Transcript of Press Briefing on the Euro Area's Monetary and Exchange Rate Policies , by Michael Deppler, Director, European I Department, IMF

November 6, 2001

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Transcript of a Press Briefing by Michael Deppler
Director, European I Department

International Monetary Fund
Tuesday, November 6, 2001
Washington, D.C.

MR. MURRAY: Just before we get going, let me just set a couple ground rules. This is on the record. First of all, my name's Bill Murray. I'm Deputy Chief Press Officer at the Fund. Today's briefing on the euro area will be on the record.

To my right is Michael Deppler, Director of the European I Department and the chief of the euro area mission, and to his right is Mr. Albert Yeager who is the Deputy Division Chief for the EU Policies Division with European I. I'll turn it over to Michael for some brief remarks.

MR. DEPPLER: Thank you. Okay. You've gotten all these papers. Let me first give you a primer on what to look at here. There are two documents. One is the technical appendices, and you can tell that by the cover after the first page, "Selected Issues." That's the technical professional work supporting the analysis in the main paper.

In the other bundle, you have the so-called Staff Report, which is the report of the staff to the Board after the discussions. This was finalized in early September. The numbers there date from essentially the August WEO.

At the back of that, you have supplementary information—you have to go quite a ways back in the pile—which gives an update of the staff's views as of mid-October, October 17th. And at the back of that, there's the summing up of the Board, that is, the views of the Executive Board as opposed to the staff. And that's given at the back there and has some relevant background information.

Then at the back of that is the view of Europeans, the ones being subject to surveillance. People are lost back there. Can I get you back on the page? If you haven't followed, just let me know. And at the very end of that piece, there is the buff by Mr. Kiekens, who is a representative for the European Presidency, and it gives their views on the staff's work.

Now, what I'm going to do here is just give you sort of an update of where we are. Where there are differences in view between the staff and the Board, I will let you know just in a brief overview.

As you all know, the situation has been shifting under everybody's feet as we do this work. The forecast that are in the back, that supplementary document I mentioned, essentially dates back to mid-October, which is before some of the latest news came out in Europe. It's the product of an interim exercise for the WEO which will be finalized later this fall.

I should also say that we have two scenarios that we're working on. You only see one here. There's a baseline scenario, which is the one that we see as the most probable. And then there is a downside or worst-case scenario, which depicts the situation given a significantly worse outcome. The estimates that are shown in the paper refer to the baseline scenario.

What do you see there? Well, a fairly weak situation, but no disaster in terms of European history; that is, you have a mild downturn in relation to what you would have seen in the history in Europe, say going back to '92, '93.

Basically we see growth on this basis of 1.5 percent, both this year and next year. The precise numbers on a European basis, as opposed to using WEO rates, is 1.6 and 1.5 specifically for the growth of the euro area in 2001 and 2002.

As I said, those estimates sort of go back three weeks now, and the news since then has been significantly on the downside of that scenario, and I would expect us to be revising those numbers down as we go along.

As you know, the basic problem is the situation is quite uncertain. The main uncertainties are the timing of the rebound in the U.S., and you know that views vary widely on that score, with some seeing an early rebound because of policies and others seeing a later rebound.

By the same token, there's also a question of what happens in Europe. Are we going to see a major investment downturn in Europe or not? The baseline scenario assumes not. There is a downturn, but not a major downturn like we've seen historically in the euro area.

Now, why do we see the baseline as the higher probability scenario? Well, basically because the fundamentals—if it weren't for all these shocks—the fundamentals in Europe are quite strong. If you look at situations like what's happening to wages, what's happening to fiscal policies, what's happening to inflation, what's happening to profits in Europe, you see some quite strong fundamentals, and it's not clear why Europe should really go into a tailspin given the shocks we've seen so far.

Basically, in terms of the mainsprings of any upturn, we would see this in consumption. Wages have been quite well behaved, but with inflation coming down, there's a kick to real disposable income, which is expected to generate a gradual—I would emphasize gradual—recovery of activity in the baseline, with growth being back above potential only in the second half of next year.

Now, on that baseline, how do we see policy requirements in the euro area? Now, on monetary policy, there's full agreement, I would say, between the staff and the Board. And basically the view is that there is scope for cutting interest rates, and this is fairly clear when you look at the implications of the forecast for inflation. Inflation is going down, partly because of sort of short-run factors, oil and things like that, but also simply because of the weight the slowing of activity puts on inflation. And we see inflation ebbing to about 1.5 percent next year. So that we see scope for interest rates cuts, and we also expect the ECB to cut interest rates.

