Monitoring the European Central Bank Update August 2001

The end of the prolonged expansion in the United States, coupled with a worldwide economic slowdown, have led to an aggressive loosening of monetary policy by the Federal Reserve. In recent months, the ECB has also faced mounting pressure to cut its lending rate in response to falling growth prospects within the EU. So far, demands for action by the ECB seem to have fallen upon deaf ears – it has only cut rates once since October 2000, from 4.75% to 4.5%.

Given its goal of price stability, the ECB has acted wisely, according to the August issue of Monitoring the European Central Bank (MECB Update), written by five leading European economists, and published by the Centre for Economic Policy Research. "The situation in the EU and the US is simply different: the US economy has experienced a dramatic slowdown, whereas not much has changed in Europe. More importantly, there are few signs yet that inflationary pressures in the euro area have diminished. The ECB has a mandate of price stability and must therefore remain cautious when considering further interest rate cuts", says Professor Francesco Giavazzi, one of the authors of the MECB Update (this report has been written by Alberto Alesina, Olivier Blanchard, Jordí Gali, Francesco Giavazzi and Harald Uhlig and is published by CEPR).

The ECB has revised downwards its GDP growth projection for 2002 to 2.6% from 3% last December. For the past fourteen months, however, Headline (HICP) inflation, has remained above the ECB limit of 2%. The authors of the MECB Update argue that "the worsening of GDP growth prospects in the euro area should not be a good enough reason for the ECB to reduce interest rates, unless those gloomy prospects are accompanied by an unambiguous, persistent decline in medium-term inflation forecasts, a possibility that has yet to materialize."

The analysis presented in the Report also finds an important shift in the monetary policy rule followed by the ECB (the way the bank sets interest rates). Up to January 2001, the interest rate decisions of the ECB can be explained rather accurately using a hybrid rule, in which the ECB responded fairly aggressively to core inflation (HICP minus food and energy), and to the one-year-ahead inflation forecast, with equal weights given to both components. Using this rule to forecast rates in 2001 yields, however, a surprising result: rates should have risen to almost 6%. The May 2001 interest rate cut thus suggests a break with the policy pattern followed by the ECB so far, and signals the bank’s decision to respond to medium-term inflationary pressures in a forward-looking manner. If so, this is potentially a very good development.

Despite repeated statements by the ECB, interest rate decisions continue to be made independently of changes to the ‘first pillar’, that is in M3 growth. This is fortunate, as it is hard to justify why this variable should be assigned any role other than as a useful leading indicator of inflation. "The ECB should stop hiding behind the first pillar and tell analysts exactly what it aims to accomplish."

The three main points of the CEPR Report are:

1. The Fed is right to be aggressive. The US would probably be doing much worse, were it not for the interest rate cuts.
   
2. The ECB is right not to be, at least so far. But it should have the right rhetoric as well.
   
3. The current account deficits of Portugal and Greece are symptoms of positive developments within the euro area. Stopping them would amount to slowing down investment by preventing an important source of finance.

Notes for Editors:

CEPR is a network of over 500 Research Fellows based throughout Europe, who collaborate through the Centre in research and its dissemination. CEPR helps it’s Research Fellows to develop projects, obtain their funding, administer them and disseminate their results. The Centre’s research ranges from open economy macroeconomics to trade policy, from the economic transformation of Central and Eastern Europe to regionalism in the world economy. For interview requests and further information about CEPR, please contact Robbie Lonie, Tel: (44 020) 7878 2918. 

The Authors:

Alberto Alesina is Professor of Economics at Harvard University and is also a Research Fellow in CEPR’s International Macroeconomics and Public Policy research programmes. Olivier Blanchard is Professor of Economics at the Massachusetts Institute of Technology. Jordi Galí is Professor of Economics at CREI, Universitat Pompeu Fabra, Barcelona, and a Programme Director of CEPR’s International Macroeconomics research programme. Francesco Giavazzi is Professor of Economics at IGIER, Università Bocconi in Milan and is also a Research Fellow in CEPR’s International Macroeconomics research programme. Harald Uhlig is Professor of Economics at Humboldt Universität zu Berlin and is a Research Fellow in CEPR’s International Macroeconomics and Financial Economics research programmes.

The research underlying this publication was supported by Citibank, a member of Citigroup, and MPS Finance Banca Mobiliare SpA & Gruppo Monte Paschi Asset Management SGR

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