchange Rate Policies of the Euro Area

April 3, 2000

On March 15, 2000, the Executive Board concluded the discussion on the monetary and exchange rate policies of the euro area (in the context of the Article IV consultations with euro-area countries).¹ The background section in this PIN reflects information available at the time of the Executive Board meeting and the views of Executive Directors are those expressed at that meeting.

Background

Euro-area economic growth—which had slowed down in the wake of the emerging market crises—started to recover during the first half of 1999 on the strength of internal demand supported by a timely monetary easing, sustained employment creation, and improved business and household confidence. By mid-1999, the recovery in the global economy and a very competitive position of the euro catalyzed a further acceleration in aggregate real GDP growth, although the pattern of growth remained geographically imbalanced, with Germany and Italy lagging behind France and Spain, and the smaller peripheral economies leading the upswing. Labor market performance was also uneven across euro-area countries, but for the area as whole the unemployment rate continued to decline, reaching 9.6 percent by year-end.

Throughout the year, headline inflation remained subdued, albeit increasing as a result of rising oil prices. It reached 2.0 percent (12-month basis) in January 2000, up from 1.7 percent last December. Core inflation—as measured by the aggregate Harmonized Index of Consumer Prices (HICP) net of its more volatile energy and food components—declined through October before edging up to about 1 percent at end-1999 and 1.2 percent in January 2000.

In November 1999, the 50 basis points increase in the European Central Bank's (ECB) principal lending rate—which fully reversed the April easing—marked a shift to a more neutral monetary stance as risks to price stability turned to the upside. This shift was underscored by the further 25 basis point increase in February 2000. Monetary conditions, though, remained supportive of activity throughout, in part as a result of the weakness of the euro, which depreciated on a multilateral basis by about 12 percent both in nominal and (unit labor cost-based) real effective terms in the course of 1999 and by an additional 2.0 percentage points through early March 2000.

As regards fiscal developments, 1999 budgetary targets were met by virtually all countries in the euro area, often despite slower-than-anticipated GDP growth. Yet, after the remarkable progress in the run-up to Stage 3 of the Economic and Monetary Union, the area-wide deficit reduction (from a deficit of 2.0 percent of aggregate GDP in 1998 to a deficit of 1.2 percent of GDP in 1999) was modest and largely accounted for by lower interest payments. The 2000 budget targets envisage an area-wide deficit-to-GDP ratio of about 1 percent.

On current WEO projections, aggregate real GDP growth would exceed 3.0 percent in 2000. Inflation is expected to remain benign, with headline HICP inflation tapering off by end-2000 to about 1.5 percent and remaining well within the ECB's definition of price stability, against the backdrop of the remaining slack in the euro-area economy. Regional divergences in growth and inflation rates, reflecting in part the catching-up process in many EMU countries, are expected to continue, although narrowing somewhat.

Risks to the near-term outlook appear balanced for inflation and, if anything, on the upside for economic activity. On the downside, real growth projections are mainly subject to uncertainties stemming from the global environment—most importantly, the timing and intensity of a possible slowdown in the United States.

Executive Board Assessment

Noting that the near-term outlook for the euro area had brightened with the deepening and broadening of the recovery, Executive Directors stressed that the key policy challenge now is to create conditions for a long period of rapid economic growth.

To this end, Directors urged the pursuit of a monetary strategy firmly focused on price stability, the implementation of national fiscal policies aimed at promoting public saving and favorable supply-side responses, and the intensification of structural reform efforts.

Directors commended the ECB for a policy stance that had been quite supportive of the economy throughout 1999, without endangering medium-term price stability. While acknowledging the need for a gradual return to a more neutral position as the cycle matured, many Directors thought that this supportive orientation should be maintained in 2000. In particular, they saw no pressing need for an increase in interest rates in the near future, in light of the remaining slack in labor and product markets, the gradual pace at which it has been taken up, the prevailing moderation in wage claims, and the downward pressures on prices stemming from deregulation in key sectors. These Directors also argued that monetary policy should be mindful of the need to probe cautiously the margins of untapped resources, taking into account some signs of an improved inflation-output trade-off in the euro area, as had occurred in the United States. Some Directors, however, considered that risks to price stability are on the upside—owing inter alia to generous liquidity conditions in 1999 and still rising oil and commodity prices—and that it remains necessary to react quickly to threats of inflation. A few of these Directors observed in this connection that further careful analysis is needed to assess whether the euro area had, in fact, seen an improvement in the inflation-output trade-off. More generally, Directors agreed that the steadfast pursuit of structural reforms offers the best chance for non-inflationary growth in the euro area and the maintenance of market confidence, while allowing monetary policy to focus on continued price stability.