You know, if you look at various monetary rules, those presaged cuts in interest rates, and we expect the ECB to have a similar kind of performance going forward.

In fact, in the discussions with the staff, they often emphasized that they have a symmetric approach to inflation. That is, they are equally concerned by upside risks as to downside risks to inflation. And we expect them to act accordingly.

On fiscal policy, I don't know how many of you are grounded in European matters; there's a bit more controversy. The controversy there springs from the framework within which fiscal policies are evaluated in Europe. They have this so-called Stability and Growth Pact which calls for countries to achieve balance or surplus in the medium term, and once they achieve that objective, then they can let the automatic stabilizers work fully. However, if they have not achieved that objective, they are expected to observe in the limit sort of the fiscal balance, the actual fiscal balances that are set out in the so-called stability plans.

Now, the problem with those fiscal balance targets is that they do not allow the stabilizers to work. And if you look at the implications for policy, what you see is the upswing in 2000. These countries were very procyclical. You know, you had very expansionary policies at the peak of the cycle. Now, under these stability plans, they were supposed to be equally contractionary this year, in 2001, keeping to fiscal balance targets that had been set earlier. The staff argues strongly that the stabilizers ought to be allowed to play.

This is a view, let the stabilizers play, but on the same token, no discretionary fiscal action, so that you in effect remain on the path to achieving medium-term balance.

This is somewhat controversial, a more controversial point. There are two views here. One is the staff is too bold; that is, we are undermining the Stability and Growth Pact in the medium term, the achievement of balance in the medium term. This is a view that you find mainly in Europe, but you also find some Executive Directors in the summing up sort of expressing similar views.

We disagree. We say that as long as you have no discretionary action above and beyond letting the stabilizers play, when the cycle reverses, you will get back to your original path and you will satisfy the Stability Pact criterion of balance or surplus.

The opposite view is that we're too timid. Why on earth, given the situation, aren't you pushing for fiscal expansion? Here I think there are a couple points, and, frankly, this is not a view heard so much in this building, but it's a view that you hear outside this building more. Here I would point out to—I would point out one aspect of the situation which is lost sight of in this discussion, and that is that the stabilizers in Europe are twice as powerful as they are in the U.S. Basically the responsiveness of the fiscal balance to the cycle is about a half in Europe and about a quarter in the U.S., reflecting the differences in the size of government, the differences in the role of transfer systems within those economies relative to the U.S.

Now, the implication of that is that if you suppose that the U.S. has a shortfall in output of 4 percent, the U.S. stabilizers provide support to the economy equal to only 1 percent, a fourth of 4 percent. European stabilizers would support the economy to the tune of 2 percent, half of 4 percent. The point being that, given the size of the stabilizers in the U.S., you need to have 1 percent of discretionary fiscal stimulus in the U.S. in order to have the same overall fiscal support to the economy that you would get if you had European stabilizers work.

So our point is, you know, let the stabilizers work; this would be a major achievement in Europe. But it also provides a lot of more support to the economy than newspaper headlines will capture in this form of measures to do this, that, and the other. The stabilizers are much more supportive than people often recognize.

I would also emphasize that letting the stabilizers play is very important in the European context because if you let them play in the downturn, which I think they will, then I think it's incumbent on the governments to let them play in the upturn, which is precisely what they did not do in 2000 and basically missed their chance to get their houses in order in that regard.

As regards policies, if you look at what actually happens to policies by country, it's looking reasonably okay. There's no discretionary stimulus, roughly speaking, but overall it's a reasonably balanced situation. And we would see it as broadly okay for the area as a whole. There are wrinkles when it comes to individual countries. Some of you I think probably were here yesterday for the discussion on France. There's another discussion I guess tomorrow, on Germany, and then later on there will be one on Italy.

I said earlier that we expect the recovery to be somewhat sluggish relative to what we would expect in the U.S. I mean, clearly this is rooted in two factors:

One, the fact that, you know, in the recent past, Europe has gotten a big boost from the monetary stimulus experienced by the countries at the margins of the euro area—I'm thinking of, for instance, Spain, where accession to EMU led to a huge reduction in interest rates and a huge spurt in consumer durables and in housing and construction. We expect this effect to be no longer there going forward.

But the other element is rigidities and the need for structural reform. Fundamentally, for Europe to grow strongly, which is their expressed ambition, they need to be much more decisive on the structural reform side. The areas listed in the paper are labor markets where there's a separate paper which compares labor market performance among the major European countries, and it's quite clear that structural reforms in those markets together with wage moderation account for a lot of the differences in performance you see across countries.

