Abstract
This paper examines monetary and exchange rate policies of the euro area. The paper reviews the European Central Bank’s definition of price stability, and examines the factors determining “the optimal rate of inflation” in the euro area. It reviews the benefits of price stability, including the reduction in the distortions of savings and investment behavior that stem from the interaction between nominal tax systems and inflation. It then goes on to evaluate arguments for maintaining a small positive inflation rate in the context of the euro area.
I. The Eurosystem’s Definition of Price Stability1
A. Introduction
1. The Eurosystem’s definition of price stability as an annual rate of increase in consumer prices of less than 2 percent, to be maintained over the medium term, has been criticized by outside observers on two counts. First, the definition has been portrayed as ambiguous and asymmetric, and less effective as an anchor for inflation expectations than a point inflation target (e.g. Svensson, 2002). Second, the 2 percent ceiling has been said to be too stringent to allow a smooth functioning of the euro economy and allow monetary policy to effectively pursue stabilization objectives in the face of large, adverse shocks (e.g., Begg et. al., 2002).
2. This paper reviews the ECB’s definition of price stability from both angles. The first part of the paper examines whether the ECB’s target definition is clear and symmetric and, to the extent that it is not, the paper discusses the relative benefits of “constructive ambiguity” versus increased specificity in the goal definition.
3. The second and more substantive part of the paper examines the factors determining “the optimal rate of inflation” in the euro area. It reviews the benefits of price stability, including the reduction in the distortions of savings and investment behavior that stem from the interaction between nominal tax systems and inflation. It then goes on to evaluate arguments for maintaining a small positive inflation rate in the context of the euro area, of which there are essentially three. First, due to various biases in the measurement of inflation, “true” inflation is likely to be lower than indicated by official price indices. Second, a small positive inflation rate may facilitate relative price and wage adjustment in an economy with downward nominal rigidities, i.e. in which there is resistance to price and especially wage cuts. In the case of the euro area, this issue has a particular dimension in that inflation may vary across member countries due to the gradual convergence in price levels, as well as the occasional need for relative wage adjustment among EMU members in response to country-specific shocks. Third, the closer the inflation goal is to zero, the higher the risk that monetary policy could be constrained by the inability of nominal interest rates to fall below zero if and when economy is hit by severe shocks.
4. The paper concludes that, although there may be benefits from adopting a point target for medium-term inflation, the arguments are finely balanced, and need to be weighed against the potential credibility cost of changing the objective. As for the level of inflation, a target toward the upper end of the ECB’s price stability range would seem, at least with the current membership of EMU, to strike a judicious balance between reaping the benefits of price stability while allowing scope for inflation to assist relative price and wage adjustment across EMU and safeguard against deflation.
B. On the Clarity and Symmetry of the ECB’s Inflation Objective
The ECB’s objective of price stability and how it compares with others
5. The Treaty on European Union established “price stability” as the primary objective of the ESCB. As a secondary objective, the ESCB is required to support the general economic policies of the euro area with a view to contributing, inter alia, to high levels of employment and sustainable growth. Lawmakers refrained from specifying the price stability objective in operational terms or from delegating the authority to do so to any particular body. Consequently, it has been up to the ESCB itself to decide whether to provide a quantitative definition of price stability, and what such a definition should be. The Treaty mandate and the definition of price stability adopted by the Eurosystem are laid out in Box 1.
6. In providing a definition of price stability, the ECB has specified its medium-term inflation objective in more precise terms than some other central banks, such as the U.S. Federal Reserve or the Bank of Japan, which do not offer quantitative definitions of their targets. The reasons for doing so were manifold: the Treaty’s emphasis on price stability made it natural to provide a definition that could guide policymaking, anchor inflation expectations, and facilitate the public’s understanding of the aims and constraints of monetary policy. Moreover, a quantitative definition was seen as helpful in establishing the anti-inflation credentials of a new institution with literally no track record of its own.
7. On the other hand, the definition of price stability provides a less clear-cut demarcation of the ECB’s inflation preferences than would an inflation target per se, for the following reasons:
A definition of price stability is not the same as an inflation target or range. It does not follow from the definition of price stability that the ECB is indifferent between all inflation rates in the 0-2 percent range, or that it aims for the mid-point of that range; indeed, there are reasons to believe—and financial market participants appear to believe—that the ECB generally prefers medium-term inflation rates in the upper half of that range, i.e., in the 1-2 percent range;
The ECB has noted that there might be measurement bias in the monetary union inflation index, and that the definition of price stability “allows for such bias by not setting the lower bound for measured price level increases at zero” however, this makes the lower bound for measured inflation imprecise and potentially time-varying;
The “medium term” horizon over which price stability is to be maintained is not specified.
Price Stability: The ECB’s Definition and its Antecedents
The Treaty on European Union states the objectives of the ECB in the following terms:
“The primary objective of the ESCB is to maintain price stability. Without prejudice to the objective of price stability the ESCB shall support the general economic policies of the Community with a view to contributing to the achievement of…a harmonious and balanced development of economic activities, sustainable and non-inflationary growth, ….[and] a high level of employment…b” (Treaty on European Union, Articles 2 and 105).
The lexicographic ordering of objectives is not necessarily a reflection of legislators’ and society’s view of their relative importance. Rather, it reflects a consensus view of what monetary policy can be expected to deliver (low inflation) and what it cannot be expected to provide (full employment). The belief is also that central banks charged with delivering price stability are best placed to contribute effectively to output stability.
