Lower Growth Forecasts Call for Rate Cut

Monitoring the European Central Bank
Volume 4 Update

David Begg (Principal-elect of Imperial College Business School and CEPR), Fabio Canova (Universitat Pompeu Fabra and CEPR), Paul De Grauwe (Katholieke Universiteit Leuven), Antonio Fatás (INSEAD, Fontainebleau and CEPR), Philip Lane (Trinity College Dublin and CEPR)

This is the Update of the fourth MECB Report published by the same authors in Spring 2002. Since November 2001 the ECB interest rate has been unchanged; its longest period of fixity to date. Yet since September 2001 the economic environment has been changing dramatically: the introduction of the physical euro, the slide of the dollar, the sharp drop in stock markets, the housing boom in many EU economies, stagnant output, and swings in HICP inflation largely unconnected with food or energy prices. Although actual inflation fell below 2% by June 2002, 'core HICP' inflation (purged of food and energy prices) remained at 2.6% for the first six months of 2002. Given these new circumstances, the authors ask again the questions posed in MECB 4. Were there unexpected or unpredictable movements in HICP inflation or GDP growth that required special attention by the ECB? The Update finds:

• Despite a strong reduction in forecasts of output growth in recent months, the ECB has kept interest rates unchanged. Despite higher inflation, both recent behaviour of output and lower forecasts of growth call for a reduction in the interest rate. Although there are signs that the ECB might react at the next Governing Council meeting this week, even if they do, they will be repeating the pattern of slow reduction during the summer of 2001 that the authors documented in their original Report.

• The need to rethink the Stability and Growth Pact keeps growing. Recent budget deficit increases and rising demand for political interpretations of the reference values do not provide the right environment in which to set monetary policy. As stressed in MECB 4, the pressing need is to devise a fiscal framework that combines short-run flexibility with a clear commitment to fiscal responsibility in the medium run. Unless this can be accomplished, the ECB may be driven to set real interest rates at uncomfortably high levels. 

• Debt levels not budget deficits should be constrained. Whether a country's budget deficit temporarily exceeds 3% or not has little bearing on its solvency. Italy apart, the countries that have recently been the focus of the Commission's concern - Germany, France, and Portugal - have relatively low debt levels.

• Despite the hope of the ECB that the 'perverse' signals given by money growth figures would disappear soon, they have continued in recent months. CEPR's Update reveals, once again, the difficulties of communicating monetary policy decisions using the first pillar.

• The recent appreciation of the exchange rate should not have a significant effect on monetary policy decisions by the ECB. There may be a role for intervention if the euro rises rapidly or overshoots plausible estimates of its long-run value. However, such intervention should be limited to establishing a ceiling for the euro and should be coordinated with other major central banks.

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Notes for Editors:

CEPR is a network of 600 Research Fellows based throughout Europe, who collaborate through the Centre in research and its dissemination. CEPR helps its 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.

About MECB:

Responsible for monetary policy in one of the world's largest economic areas, the European Central Bank (ECB) comes under intense public scrutiny. The ECB acts on behalf of all euro area members, who have diverse traditions and differing views about the conduct of monetary policy. The ECB is accountable to the European Parliament. For all these reasons, it is important to provide regular, rigorous, non-partisan and pan-European analysis of monetary policy in the euro area.

Monitoring the European Central Bank (MECB) addresses this need. Written by a team of distinguished academic economists, known internationally for their work in this field, each year MECB produces a spring report and an autumn update.

The research underlying this publication was supported by Citibank, a member of Citigroup, MPS Finance Banca Mobiliare SpA & Gruppo Monte Paschi Asset Management SGR. The Economic and Social Research Council (ESRC) supported the launch of this Update. The views expressed in the Update are the authors' own, however, and do not reflect the views of CEPR, nor the Report's funders, who take no institutional positions.