Public Information Notice

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

With effect from January 1, 1999, the European Central Bank (ECB) has taken charge of euro-area monetary policy and shares responsibility for exchange rate matters with the Council of Ministers of the European Union. The Executive Board of the International Monetary Fund (IMF) has decided to meet once a year to discuss these policies in the context of the Article IV consultations of euro-area countries and that, in order to provide adequate context for its discussions, such meetings will also cover fiscal and structural policies at the euro-area level.¹ On March 26, 1999, the Executive Board concluded its first meeting on the monetary and exchange rate policies of the euro area. The background section in this PIN reflects information available at the time of the Executive Board meeting and the views of the Executive Directors are those expressed at that meeting, which took place before the ECB’s announcement on April 8 of a reduction of 50 basis points in its principal lending rate.

Background

The changeover to the euro during the weekend of January 1-3, 1999, went well, reflecting intensive work over the changeover weekend itself as well as extensive preparations over the previous months. On October 13, 1998, the ECB’s Governing Council agreed on a monetary policy strategy consisting of three elements. First, price stability—the ECB’s primary mandate—is defined as an annual rise in the HICP below 2 percent, and is to be achieved in a medium-term context. Second, the strategy will give a prominent role to money, to be signaled by a quantitative "reference" value for the growth of a broad aggregate, derived in a manner consistent with price stability. Third, in parallel with an analysis of monetary growth, the ECB will make a broadly-based assessment of the outlook for future price developments using a range of economic and financial indicators. This was followed on December 1, 1998, by the announcement that the reference value for broad money growth would be 4½ percent, based on potential output growth of 2-2½ percent, inflation below 2 percent, and a trend decline in velocity of ½-1 percent. The reference value would be monitored continuously on the basis of a three-month moving average for 12-month broad money growth. It would, thus, not apply to a specific time frame, but it would be reviewed on a regular basis, with the first review scheduled for December 1999.

Meanwhile, the macroeconomic environment for euro-area policymakers has become increasingly difficult. Euro area GDP grew by almost 3 percent in 1998, but there was a marked deceleration in economic activity in the fourth quarter of the year that extended into the first quarter of 1999. The deceleration was largely induced by the weakening in external demand resulting from the broadening of the emerging-market crisis. This in turn was reflected in slowing industrial production in the euro area and a marked decline in industrial sector confidence. Outside of industry, however, economic activity has remained resilient as the healthy financial position of households and strong consumer confidence have buoyed consumption. The unemployment rate has declined by about 1 percentage point from its peak in 1997 to a little above 10½ percent of the labor force in the first quarter of 1999.

GDP growth is projected to pick up in the second quarter of 1999 and strengthen in the second half of the year, resulting in output growth on average of 2 percent in 1999 and close to 3 percent in 2000. With labor market conditions showing no signs of deteriorating—reflecting buoyant activity in services, a strengthening of construction, and active labor market measures—consumer confidence is expected to remain strong. This, together with the envisaged start of a recovery in external demand, should lead to a gradual improvement in industrial confidence.

The downside risks in the projections are much greater than usual. This reflects in part the strains and imbalances that have resulted from the emerging market crises and the unsustainable global pattern of growth in recent years. But there are also important risks emanating from within the euro area. Notably, industrial confidence has continued to deteriorate in early 1999. If it does not pick up soon, unemployment could start to rise and the sustainability of consumer confidence would come into question. A marked delay in the recovery would lead to a substantial downward revision of growth projections for 2000 as well as those for 1999.

Inflation is well under control in the euro area. The harmonized index of consumer prices (HICP) rose by just over 1 percent in 1998, held down in part by falling energy prices. In late 1998 and early 1999, the 12-month rate of inflation fell below 1 percent. A "core" measure of the HICP inflation, excluding food and energy, averaged about 1½ percent in 1998, but with adownward tendency in recent months. Consumer price inflation is projected at around 1 percent in 1999-2000. While energy prices are expected to recover somewhat during the period ahead, "core" inflation is expected to ease further as low actual inflation fosters continued moderate wage growth, while lower interest costs, uncertain demand prospects, and more intense external competition tend to restrain gross profit margins, which have been rising in recent years.