Taking its cue from the experience and practices of a number of participating central banks, as well as from the EU Council’s prescription in successive Broad Economic Policy Guidelines, the ECB adopted the following definition:
“price stability shall be defined as a year-on-year increase in the Harmonized Index of Consumer Prices (HICP) for the euro area of below 2 percent.” Price stability according to this definition “is to be maintained over the medium term.”
The ECB has since noted that the use of the word “increase” implied that deflation would not be deemed consistent with price stability.
The ECB also noted that there might be measurement bias in the HICP, and that this bias might vary over time. “Therefore, the definition has avoided explicitly embodying specific estimates of the HICP measurement bias, while allowing for such bias by not setting the lower bound for measured price level increases at zero.” Informally, ECB officials have, on occasion, interpreted the definition to mean measured inflation rates in the range [x-2] percent, where x is the (unknown) inflation measurement bias. The corresponding definition of price stability for “true” inflation would be [0-(2-x)] percent.
The most important antecedents to this definition were the practices of a number of EU central banks prior to EMU. The Bundesbank used a 2 percent “price norm” or “medium-term price assumption” in its calculation of target money growth for a number of years. During 1997 and 1998, this was lowered to 1.5-2 percent. Other participating central banks had also adopted inflation norms not exceeding 2 percent.
Language adopted by the Council of Ministers of Economic and Financial Affairs in the 1995 Broad Economic Policy Guidelines was also seen by the ECB to specify 2 percent as the maximum inflation rate compatible with price stability (see Issing et.al., 2001, p. 71.)
8. By way of comparison, some inflation targeting central banks have adopted point targets—e.g., 2 percent in Canada and Sweden and 2.5 percent in the United Kingdom2—while others have adopted target ranges (e.g., 2-3 percent in Australia and 0-3 percent in New Zealand). For those that have adopted ranges, the lower bound is explicit, and the mid-point of the range is generally taken to represent the preferred inflation outcome.
9. The policy horizon for most inflation-targeting central banks is specified at 1½-2 years, consistent with the lags with which monetary policy affects inflation and with the dying out of temporary and erratic price level shocks. (One exception is Australia, where the target is to be achieved over an unspecified business cycle.) The trend among both policymakers and academics has been to see real world inflation targeting as “flexible” rather than “strict” inflation targeting (in the terminology of Svensson, 1999). Flexible inflation targeting means that the central bank does not focus exclusively on the inflation forecast at some point in time but also has concern for the stability of the real economy. Among other things, this implies that inflation-targeting central banks aim to meet the inflation target further in the future when a large shock has moved inflation away from target.
Interpretations of the ECB’s price stability objective
10. Observers have spent a fair amount of energy trying to deduce from the ECB’s definition of price stability, as well as from ECB communications and actions, what level of inflation the ECB may “really” be targeting. Svensson, 1999 pointed out that the ECB’s calculation of its reference value for M3 growth seemed consistent with inflation in the 1-2 percent range, the mid-point of which is 1½ percent. Others have noted that the mid-point of the Eurosystem’s published inflation forecast ranges have also tended to be at 1½ percent towards the end of the projection horizon. Statements by ECB Board Member Issing at the 2002 ECB Watcher’s Conference have also brought some clarification by recognizing that a small positive rate of inflation, “say between 1 and 2 percent” would significantly reduce the risks of getting trapped in a deflationary spiral, and stressing the need for vigilance were inflation to fall below 1 percent.
11. Although the ECB’s preferences probably cannot be reduced to a time-invariant utility function in inflation, some stylized considerations may illustrate the extent to which the ECB’s target is symmetric and well-defined. The top half of Figure 1 represents the ECB’s utility function if and when the bank is indifferent between any medium-term inflation outcome in the price stability range (x-2 percent, where x is measurement bias). The bank will be indifferent between these outcomes if there is no trade-off between inflation and the level or variability of output (Section D discusses issues such as the zero interest rate floor and relative wage adjustment that may introduce such trade-offs at low inflation). At the relevant policy horizon, and assuming for illustrative purposes that the uncertainty surrounding the central inflation projection is symmetric, the bank’s inflation target would be the mid-point of the x-2 percent range.
Interpretations of the ECB’s Inflation Objectives
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Interpretations of the ECB’s Inflation Objectives
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Interpretations of the ECB’s Inflation Objectives
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
12. The lower half of Figure 1 depicts the situation if and when the bank perceives a tradeoff between inflation and the level or variability of output (e.g., if a small positive inflation rate facilitates relative price and wage adjustment, or if keeping some distance to zero inflation reduces the risk of deflation). Given the secondary objective of the ECB, the utility function would be tilted towards the upper end of the range defined as price stability. Over the policy horizon, a risk-conscious Governing Council would want to maintain a safety margin by aiming for an inflation forecast below 2 percent.
13. Although the definition of price stability is symmetric in a formal sense (0-2 percent), these factors imply some degree of asymmetry in practice, and it is difficult to know around which point exactly the ECB starts to worry about downside risks to price stability.
14. Needless to say, these conjectures do not capture the full sophistication and complexity of the ECB’s preferences—it is entirely possible that the ECB’s inflation preferences at the policy horizon are in fact state dependent and time-varying.
Potential benefits of “constructive ambiguity”
15. There may be good reasons for not adopting an overly precise inflation target and policy horizon. After all, inflation-targeting is not the “only game in town”, and there is still room for alternative monetary strategies and goal specifications.
16. Essentially two arguments have been forwarded by ECB officials for not providing an (even) more precise definition of the ECB’s objectives:
The economics profession has not come to an agreement on the optimal rate of inflation. In the words of Issing et. al. “Both theoretical and practical arguments can be made in support of and against an inflation rate exactly equal to zero (possibly through a price level objective), or a small, but positive, rate of inflation… Given this situation, it could appear wise to refrain from the specification of an exact figure, let alone choose between zero and small positive inflation” (Issing et.al., 2001, p. 69).
