1. This supplement reports on information on economic and financial developments in the euro area available since the issuance of the staff report on the area’s monetary and exchange policies (SM/00/212) to the Executive Board. The information does not alter the thrust of the staff appraisal.
2. Some recently released data suggest that the pace of the expansion in the euro area may be slowing somewhat, in line with the staffs (quarterly) projections. In September, a main indicator of aggregate manufacturing activity (the Purchasing Managers’ Index) declined for the fifth successive month, while consumer confidence fell markedly in the largest economies, at least partly as a result of uncertainty about the impact of higher energy prices. On the other hand, the latest industrial production index for Germany points to strong activity, and area-wide employment creation remained buoyant—with the euro-area unemployment unchanged at 9.0 percent in August. Total nominal hourly labor costs in the area as a whole rose by 3.5 percent in the second quarter of 2000 (year on year), marginally less fast than in the first quarter but somewhat faster than in 1999. Recent wage settlements in Germany and France also suggest that wage moderation continues to prevail in spite of the mid-year uptick in headline inflation.
3. On September 22, 2000 the European Central Bank (ECB) and other central banks1 intervened jointly in a defense of the euro that was appropriate under the circumstances. The move took markets by surprise and the euro initially appreciated sharply vis-à-vis the U. S. dollar but the exchange rate has since drifted back toward its pre-intervention level, which by the staffs assessment in SM/00/212 is a highly undervalued one. The intervention seems to have set a precedent that market participants may take into consideration in exerting further downward pressure on the euro. While on-going portfolio adjustments suggest that capital account transactions may continue to bear on the euro for some time to come,2 it is reasonable to expect this to end at some stage, in which case current account transactions will come to predominate and prompt an appreciation of the currency.
4. On October 5, 2000 the ECB increased its main refinancing rate by 25 basis points to 4.75 percent, citing heightened inflationary risks from the higher oil prices and persistently weak euro. With this adjustment, the ECB has now raised interest rates seven times since November 1999 by a cumulative 225 basis points. Although an interest rate increase was priced into the yield curve, the timing of the rate hike was largely unexpected by markets: the euro appreciated slightly vis-à-vis the U.S. dollar on announcement, but later lost the ground gained. Participants in forward markets appear not to have materially changed their expectations and no further interest rate increase is anticipated through the end of the year. Given the weakening of the currency since the second quarter of the year, monetary conditions for the euro area as a whole have not been substantially affected by the latest ECB move.
5. The staff has revised its macroeconomic projections for the euro area, based on updated country information, market expectations for interest rates, and a new baseline for oil prices (some US$5 per barrel above the baseline in the published WEO, with an average oil price of US$29 per barrel for 2000).3 Area-wide real GDP is now expected to grow by 3.4 percent in 2000 and by 3.2 percent in 2001 (compared to 3.5 percent and 3.4 percent, respectively, in SM/00/212), while inflation is projected to average 2.3 percent in 2000 and 2.1 percent in 2001 (compared with 2.1 percent and 1.7 percent, respectively, in SM/00/212). The overall fiscal balance is projected to remain unchanged with a deficit of-0.8 percent of GDP in 2000 largely because of revenue overperformance, and to reach -0.7 percent of GDP in 2001 (compared to -0.6 in SM/00/212), in part because of energy-related tax relief and slower growth. These revisions to area-wide aggregates result from combining preliminary country-level updates.
6. On balance, these revisions do not change the staffs policy advice. However, they point to heightened downside risks for the short-run, including as regards the smoothness of the growth path. Model-based estimates of the sensitivity of the euro area to oil shocks under an assumption of ongoing wage moderation are broadly consistent with the revised projections, but simulations suggest that the stagflationary effects would be considerably greater in the absence of such an assumption.4 Thus, wage moderation remains key to supporting the expansionary momentum. In this connection, the increasing emphasis on general tax cuts throughout the euro area may serve to sustain wage moderation, and might help contain downside risks to the near-term outlook and keep the expansion on track. However, cutting taxes on oil products or their complements in a setting of higher uncertainty in the energy markets may undermine the attainment of a desirable tax structure and prompt increases in world prices.
7. As regards the aggregate fiscal stance, the lower growth projection for 2001 lessens somewhat concerns about the insufficient ambitiousness of nominal fiscal targets. The key policy message remains that pro-cyclicality of policies must be avoided in either direction, i.e., also by letting automatic stabilizers come into play to cushion the impact of a negative shock when downside risks loom larger. Budgetary goals should be made contingent on the stated growth assumptions, and fiscal positions should be evaluated relative to the cycle.
8. As regards monetary policy, the recent information does not alter the advice that at this juncture monetary tightening should be aimed at forestalling second-round effects—which appear to be contained as long as wage moderation prevails—and might need to be reversed as the risks to medium-term price stability shift to the downside. Although the recent increase in the ECB refinancing rate completes the tightening cycle expected by staff through the end of the year, further increases should not be ruled out if a deterioration in the core inflation rate undercuts wage moderation.
Beside the ECB, the central banks reportedly involved in the intervention included the United States’ Federal Reserve, the Bank of England, the Bank of Canada, and the Bank of Japan.
The pipeline of merger and acquisition transactions into the United States and out of the euro area is currently at an all time high. Similarly, the outflows from equity fund managers out of the euro area suggest continued downward pressure on the exchange rate.
The overall terms of trade deterioration since the launch of the euro amounted by mid-2000 to about 20 percent—equivalent to a rise in taxes of some 3 percent of GDP.
For example, in a scenario of real wage rigidity, MULTIMOD simulations indicate that a US$10 increase in the price of oil above baseline would trim about ¾ of 1 percent off the baseline projection for GDP and add about 1½ percentage points to the inflation forecast within two years. Because of less labor market flexibility, the stagflationary effect is worse than in the United States, raising the issue of a persistent cyclical divergence between the two blocks.