After the considerable efforts to satisfy the Maastricht criteria in 1996-97, fiscal consolidation has stalled. The projected general government deficit for the euro area in 1999, at 2 percent of GDP, is about ½ percentage point lower than in 1997. This entails, however, little change since 1997 in the cyclically-adjusted deficit—currently estimated at about 1 percent of GDP—despite a decline in interest spending of ¾ percentage point of GDP.

Monetary and financial conditions have been broadly supportive of economic activity. The three-month interest rate in the euro area, currently 3 percent, is about 1 percentage point lower than at the beginning of 1998, leaving real short-term interest rates at about 2 percent, however. Broad money (M3) growth over the past twelve months stood at 5.2 percent in February. At the same time the 3-month moving average of 12-month growth rates was 5.1 percent, which is slightly above the Eurosystem’s reference value of 4 ½ percent. However, these data have to be interpreted with some caution because of the monetary policy regime shift. At end-March 1999, the nominal effective exchange rate of the euro area had depreciated by 5¾ percent from its level at the introduction of the euro, leaving it broadly unchanged from the beginning of 1998. Long-term interest rates have fallen by 1¼ percentage points since the end of 1997, resulting in a yield curve that is relatively flat for this stage of the cycle.

Executive Board Assessment

Executive Directors extended their congratulations on the successful launch of the euro, noting that this milestone in European history represented an unprecedented example of economic and political cooperation. They welcomed this first opportunity to discuss the monetary and exchange rate policies of the euro area in the context of Article IV consultations with euro-area countries. They noted that the staff paper had provided a comprehensive and balanced assessment of the current situation and prospects for the euro economy.

Directors observed that the European Economic and Monetary Union (EMU) offered participating countries and the world economy potential for greater economic stability and enhanced economic performance. Much had been done already by euro-area authorities in establishing the foundation for realizing these benefits. A solid framework had been put in place to guide both monetary and fiscal policies; price stability had been achieved, and seemed secure for the foreseeable future; headway in fiscal consolidation had been made in satisfying the Maastricht convergence criteria; and the internal market program had substantially increased market integration in the European Union. However, important challenges remain. In particular, further adjustment is required to establish fiscal positions of balance or small surplus and national authorities need to address urgently the structural rigidities that are impeding employment and growth.

Directors noted that the tasks facing euro-area policy makers had been made more difficult by the weakening of short-term growth prospects over the past half year. While it was important that sights remained firmly fixed on medium-term requirements, it was at the same time essential that policies were adequately attuned to supporting domestic demand. The euro-area needed a sustained period of strong domestic demand to help close the current sizable output gap and absorb the cyclical component of unemployment. Moreover, most Directors believed that the euro area should play a greater role in supporting global demand.

Directors thought that, with price stability well assured and room for the operation of automatic fiscal stabilizers limited in many euro-area countries by the need for further fiscal adjustment, any easing in the overall macroeconomic policy stance should come from monetary policy. They noted that short-term interest rates in the euro area had declined significantly over the past year, providing welcome support for economic activity. Directors generally thought the case for a further interest rate reduction had increased in recent months, ² given the continuing uncertainties regarding the strength of the expected economic recovery in the euro area, the further heightening of global economic risks, and the continued downward pressures on inflation in the euro area. Underscoring that the risks were clearly on the downside, a number of Directors thought that these considerations already warranted a rate cut. In their view, this would not jeopardize price stability, which was well assured in the present cyclical context. A number of other Directors, however, were more cautious in this regard, noting that the recent depreciation of the euro against the U.S. dollar had entailed a further easing in monetary conditions, and that given lags in policy transmission, the full effect of the last reduction in interest rates was still to be felt. These Directors were of the view that monetary policy makes its best contribution by maintaining price stability in a credible and forward-looking manner, and that prudence was particularly important at a time when monetary policy in the euro area needs to establish its own track record.