The return to price stability after a shock should be gradual and depend on circumstances. A “differentpolicy response can be optimal depending on the initial conditions and the source and dimension of the exogenous shocks that cause deviations [of inflation] from the objective.” Consequently, “the central bank must be granted some room for maneuver”, for example in the interpretation of the nature of the shocks hitting the economy at a given point in time (Issing et. al., 2001, p. 69). For instance, the central bank may wish to raise real interest rates to prevent financial bubbles from gathering momentum, even if inflation is (temporarily) below its medium-term objective (e.g., the asset price bubble in Japan in the late 1980s and the recent high-tech bubble in United States emerged alongside low inflation).3
17. ECB officials have stressed that, on some of these points, similar conclusions appear to have been implicitly drawn for instance by the U.S. Federal Reserve. The Fed has striven to convey its anti-inflationary resolve without providing too precise quantitative definitions, and it retains a significant amount of discretion and policy flexibility in its response to shocks.
18. The ECB’s definition also leaves open the possibility that policies may correct past over- or undershootings of the inflation target. (This contrasts with the traditional view of inflation targeting central banks as continually focusing on meeting the inflation target in the future while letting “bygones be bygones.”) Provided the public knows that inflation overshoots will subsequently be corrected, an adverse price shock may be more easily absorbed if expectations of future inflation are lowered at the same time (e.g. Woodford, 1999). In a similar vein, some argue that targeting a price level path may help to stabilize output and prevent deflationary traps because inflation expectations are raised when prices fall (e.g., Svensson, 1999). However, the ECB has not indicated that it follows either of the two approaches.4
Potential costs of ambiguity
19. There are three potential costs associated with the ambiguity in the ECB’s inflation goal, to do with policy setting, communication, and inflation expectations, respectively:
First, the definition of price stability provides a less clear and less symmetric guide for policymakers than would a point target. Even when policymakers strive to be evenhanded there remains a risk that well-defined transgressions of price stability in the upward direction receive more focused attention than less clearly defined transgressions in the opposite direction.
Second, the ambiguity may hamper understanding of the ECB’s policies. For instance, it is unclear whether there is a zone of policy inaction when projected inflation is inside the price stability range. There is also uncertainty about what downside risks to price stability mean.
Third, the ECB’s definition arguably provides a less clear guide to inflation expectations than would a point target for inflation. A clear anchor for inflation expectations may improve the available trade-off between inflation and output variability, and it facilitates long-term contracting, saving and investment. In the context of wage negotiations, the starting point for inflation could vary more between the negotiating parties if the central bank has a somewhat vaguely defined objective than with a point target for inflation.
The experience of the first years
20. In view of inflation’s persistent overshooting of the ECB’s upper limit for price stability in the last couple of years the Eurosystem cannot be said to have been overly aggressive in pursuing price stability to the detriment of other considerations. The interest rate cuts in early 1999 and in 2001 demonstrated that the ECB was concerned about not letting the economy languish with inflation in the lower half of the price stability band. Although the Eurosystem has a track record of predictability that broadly compares with other major central banks, there are indications that markets were surprised about the timing of interest rate cuts in early 1999 and in 2001, see Chapter 3 of these Selected Issues. Uncertainty about the lower bound of the inflation objective may have contributed to difficulties in communication and understanding of ECB policies at the time, but so may other factors, including hard-to-interpret signals from the first pillar, above-target inflation in 2001, and the Governing Council’s consensual approach to decision-making.
21. When it comes to guiding inflation expectations, surveys of professional forecasters suggest that expectations at the 5 year horizon have remained pinned down at 1.8-1.9 percent since the inception of EMU (Figure 2). Ten-year ‘breakeven’ inflation rates derived from index-linked and nominal bonds confirm that inflation expectations have generally stayed close to but below 2 percent (Figure 3, top panel). A temporary up tick above the 2 percent limit in the spring of 2002 occurred also in other countries and presumably reflected short-term financial premia unrelated to long-term inflation expectations. A comparison with other countries suggest that breakeven inflation expectations have been more stable in the euro area than in the United States, presumably by virtue of the quantitative definition of price stability (Figure 3). Long-term inflation expectations do not appear to have been less stable in the euro area than in the United Kingdom or Sweden (which have point inflation targets), although such comparisons are hampered by the different characteristics of the economies, and by shifting expectations that the United Kingdom or Sweden might join EMU and thus abandon their current targets within the ten-year horizon (evidence from financial market prices may also be distorted by liquidity and inflation risk premia). All told, although there is anecdotal evidence that short-term inflation expectations used in wage negotiations have shifted upwards to 2 percent following the recent overshoots of the ECB’s inflation ceiling, long-term inflation expectations have been well anchored in the euro area. If, however, the ECB was aiming for 1½ percent inflation, as suggested by some, expectations have been less firmly on target than might have been the case.
Euro Area: Average Inflation Rates Expected Five Years Ahead
(Annual Percent Changes)
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: ECB, surveys of professional forecasters.
Euro Area: Average Inflation Rates Expected Five Years Ahead
(Annual Percent Changes)
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: ECB, surveys of professional forecasters.Euro Area: Average Inflation Rates Expected Five Years Ahead
(Annual Percent Changes)
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: ECB, surveys of professional forecasters.
Break-Even Inflation Rates in Selected Countries
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: Bloomberg.