The other one is financial markets where we feel strongly that Europe is just sort of foregoing one of the big benefits of monetary union by not sort of pushing much harder on integrating their markets. They have integrated the money market, but all the securities and all the non—very short-term markets, there's a lot of work left to be done to integrate those markets.

I guess I'd leave it at that for now.

QUESTIONER: Michael, if you could just explain a little bit to those of us whose backgrounds aren't in-depth economic study, automatic stabilizers, can you explain some of the elements of those so that we've got a better appreciation of what you're exactly talking about there?

MR. DEPPLER: Sure. You know, if growth is high, tax receipts are high and your fiscal balance will improve correspondingly. Now, in Anglo-Saxon countries it's routine and normal to let those stabilizers play; that is, if the economy is doing well, you let the tax receipts come in, and you don't spend them. And by the same token, when the economy weakens, those tax receipts fall short and you don't contract. It's part of the stabilizing role of the fiscal policy. You just—no discretionary action, but simply the cycle pushes the fiscal balance around, and you simply accept that because it's a shock absorber on the system.

In Europe, they come from a rather different tradition focused on achieving particular nominal targets. Think of the Maastricht target; the 3-percent rule is sort of the quintessential one in that regard. But there are many others.

Now, the implication of focusing on nominal targets is that if revenues are plentiful, you start spending like crazy, sort of amplifying the cycle; and, conversely, if revenues fall short, you start squeezing like crazy on expenditures, again, amplifying the cycle on the downside.

Now, when you're in a process of adjustment and achieving credibility, which is the problem of many countries, sometimes you need a nominal target in order to get to where you want to get. You sort of have the political discipline. But within the euro area, they've converged. The fiscal deficit for the area as a whole is something like 1 percent. There's nothing particularly troublesome by the overall situation. And for that monetary union to work well, they basically need to allow the fiscal position to absorb the shocks in the cycle.

And I think Europe is making this transition towards this new framework. In particular, I would emphasize that the Stability and Growth Pact says that once you have achieved balance or surplus, then you can let the stabilizers play. The problem right now is 75 percent of the union hasn't met that task; that is, France, Germany, Italy, and Portugal, four of the 12 members, but three of the largest ones.

And so it's important from the point of view of the performance of the economy that they let the stabilizers play, but not only in a downturn but also in the upturn. And I think they're going to let them play—I'm sure they're going to let them play in the downturn. What I'm more worried about is whether they'll let them play in the upturn.

QUESTIONER: Mr. Deppler, at the start of your presentation, you said that growth for 2001 and 2002 was going to be 1.6 percent and 1.5 percent. They're not the numbers in the paper, which are 1.7 and 1.6. Have you revised them lower since these papers or—

MR. DEPPLER: Okay. I mean, you're a close reader of the paper. Congratulations.

If you look in that same paper, that same table, you'll see there's a footnote which says based on euro area as—something about Eurostat weights versus PPP weights. And, frankly, the WEO is going to change over to this new basis the next time around.

To be comparable to European presentations on this basis, you need to refer to the item in the—I think it's the last item in the table.

QUESTIONER: Real GDP Eurostat weights.

MR. DEPPLER: Yes, that's right. That's 1.6 and 1.5.

QUESTIONER: That's the one we have to use, right?

MR. DEPPLER: I would—yes, I would use that one.

QUESTIONER: So they would be the figures that would be comparable with Europe's own forecast?

MR. DEPPLER: Yes. Yes.

QUESTIONER: Mr. Deppler, could you talk about in your forecast for next year, are there particular countries within Europe among the major economies that are going to be doing considerably better or those who are going to be doing considerably worse? Also the paper seems to suggest that the euro's weakness is primarily a function of [inaudible] dollar and the equity markets, but the equity markets in the U.S. have tumbled [inaudible] done much of anything [inaudible]? I'm wondering if that explanation [inaudible].

MR. DEPPLER: Okay. The first question, I mean, one point I forgot to mention at the outset is, you know, U.S. and European growth have not been very closely correlated for most of the '90s. It's only in the latter part of the '90s that you see, and more immediately in 2000 and 2001, that you see a much closer correlation in the performance, a synchronization of performance across the North Atlantic.

Now, and so a lot of what we see a lot of the developments nowadays reflecting common shocks as opposed to idiosyncratic shocks. I mean, we don't see this as a U.S.-inspired downturn. It's sort of something that reflects general developments, be it oil prices, the tech stock bubble bursting, and now these confidence effects stemming from 9/11. So we see these as sort of generalized global common shocks, and they are impacting virtually everybody.