Directors agreed, however, that the European Central Bank (ECB) should act decisively if there were signs that the slowdown was persisting. In particular, they considered that a reduction in interest rates would be warranted if the global environment deteriorated further, if consumer confidence weakened significantly, or if a recovery in industrial confidence did not materialize. To wait until the effects showed up in actual GDP data could allow downside forces to gather momentum. ²

Directors considered that the depreciation of the euro since its introduction reflected the continuing strength of the U.S. economy and uncertainties about economic prospects in the euro-area.

Directors underlined that it was particularly important at the early stages of the ECB, in view of the uncertainties in the outlook for the euro area and the global economy, that the publicunderstand and have confidence in the monetary framework. Directors generally commended the work done in elaborating the ECB’s approach to monetary policy, which they thought both sensible and pragmatic in light of the uncertainties of the change in regime. A few thought, however, that especially given the uncertain relationship between monetary aggregates and interest rates and prices, there should be even less emphasis on M3 and correspondingly greater emphasis on the broad-based assessment of inflation prospects.

Several Directors considered that the ECB needs to specify an explicit lower bound for inflation, noting that this would help improve policy discipline and accountability. Others were of the opinion that such a bound would necessarily be arbitrary, given the lack of conclusive studies of the measurement bias in the new inflation index, and underscored that, in any event, the ECB had clearly stated that it attached equal importance to both inflation and deflation.

Directors noted that the ECB had made important strides in communicating with the public, and encouraged its efforts to develop its communication strategy further. In particular, many thought that the ECB needed to provide greater detail of its assessment of inflation prospects, and be more forthcoming in explaining how it would adapt monetary policy to changing economic conditions, including changes in inflation within the range that defines price stability. A few Directors indicated, however, that there were limits to what could be conveyed by such statements of intent, given the complex considerations that went into monetary policy decisions, and that greater public understanding of the ECB’s monetary policy would come from seeing the ECB in action and listening to its explanations for these actions. Some Directors thought that providing summaries of discussions in the Governing Council of the ECB would help advance its goal of communicating with the public in a clear and effective manner. Some others, however, considered that it was more important to convey to the public the main arguments underlying policy decisions, and for the ECB to speak with one voice, while ensuring an area-wide perspective, as the ECB currently seeks to do. A few Directors were of the view that the ECB should go even further by releasing minutes of the meetings of the Governing Council. A few speakers also suggested that the ECB should make public the economic models and the econometric analysis used in its decision making.

Many Directors observed that an understanding of how the ECB was likely to respond to macroeconomic developments was also important to fiscal authorities in gauging the appropriate macroeconomic stance of fiscal policy. They noted that while the appropriate stance of fiscal policy in specific countries would depend on a range of economic considerations which would be addressed in individual Article IV consultations, the need for further fiscal consolidation in a number of euro-area countries—especially those with relatively high deficits or debts—and the lack of underlying fiscal adjustments in 1998 and in budgets for 1999 constrained the extent to which the automatic stabilizers could be allowed to operate in the face of weaker activity. At the same time, the appropriate use of stabilizers would also depend on the pace of economic activity and on the degree of support that monetary policy was providing. Some Directors thought that the economic stabilizers should be allowed to operate fully, especially in countries with particularly weak domestic demand, although it would be desirable to ensure that the framework established by the Stability and Growth Pact is respected. Directors generally underscored that it was especially important in the current uncertain macroeconomic environment that the mixresulting from fiscal and monetary policies fosters an appropriate level of aggregate demand in the euro area.

Directors stressed, however, that demand management alone would not provide the antidote to the slow growth and high unemployment that had plagued the euro area in the 1990s. Determined reforms of government spending and taxation systems and a forceful attack on structural rigidities were essential if unemployment was to be lowered substantially. Moreover, early action on these fronts would both boost confidence and ease the task of policy makers in tackling the current cyclical weakness.