Break-Even Inflation Rates in Selected Countries
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: Bloomberg.Break-Even Inflation Rates in Selected Countries
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: Bloomberg.C. Benefits of Price Stability
22. We next turn to the issues involved in defining an appropriate or “optimal” rate of inflation to target over the medium term. Choosing a target rate of inflation involves difficult trade-offs between the “sand” and “grease” effects of inflation on the workings of the price mechanism, capital taxation, and the dangers of hitting the zero interest rate floor for monetary policy. Moreover, official inflation measures likely overstate “true” inflation by an unknown amount. Against this background, countries that have adopted explicit inflation targets have generally opted for small but positive inflation rates.5 The remainder of this paper considers the relevant trade offs from the vantage point of the euro area.
23. The analysis is based on the premise that there are significant advantages of maintaining stable and low inflation (“low” taken to mean inflation rates below 2½-3 percent). The price mechanism works best at low inflation, thereby promoting a more efficient allocation of resources and higher output, and the long run Phillips curve is taken to be vertical for higher inflation rates. Following a long line of research which established that double-digit rates of inflation reduce economic growth (e.g., Fischer, 1993; Barro, 1995; Sarel, 1996), a study by Andres and Hernando, 1999 found that even moderate inflation had a sizeable and permanent negative effect on output by reducing investment and the efficiency with which factor inputs are used (however, since very few data points in the sample had inflation rates below 3 percent, the results could say very little about inflation below that level). Consequently, this paper is only concerned with the choice between different rates of low inflation.
24. Some of the most important benefits of low inflation have more to do with the stability of the inflation rate rather than the level of inflation per se. This holds notably with respect to the anchoring of inflation expectations and the functioning of the price mechanism. There is little to suggest that inflation would be more variable and that price and wage setters would be more liable to confuse general price movements with relative price changes if the inflation target was set at, say, 2 percent rather than 1 percent. Indeed, such “sand effects” of inflation on the working of the price mechanism might be more likely if the inflation target varies over time or is unclearly defined. By the same token, the macroeconomic benefits of a better anchoring of inflation expectations at low inflation stem from the priority accorded to price stability and the central bank’s anti-inflation credentials (including its independence) rather than from the precise level of the target.
25. Other traditional benefits of price stability—in terms of “shoe leather” and price adjustment (menu) costs—will vary only trivially among inflation rates inside or close to the ECB’s definition of price stability.
26. A key benefit of price stability stems from the interaction of inflation with nominal tax systems, notably through taxation of the part of nominal returns on capital that compensate for inflation and tax deductibility of the same components of nominal interest expenditure. In most countries, this interaction means that higher inflation weakens incentives to save and induces overinvestment in housing. Reducing inflation would produce a permanent welfare gain through a better allocation of resources. Feldstein, 1997 found that the gain from price stability associated with the tax-inflation interaction is very large: going from 2 percent inflation to zero inflation in the U.S. would permanently raise welfare by an amount equal to about 1 percent of real GDP.
27. In a set of papers collected in Feldstein, 1999 similar methods were applied to Germany, Spain, and the United Kingdom. In the case of Germany, Tödter and Ziebarth, 1999 found that the gain from reducing inflation by 2 percentage points was equivalent to a perpetuity of 1.4 percent of GDP. The gain is somewhat larger than for the U.S. primarily because of the higher marginal rate of tax in Germany. For Spain, Dolado et. al. 1999 found an even larger gain (1.7 percent of GDP), principally because of the higher distortions in favor of housing demand. On the other hand, Bakhshi et.al., 1999 found a much smaller gain in the case of Britain (0.2 percent of GDP), reflecting the ways in which U.K. taxpayers can reduce the tax on investment income and the limited tax advantage of home mortgages. Britain indexes capital gains for inflation and provides more opportunities for individuals to save in untaxed forms than do the other countries examined.
28. If these numbers are applied in an approximate fashion to the euro area, the perpetual gain from reducing inflation from 2 to 1 percent comes out roughly at 0.5 percent of GDP, the present value of which is 17 percent of GDP (discounted at a 3 percent real interest rate).
29. The most natural response to this distortion would be to change tax laws, and the incentive to do so would be considerable if the potential gains are as large as claimed. Feldstein 1997 lists some legal and administrative reasons why comprehensive tax indexing is, in his view, unlikely to be enacted and notes that full indexing has not been adopted by any major industrial country. On the other hand, the estimate for Britain suggests that changes in tax laws have the potential to massively reduce the distortions. Besides, doubts have been raised about the magnitude of the estimated benefits, and it has been argued that there may be a political economy equilibrium that determines the rate of capital income taxation and housing subsidization (Fischer, 1999). A reduction in effective capital taxation or mortgage subsidization induced by lower inflation could lead to offsetting changes in explicit tax rates on capital income and mortgage deductibility.
30. The benefits of zero inflation need to be weighed against possible downsides of maintaining inflation rates too close to that level. We turn next to the possible motives for maintaining a small positive inflation rate.
D. Benefits of Small Positive Inflation Rates
31. Maintaining a small positive inflation rate might be preferable to zero inflation on three principal counts. First, official measures of inflation likely overstate true inflation; second, inflation may help relative price and wage adjustment when the economy is beset by downward nominal rigidities; and third, countercyclical monetary policy action risks being constrained by the zero floor if inflation and nominal interest rates are kept too low in steady state, hi the euro area, these issues are complicated by the fact that trend inflation may vary across countries and real exchange rates may need to adjust to country-specific shocks. Following a brief review of inflation measurement biases, this part draws together the empirical evidence on the likely divergence in trend inflation across EMU as a prelude to the analysis of relative price and wage adjustment. The last section examines the implications of the zero interest rate floor at low inflation rates.