Directors observed that the ECB had made important strides in providing information to the public on its strategy and its assessment of economic conditions, but indicated that greater transparency could make monetary management more effective. In this connection, they welcomed the intention to publish macroeconomic projections, including projections of inflation—which, without implying a departure from the accepted monetary policy strategy—would promote a better understanding of how the ECB forms its views of the inflation outlook, and would enhance the credibility and predictability of policy.

Against the backdrop of stronger activity in the euro area and of the current and capital account imbalances among the major currency zones, Directors agreed that the current weakness of the euro is undesirable. They underscored that lagged exchange rate responses of trade flows could exacerbate existing patterns of trade imbalances and heighten the risks of abrupt exchange rate reversals and of protectionist pressures.

Directors remarked, nonetheless, that a monetary policy reaction would be appropriate only if there were a threat to medium-term price stability. They noted that, to the extent that a weak euro reflected the relative cyclical positions of the United States and the euro area, as well as markets' concerns about the structural rigidities that could undermine the sustainability of the expansion, a monetary response in the absence of clear risks to price stability would do little to strengthen the currency. In their view, a recovery of the euro would come from markets becoming better attuned to the fundamental strength of the euro-area economy, greater cyclical convergence between the United States and the euro area, and greater progress on structural and fiscal reform in many euro-area countries.

Directors acknowledged the progress toward fiscal sustainability in the run-up to Stage 3 of the Economic and Monetary Union. Most Directors pointed out, however, that the adjustment effort had slackened in 1998-99 and needed to be reinvigorated. Such improvements are necessary to create the room for discretionary fiscal policy that is particularly important in the framework of a uniform monetary policy. These Directors indicated that, although the updated stability programs for 2002-03 were, in some cases, more ambitious than the previous ones in proposing tax cuts, the programs did not go far enough to provide the area as a whole with the necessary improvements in structural primary balances and reductions in tax burdens.

Directors argued that in the improved cyclical setting, manageable targets for 2003 should include the achievement of fiscal balances or surpluses in all euro-area countries, and reductions in the euro-area revenue-to-GDP ratio. Directors also stressed the importance of ensuring durable improvements in the fiscal positions of most countries by further reforming health care and pension systems—measures that would guarantee lasting reductions in public spending. Such spending restraint is essential to allow tax rates to be reduced significantly from current levels, while maintaining fiscal prudence and achieving the approximate fiscal balances or surpluses envisaged under the Stability and Growth Pact.

Turning to the labor and product markets, Directors observed that considerable progress had been made in reforming the product, services, and capital markets. Directors noted, however, that the euro-area reform strategy is still too limited in scope. In order to continue cutting area-wide unemployment, they urged the authorities to accelerate the pace of labor market reform.

In the labor market, most Directors saw the need in many countries to reassess the eligibility conditions for unemployment compensation and welfare assistance, promote a less rigid and more differentiated wage structure, and broaden the scope of the most effective vocational and apprenticeship programs.

In the product and service markets, Directors welcomed the ongoing progress in privatization and deregulation, but called for stepped-up efforts to lock in the beneficial effects of competition. They noted the ample scope for further opening up access to still sheltered sectors, as well as for removing administrative barriers to business formation, and to job creation in the service sectors and commercial activities.

Some Directors noted that trade liberalization offers important benefits not only for augmenting world growth potential, but also for the euro countries themselves, in terms of the implications for domestic prices, resource allocation, and the external position. They encouraged the euro countries to allow increased market access to exports from low- and middle-income countries, noting that trade protection, especially in agriculture, remains high.