Many Directors noted that countries’ medium-term stability programs generally relied on cyclical improvements and falling interest spending to achieve further reduction in fiscal deficits, and that they had not planned even the relatively modest annual adjustments in primary structural balances that would have been sufficient to realize balanced fiscal positions in 2001–2002. Moreover, the modest curtailment of spending growth planned by most countries left insufficient room for tax cuts. These Directors stressed that more ambitious medium-term fiscal strategies would bolster the credibility of the Stability and Growth Pact, provide the monetary authorities with greater room for maneuver, and help prepare for the effects of population ageing.

In the area of structural reform, Directors noted that some countries had already made good headway in labor market reform and that there had been some important further progress in recent years in strengthening the European Union’s internal market, including through increased competition in telecommunications and liberalization in the utilities sector. However, progress in attacking the root causes of high unemployment in the euro area as a whole had been disappointing. It was important for countries now to follow through by implementing comprehensive packages of reforms. In particular, there was a need to train the large number of unskilled workers, many without recent job experience; to address pervasive rigidities in labor and product markets; to cut the heavy tax burden on labor; and to reduce disincentives that result from the interaction of generous unemployment and welfare benefits, their long duration, and inadequate tests of the availability for work of those receiving benefits. A number of Directors also emphasized that further trade liberalization, especially in agriculture, would contribute to a more efficient allocation of resources, as well as facilitate the task of maintaining price stability. They took note of the importance the EU countries attached to consolidating the multilateral framework for trade and their intention to participate actively and in a constructive manner in the next WTO round.

Directors found it reassuring that the ECB viewed euro-area financial institutions as remaining in sound financial condition in the face of the recent global financial crisis and that there has been no evidence of a credit crunch. Nevertheless, given the increasing integration of European financial markets and the mushrooming of complex operations, there was a need to review whether the existing arrangements were capable of dealing effectively with any rapidly emerging financial problems in European markets. A key suggestion in this regard was that it was important to ensure the efficient and rapid flow of information between the national supervisory authorities and the European central banking system.

Euro Area: Selected Economic Indicators
	1995	1996	1997	1998	1999	1/
	In percent
Real Economy
Change in real GDP	2.2	1.7	2.5	2.9	2.0
Change in final domestic demand	2.0	1.6	1.5	2.9	2.6
Change in consumer prices 2/	2.9	2.2	1.6	1.1	0.9
Unemployment rate 3/	11.4	11.6	11.6	11.0	10.6
	In percent of GDP
Public Finance
General government balance	-5.1	-4.2	-2.5	-2.1	-2.0
Public debt	75.9	77.2	76.4	75.1	74.7
	In percent
Money and Interest Rates
Change in M3 (end of year)	5.7	4.0	4.1	4.5	5.2	4/
Money market rate (3 month money)	6.1	4.6	4.1	3.9	3.1	5/
Government bond yield (10 year bonds)	8.5	7.1	5.9	4.7	4.2	5/
	In percent of GDP
Balance of Payments
Trade balance	1.9	2.3	2.5	2.3	2.0
Current account	0.9	1.3	1.8	1.4	1.5
Official reserves (US$ billion)	...	...	...	...	281.3	6/
	In percent
Exchange Rates
Change in nominal effective exchange rate	4.5	0.1	-8.8	-0.1	1.4	7/
Change in real effective exchange rate	4.6	-0.5	-10.9	-3.0	0.4	7/
Sources: European Central Bank; EUROSTAT; national authorities; and IMF staff estimates.
1Staff projections, except for money and interest rates, exchanges rates and official reserves.
2Harmonized definition, from 1996 onward.
3Harmonized definition in percent of labor force.
4February 1999 compared with February 1998.
5March 1999.
6Total reserves minus gold (Euro system definition); end January.
7March 1999 compared with March 1998.
1Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. In this PIN, the main features of the Board's discussion on the monetary and exchange rate policies of the euro area are described. In the course of preparing its papers for the Executive Board, the Fund staff held discussions with EU institutions, including the ECB. The ECB’s observer at the Fund also participated in the meeting of the Executive Board. 2This view was based on information available at the time of the Executive Board Meeting on March 26 before the ECB announced a reduction of 50 basis points in its principal lending rate.