Allowing for biases in inflation measurement
32. In the wake of the influential 1996 Boskin report on measurement biases in the U.S. CPI, several studies have tried to estimate the inflation measurement bias in European indices. These studies have generally found that the bias was lower than the Boskin estimates owing to a smaller “substitution bias” (Table 1). Lower substitution bias was due to more frequent updating of the weights than was the case in the U.S. at the time and differences in the detailed index calculation methods used.
Estimates of the Measurement Bias
(percent)
Does not include ‘quality bias.’
Recent methodological changes have reduced the bias since Boskin’s estimate.
Sources: Boskin, 1996; Cunningham, 1996; Hoffman, 1998; Lequiller, 1997; Crawford, 1998.
Estimates of the Measurement Bias
(percent)
| Total | Range | |
|---|---|---|
| Germany | 0.75 | 0.5-1.5 |
| France 1/ | - | > 0.1-0.25 |
| United Kingdom | - | 0.35-0.8 |
| United States 2/ | 1.1 | 0.8-1.6 |
| Canada | 0.5 | - |
Does not include ‘quality bias.’
Recent methodological changes have reduced the bias since Boskin’s estimate.
Sources: Boskin, 1996; Cunningham, 1996; Hoffman, 1998; Lequiller, 1997; Crawford, 1998.
Estimates of the Measurement Bias
(percent)
| Total | Range | |
|---|---|---|
| Germany | 0.75 | 0.5-1.5 |
| France 1/ | - | > 0.1-0.25 |
| United Kingdom | - | 0.35-0.8 |
| United States 2/ | 1.1 | 0.8-1.6 |
| Canada | 0.5 | - |
Does not include ‘quality bias.’
Recent methodological changes have reduced the bias since Boskin’s estimate.
Sources: Boskin, 1996; Cunningham, 1996; Hoffman, 1998; Lequiller, 1997; Crawford, 1998.
33. Compared to the wealth of detailed price studies available for the U.S., however, the European results were based on very incomplete evidence as regards the “quality bias” which may arise from the inadequate adjustment of prices to take account of quality improvements. Even the Boskin report’s estimates were subject to a large margin of uncertainty since quality biases are by nature hard to quantify. (As statisticians like to point out: if quality improvements were readily quantifiable, the indices would already be adjusted.) The less widespread use of hedonic price measures in Europe suggests that the quality bias could be higher than in the U.S. For example, the U.S. series for “personal computers and peripheral equipment” show a much more rapid price decline (roughly -30 percent per year since the introduction of hedonic prices in January 1998) than the euro area series for “information processing equipment” (-13 percent per year, and -20 percent in France which uses hedonic pricing).
34. On the other hand, the euro-area HICP does not presently include owner-occupied housing (an omission which is likely to reduce any overall bias), and recent research has found examples of potential downward biases in inflation measures, e.g. related to difficulties in separating changes in “fashion” from quality (see references in Wynne and Rodriguez-Palenzuela, 2002).
35. A recent ECB working paper concluded that “there is very little scientific basis for putting a point estimate on the likely magnitude on the overall bias in the HICP.” (Wynne and Rodriguez-Palenzuela, 2002). The paper also noted that the HICPs are work in progress, so measurement biases may change over time. An experimental index for owner-occupied housing is in the works with a view to possible later inclusion in the HICP on the basis of the net acquisition principle. Moreover, progress in harmonizing methods of quality adjustment across EU countries could also induce changes in the overall bias.
36. Even if a numerical assessment of the bias in the HICP remains elusive, however, a qualitative comparison with the well-researched CPI in the United States—on the basis of the studies of national CPIs quoted above and given that the national HICPs and CPIs mostly share the same detailed price information—would suggest that substitution biases are likely to be substantially lower than was the case for the U.S. CPI when the Boskin report was issued, while quality and possibly new product biases are likely to be at least as high in the euro-area HICP as in the U.S. owing to more extensive use of hedonic measures in the U.S. Consequently, measurement error may well account for a significant fraction of observed inflation in the euro area.
Allowing for cross-country variation in inflation
37. We next turn to the issue of judging the potential dispersion in trend inflation across EMU members owing to prospective price convergence. If some countries were to experience significantly below average inflation the smooth adjustment of relative wages and prices within and across countries might be stifled. The scope for steady-state inflation differences in EMU is assessed on the basis of three complementary approaches: applications of the Balassa-Samuelson model; examination of long-period real exchange rate trends; and an assessment of the pace of convergence in absolute price levels across EMU countries.
Balassa-Samuelson effects in EMU
38. The Balassa-Samuelson model explains real exchange rate movements in terms of sectoral productivity growth differentials, and rests on two components. First, the relative price of nontradables relative to tradables in each country reflects the relative productivity of labor in the traded and non-traded goods sectors. Second, the model assumes that purchasing power parity (PPP) holds for traded goods (in the long run). In EMU, this implies that price increases are equal across countries for traded goods, but that slower productivity growth in the non-traded goods sector makes for more rapid increases in unit labor costs and prices in that sector. National inflation differences will thus be determined by the cross-country variation in the sectoral productivity differentials and the weights of nontradables in national price indices.
39. Table 2 summarizes the results of several recent studies, realigned for comparability on an average trend inflation in the euro area of 1.5 percent, and assuming that sectoral productivity differentials observed in the past will continue in the future. The results vary considerably depending on the sample, data, and methodology employed, and the most recent additions to the literature have significantly inflated the margin of uncertainty: Reuter and Sinn, 2000 provide much larger estimates of the dispersion than previous studies, while the opposite is the case for De Grauwe and Skudelny, 2000.