Now, within Europe, it's fairly clear that Germany is much harder hit than others, and to a certain extent Italy is much harder hit than the average of the euro area countries. And the German discussion tomorrow I'm sure will go into some of the reasons for that.

But, by the same token, I would say that the weakening across the area is pretty uniform. It's not entirely uniform. Some of the Nordics, for instance, are particularly hard hit by the tech stock reversal. So there are country peculiarities. But I would say that there's a general downscaling across the union as well, but with Germany still being the weak performer, has been and basically expected to remain a weak performer within the union.

QUESTIONER: My question on the euro, your report seems to put a lot of emphasis on the run-up in the U.S. equity markets and the strength of the dollar as an explanation for the euro's weakness. But the U.S. equity market's been weakening for more than a year now, and the euro doesn't seem to have recovered much of anything that I can tell. So I'm wondering if there's more internal European explanations for the euro's weakness.

MR. DEPPLER: I mean, we've tried every explanation for the euro, and basically I've given up and become quite agnostic.

Now, personally I still find the analysis in the supplementary paper as quite persuasive in that it sort of brings a lot of elements together into a consistent and coherent story.

Now, with respect to your specific question, don't forget that there are two principal elements in the explanation. One is this capitalization equity market effect. The other one is this advent of the euro and the prompting towards diversification on both the liabilities and the asset side that this has created.

Now, in our view, that second element is still going on, that is, portfolios both in terms of assets and liabilities are still being diversified away in the case of the residents, and towards in the case of non-residents the euro. And that is still a phenomenon that's out there and weighing on the euro today.

On the role of the equity markets, basically the correction is not nearly as large in historical perspective as is often considered. I mean, our starting point in '95, and I think the stock markets are only back to '99. So there's still some way to go. And, besides that, the analysis assumes a lag of about a year. So I wouldn't put pay to that analysis yet.

QUESTIONER: You said this 1.5, 1.6 is the baseline figure for growth in the euro area. Would you care to mention what's the corresponding figure for this worst-case scenario? Is there any means of estimating that?

MR. DEPPLER: No. We're still doing work on that. I mean, certainly it's somewhere between a half and one weaker. It's not quite clear to us how much weaker it would be. But I would—and it depends a bit on how you see the investment cycle going in Europe in particular. And we're still in the dark in what we think on those issues.

But the point I would emphasize is that it's not our baseline forecast. We would see this as having a probability, but something of the order of a fourth—a third or fourth, something like that, as opposed to the baseline, which we would see as having something like a two-thirds, three-fourths probability in terms of our current ways of thinking.

But I would also emphasize that I think the baseline is going to weaken as we finalize the numbers over the next month. So the numbers—you know, unless the IFO and such indicators are showing very temporary shocks and reverse quickly, there is a need to bring that baseline number down, for 2002, particularly.

QUESTIONER: You said that the ECB had scope and you hope and you think will cut rates. Since Mr. Duisenberg said at the Ecofin meeting right now he was really thinking that inflation was to go below 2 percent faster, do you think that this could mean a rate cut Thursday? Or if not, what's your timeframe and the size of the rate cut?

MR. DEPPLER: I mean, on timing issues I wouldn't want to second-guess the ECB. But the markets, you know, are in the business of predicting ECB action, and they make money by making those predictions, or lose money, as the case may be. And in making our forecasts, we assume expected market rates in our baseline, so our forecast, this 1.5 percent for next year, assumes interest rates developing in line with market expectations, which had, I think, a 50- or 60-basis-point reduction by the second quarter of next year.

Now, since then, market rates have moved down further because the news has weakened further. In general, you know, markets are reasonably good predictors of the ECB—not in terms of day to day, meeting to meeting, necessarily, but certainly in terms of month to month, quarter to quarter, they're quite accurate predictors.

QUESTIONER: Mr. Deppler, given that this is a review of the euro area's monetary policy, I'm just interested in if you could give some assessment on the administration of policy by the ECB. Do you think that they've established credibility? Obviously they've adopted a somewhat different means of communicating their policy that here in the United States they have press conferences, whereas the Federal Reserve does not. If you could just talk a little bit about your assessment of their administration of policy and whether—do you think that they've established themselves as a credible institution at this point?