Steady State Inflation Rates Implied by Balassa Samuelson Effects
(aligned to average Euro area inflation of 1.5 percent).
Steady State Inflation Rates Implied by Balassa Samuelson Effects
(aligned to average Euro area inflation of 1.5 percent).
| Sample | Calculations based on: | |||||||
|---|---|---|---|---|---|---|---|---|
| Average of all columns | Alberola and Tyrväinen (1998) | Canzoneri et. al. (1998) | De Grauwe et. al. (2000) | Sinn and Reuter (2000) | HICP Proxy | |||
| 1975-1995 | 1985-1995 | 1973-1997 | 1973-1997 | 1971-1995 | 1987-1995 | 1995-2001 | ||
| value-added deflators | CPI | |||||||
| Austria | 1.6 | 1.3 | 1.0 | 1.7 | 1.3 | 2.0 | 2.0 | 2.0 |
| Belgium | 2.0 | 2.6 | 2.2 | 2.9 | 2.1 | 1.6 | 1.4 | 1.5 |
| Finland | 1.8 | 1.9 | 1.0 | - | 1.9 | 0.9 | 3.3 | 1.8 |
| France | 1.5 | 1.2 | 1.1 | 1.6 | 1.9 | 1.1 | 1.9 | 1.4 |
| Germany | 0.8 | 0.8 | 0.8 | 0.5 | 0.5 | 1.2 | 0.6 | 1.4 |
| Greece | 3.5 | - | - | - | - | - | 4.7 | 2.2 |
| Ireland | 2.9 | - | - | - | - | - | 2.9 | 2.9 |
| Italy | 2.0 | 1.9 | 1.9 | 2.5 | 2.3 | 1.9 | 2.1 | 1.4 |
| Netherlands | 1.7 | 1.8 | 1.6 | 1.5 | 2.0 | 1.8 | ||
| Portugal | 1.7 | - | - | - | - | 1.6 | 1.4 | 2.2 |
| Spain | 2.1 | 2.6 | 3.0 | 2.0 | 1.9 | 1.5 | 2.1 | 1.8 |
| Euro area | 1.5 | 1.5 | 1.5 | 1.5 | 1.5 | 1.5 | 1.5 | 1.5 |
| Max-Min | 2.6 | 1.8 | 2.2 | 2.4 | 1.8 | 1.1 | 4.1 | 1.5 |
| Dispersion | 0.7 | 0.6 | 0.8 | 0.8 | 0.6 | 0.4 | 1.1 | 0.5 |
Steady State Inflation Rates Implied by Balassa Samuelson Effects
(aligned to average Euro area inflation of 1.5 percent).
| Sample | Calculations based on: | |||||||
|---|---|---|---|---|---|---|---|---|
| Average of all columns | Alberola and Tyrväinen (1998) | Canzoneri et. al. (1998) | De Grauwe et. al. (2000) | Sinn and Reuter (2000) | HICP Proxy | |||
| 1975-1995 | 1985-1995 | 1973-1997 | 1973-1997 | 1971-1995 | 1987-1995 | 1995-2001 | ||
| value-added deflators | CPI | |||||||
| Austria | 1.6 | 1.3 | 1.0 | 1.7 | 1.3 | 2.0 | 2.0 | 2.0 |
| Belgium | 2.0 | 2.6 | 2.2 | 2.9 | 2.1 | 1.6 | 1.4 | 1.5 |
| Finland | 1.8 | 1.9 | 1.0 | - | 1.9 | 0.9 | 3.3 | 1.8 |
| France | 1.5 | 1.2 | 1.1 | 1.6 | 1.9 | 1.1 | 1.9 | 1.4 |
| Germany | 0.8 | 0.8 | 0.8 | 0.5 | 0.5 | 1.2 | 0.6 | 1.4 |
| Greece | 3.5 | - | - | - | - | - | 4.7 | 2.2 |
| Ireland | 2.9 | - | - | - | - | - | 2.9 | 2.9 |
| Italy | 2.0 | 1.9 | 1.9 | 2.5 | 2.3 | 1.9 | 2.1 | 1.4 |
| Netherlands | 1.7 | 1.8 | 1.6 | 1.5 | 2.0 | 1.8 | ||
| Portugal | 1.7 | - | - | - | - | 1.6 | 1.4 | 2.2 |
| Spain | 2.1 | 2.6 | 3.0 | 2.0 | 1.9 | 1.5 | 2.1 | 1.8 |
| Euro area | 1.5 | 1.5 | 1.5 | 1.5 | 1.5 | 1.5 | 1.5 | 1.5 |
| Max-Min | 2.6 | 1.8 | 2.2 | 2.4 | 1.8 | 1.1 | 4.1 | 1.5 |
| Dispersion | 0.7 | 0.6 | 0.8 | 0.8 | 0.6 | 0.4 | 1.1 | 0.5 |
40. Taken at face value, the results suggest that steady state inflation in Germany could be significantly below the euro area average, and perhaps below 1 percent if the ECB aims for 1.5 percent for the aggregate. Catching-up countries generally would register higher-than-average inflation rates although the results are more divided in this respect than one might have expected. Most of the remaining countries would be close to the average.
41. Also of interest are the underlying differences across sectors. The average productivity growth differential between the tradables and nontradables sectors in the euro area has been 1¾ percent per year, and the average inflation rate for nontradables have exceeded that of tradables by the same amount. Given their respective weights in GDP, average trend inflation of 1.5 percent in the euro area would imply trend inflation for tradables as low as 0.3 percent, and 2.0 percent for services (value-added deflators). The trend inflation for goods retail prices would be around ¾ percent owing to the retail and distribution components of their final sales prices.
42. Despite its intellectual attraction, the Balassa-Samuelson model has not received unequivocal backing in the empirical literature. Most studies do find that relative prices generally reflect relative labor productivities in the long run (and in some empirical applications, relative wages), but the evidence on purchasing power parity in traded goods is less favorable (see Canzoneri et.al., 1999). As to whether the Balassa-Samuelson model or PPP for broad price measures provides the best description of long-run real exchange rate movements, Rogoff, 1996 concluded that:
“Overall, there is substantial empirical support for the Balassa-Samuelson hypothesis, especially in comparisons between very poor and very rich countries, and in time series data for a select number of countries, including especially Japan. Whether [it] is of broader importance in explaining real exchange rates across industrialized countries is a matter of some debate. We have already seen that a substantial body of evidence suggest that across industrialized countries, there is long-run convergence to PPP, the Balassa-Samuelson effect notwithstanding” (Rogoff 1996, p. 662).
43. There are several reasons to believe that the above quantifications of the Balassa-Samuelson effect may overestimate the extent of likely inflation divergences in EMU:
Fast productivity growth in the traded-goods sectors in catching-up countries owes, at least in part, to rising capital-labor ratios. Consequently, total costs per unit and thus prices may diverge less between sectors than unit labor costs alone would indicate;6
The value-added deflator in the tradables sector may not be an adequate measure of the price of domestically produced tradables; in fact, input-output data show that domestic non-traded goods sectors provide substantial inputs to the tradables sector;
Different sector productivity trends owe in part to shifts in the composition of labor (e.g. towards more use of low-skill and part-time employment in services relative to manufacturing) which may equally affect service sector wages. Such productivity changes would have little impact on unit labor costs and relative prices. (Alberola and Tyrväinen, 1998 are among the few to control for sectoral wage differences).
44. The HICP proxy in the right-hand column of Table 2 is calculated by assuming that the trend differential between industrial goods (excluding energy) and services in each country’s HICP remains constant going forward. This simple proxy is immune to the criticisms above since it relies directly on observed inflation differentials, not productivity differentials, and because PPP may be a more appropriate assumption for the consumer basket of tradables (which includes a mix of foreign and domestic goods) than the value-added deflator (which covers only domestic goods). This proxy shows an inflation range in EMU from 1.4 percent in France and Germany to 2.9 percent in Ireland.
Extrapolating past real exchange rate trends
45. If money is neutral in the long run, real exchange rates movements should ultimately be determined by factors in the real economy. Consequently, the fact that EMU countries used to have separate currencies should not be a prime determinant of past long-period real exchange rate trends, and the latter may therefore provide pointers to what could be in store in EMU. This approach imposes much less structure than the Balassa-Samuelson model, and largely leaves open what factors explained past trends. On one level this is an advantage because it allows for an unrestricted array of determinants of real exchange rate movements. On another level it is a drawback, because in the absence of specific hypotheses of what drives real exchange rates, it is hard to assess whether and to what extent they are likely to continue in EMU.
Figure 4 shows the movements in EMU countries’ price levels relative to Germany since 1960 when measured in common currency; and Table 3 shows implied steady state inflation rates in EMU based on extrapolations of past relative price adjustments.
Euro Countries: Consumer Prices Relative to Germany, 1960-2001.
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Euro Countries: Consumer Prices Relative to Germany, 1960-2001.
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Euro Countries: Consumer Prices Relative to Germany, 1960-2001.
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Steady State Inflation Based on Extrapolation of Real Exchange Rate Trends
Deflator of private consumption.
Source: EU Commission, and own calculations.
Steady State Inflation Based on Extrapolation of Real Exchange Rate Trends
| Consumer prices 1/ | GDP deflator | |||
|---|---|---|---|---|
| 1961-2001 | 1975-2001 | 1985-2001 | 1975-2001 | |
| Austria | 1.9 | 2.1 | 1.9 | 1.7 |
| Belgium | 1.2 | 1.2 | 1.1 | 1.5 |
| Finland | 1.0 | 1.4 | 1.2 | 0.3 |
| France | 1.1 | 1.3 | 1.1 | 1.1 |
| Germany | 1.5 | 1.4 | 1.3 | 1.5 |
| Greece | 0.9 | 1.1 | 1.7 | 2.1 |
| Ireland | 1.6 | 1.7 | 2.3 | 1.3 |
| Italy | 1.5 | 1.5 | 2.0 | 1.6 |
| Luxembourg | 1.1 | 1.4 | 1.5 | 1.9 |
| Netherlands | 2.0 | 1.9 | 1.5 | 1.6 |
| Portugal | 1.7 | 2.0 | 2.0 | 3.0 |
| Spain | 2.2 | 2.2 | 2.0 | 1.9 |
| Euro area | 1.5 | 1.5 | 1.5 | 1.5 |
| Max-min | 1.4 | 1.1 | 1.2 | 2.7 |
| Dispersion | 0.5 | 0.4 | 0.4 | 0.6 |
Deflator of private consumption.
Source: EU Commission, and own calculations.