MR. DEPPLER: In terms of credibility and predictability, I think that the fact that markets are reasonably accurate predictors of policy sort of means that in some sense they are transparent. Right? Occasionally they surprise the market on a particular meeting, but as a general matter, I think markets feel reasonably confident about what they're likely to do.

I would also say that if you look at—the French have these index-linked bonds, and if you looked at the break-even inflation rate that comes out of that, there's no question but that they have—these are ten-year bonds. There's no question but that they have credibility within those markets; that is, inflation expectations are very well behaved as observed by those markets.

Now, when you come to the more formal aspects of transparency, there have been issues about sort of the emphasis between the various pillars, you know, the monetary pillar versus the inflation-targeting pillars, and the markets have raised some issues about shifting from one to the other. But, in general, if you look at what they do in markets, particularly in explaining current behavior as opposed to future behavior, they're extremely transparent. They're extremely transparent.

QUESTIONER: Just a follow-up on that. In the News Brief that we got regarding this, you do say that Directors encouraged the authorities to continue their efforts to improve market understanding of the policy framework underlying the ECB monetary decisions. So what aspects of the framework are you pointing to specifically?

MR. DEPPLER: It's this two-pillar approach—the ECB has—first of all, you have to understand that, unlike the Fed, they have a price stability mandate. This is the overriding mandate.

Now, in applying that, in seeking to achieve that mandate, they have a framework which has two pillars: a monetary pillar, which basically looks at money from the standpoint of its predictive power about future inflation, and there's certainly a case for that approach; and, separately, a sort of standard inflation-targeting approach, sort of conventional, as you find in the U.K. or Sweden. The U.S. is a bit less clear.

Now, if there's been some issues about the markets have been surprised at times by the emphasis given to one element over another element and led to some surprises. Last spring, there was a reliance on the monetary pillar all of a sudden, which surprised markets. And this is what the Board was referring to.

QUESTIONER: Could you just go back to the first question you had on the automatic stabilizers, could you just for the layman define what that means for the euro countries? I mean, is it basically spending? Is it always new spending policies on the downturn?

MR. DEPPLER: No. It's not a question of spending. It's a question of letting your fiscal balance be influenced by the cyclical developments in the conviction that bad times will be succeeded by good times and, on average, your fiscal position will end all right if you simply allow the flopping back and forth of your fiscal balance.

The problem in Europe has been that, unlike in the U.K. or in the U.S., they have tended to resist the cyclical movements in their fiscal positions. They've tried to offset the role of revenue shortfalls and windfalls, and this has led them into trouble, repeatedly, if you look at the history. And they're in a process of moving away from this, and our point is they should emphasize this shift away from a nominal approach towards letting the stabilizers play, and if they do so, you will see that because the stabilizers are much more important in Europe than in the U.S., because they're twice as large, in effect the Europeans are getting what in U.S. terms would be viewed as fiscal stimulus.

You know, here we have Bush making sort of discretionary actions, but he simply needs to do that in order to keep up with the fact that they have relatively low stabilizers. In Europe, you don't need to do that if you let the stabilizers play because the stabilizers are more important and hold up the economy better than they do in the U.S.

So, you cannot sort of compare the U.S. and Europe and say one is focusing on the cycle and the other one is not—unless you adjust for this different role of the stabilizers. And as I said for a shock in the U.S. of 4 percent, which is basically what's expected between 2000 and 2002, the Europeans would automatically provide support to the tune of 2 percent. In the U.S. it would only be 1 percent. And, therefore, for the U.S. to be comparable to what would happen in Europe, you need to have a discretionary stimulus of 1 percent.

QUESTIONER: A follow-up. Why is it that the stabilizers are larger in Europe? Is it because of the size of government? MR. DEPPLER: Exactly. The size of government and the role of transfers. You know, transfers, which basically sort of—

QUESTIONER: [inaudible].

MR. DEPPLER: Exactly. Exactly. If you look at the ratio of public spending to GNP between continental Europe and the U.S., you'll see it's basically twice as large, and that's why the stabilizers are twice as large.

QUESTIONER: When do you expect to have the revised baseline figures?

MR. DEPPLER: Well, we're constantly revising.

QUESTIONER: Right. Well, factoring in, say [inaudible]—

MR. DEPPLER: But my guess would be some of those figures will be used for the IMFC meeting in Ottawa later this month. But the exercise is not to be concluded until early December, so it will go on after that as well.

MR. MURRAY: Okay. Thank you very much for coming. If you have any questions, you can contact Conny Lotze or anyone else in the Media Office. Thanks.

[Whereupon, the press briefing was concluded.]