Steady State Inflation Based on Extrapolation of Real Exchange Rate Trends
| Consumer prices 1/ | GDP deflator | |||
|---|---|---|---|---|
| 1961-2001 | 1975-2001 | 1985-2001 | 1975-2001 | |
| Austria | 1.9 | 2.1 | 1.9 | 1.7 |
| Belgium | 1.2 | 1.2 | 1.1 | 1.5 |
| Finland | 1.0 | 1.4 | 1.2 | 0.3 |
| France | 1.1 | 1.3 | 1.1 | 1.1 |
| Germany | 1.5 | 1.4 | 1.3 | 1.5 |
| Greece | 0.9 | 1.1 | 1.7 | 2.1 |
| Ireland | 1.6 | 1.7 | 2.3 | 1.3 |
| Italy | 1.5 | 1.5 | 2.0 | 1.6 |
| Luxembourg | 1.1 | 1.4 | 1.5 | 1.9 |
| Netherlands | 2.0 | 1.9 | 1.5 | 1.6 |
| Portugal | 1.7 | 2.0 | 2.0 | 3.0 |
| Spain | 2.2 | 2.2 | 2.0 | 1.9 |
| Euro area | 1.5 | 1.5 | 1.5 | 1.5 |
| Max-min | 1.4 | 1.1 | 1.2 | 2.7 |
| Dispersion | 0.5 | 0.4 | 0.4 | 0.6 |
Deflator of private consumption.
Source: EU Commission, and own calculations.
46. These calculations suggest that the scope for inflation differentials in EMU is smaller than Balassa-Samuelson calculations imply (especially bearing in mind the absence of data for Portugal, Ireland, and Greece in most studies reported in Table 2). Nonetheless, they do not rule out that trend inflation could be around 1 percent in one or more countries if the euro area average were to be maintained at 1.5 percent.
Convergence in absolute price levels
47. However, income convergence has progressed across the EU during recent decades and real exchange rate appreciation for lower-income countries may therefore be smaller going forward than in historical samples.
48. Absolute price levels vary across the EU in a manner that relates fairly closely to relative living standards (Figure 5). The correlation coefficient between absolute 1999 price levels and per capita income is 0.68. Correcting for differences in indirect taxes the correlation was 0.83 in 1996, the latest year for which price data excluding taxes are available.
EU Countries: Price Levels and GDP per Capita, 1999
(indices; euro area=100)
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
EU Countries: Price Levels and GDP per Capita, 1999
(indices; euro area=100)
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
EU Countries: Price Levels and GDP per Capita, 1999
(indices; euro area=100)
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
49. Table 4 breaks down the overall price levels in terms of six goods and services categories. As is evident from column 1, the price levels of ‘core’ goods (which excludes food, alcohol and tobacco) are very similar across EMU, indicating highly integrated markets: the only significant outliers are geographically isolated Finland and Greece. The degree of price convergence appears almost surprisingly large, given the relatively high share in retail prices of domestic inputs (retail, distribution and indirect taxes). However, cheaper labor and land inputs in the distribution sectors of lower-income countries are seemingly off-set by lower efficiency, possibly related to high numbers of small-scale outlets. Moreover, cross-border shopping provides for arbitrage at the retail level, particularly among neighboring countries (although prices do vary considerably for many individual subcomponents of ‘core goods’).
EU Countries: Price Levels Compared
(1999; index EU12=100)
EU Countries: Price Levels Compared
(1999; index EU12=100)
| Goods | Services | |||||
|---|---|---|---|---|---|---|
| Core goods 1/ | Food, tobacco | Energy | Core services 2/ | Communications | Rents | |
| Austria | 99 | 104 | 102 | 107 | 128 | 81 |
| Belgium | 100 | 101 | 95 | 102 | 113 | 87 |
| Finland | 117 | 109 | 83 | 102 | 85 | 93 |
| France | 106 | 110 | 103 | 107 | 96 | 101 |
| Germany | 99 | 102 | 108 | 109 | 111 | 112 |
| Greece | 108 | 88 | 65 | 52 | 72 | 60 |
| Ireland | 99 | 97 | 86 | 89 | 108 | 65 |
| Italy | 97 | 102 | 96 | 85 | 87 | 54 |
| Netherland | 97 | 94 | 91 | 94 | 89 | 104 |
| Portugal | 97 | 80 | 102 | 64 | 103 | 31 |
| Spain | 95 | 83 | 74 | 83 | 83 | 57 |
| Euro area | 100 | 100 | 100 | 100 | 100 | 100 |
| Denmark | 124 | 134 | 155 | 112 | 79 | 84 |
| Sweden | 105 | 114 | 94 | 121 | 94 | 105 |
| U.K. | 94 | 101 | 87 | 103 | 105 | 78 |
EU Countries: Price Levels Compared
(1999; index EU12=100)
| Goods | Services | |||||
|---|---|---|---|---|---|---|
| Core goods 1/ | Food, tobacco | Energy | Core services 2/ | Communications | Rents | |
| Austria | 99 | 104 | 102 | 107 | 128 | 81 |
| Belgium | 100 | 101 | 95 | 102 | 113 | 87 |
| Finland | 117 | 109 | 83 | 102 | 85 | 93 |
| France | 106 | 110 | 103 | 107 | 96 | 101 |
| Germany | 99 | 102 | 108 | 109 | 111 | 112 |
| Greece | 108 | 88 | 65 | 52 | 72 | 60 |
| Ireland | 99 | 97 | 86 | 89 | 108 | 65 |
| Italy | 97 | 102 | 96 | 85 | 87 | 54 |
| Netherland | 97 | 94 | 91 | 94 | 89 | 104 |
| Portugal | 97 | 80 | 102 | 64 | 103 | 31 |
| Spain | 95 | 83 | 74 | 83 | 83 | 57 |
| Euro area | 100 | 100 | 100 | 100 | 100 | 100 |
| Denmark | 124 | 134 | 155 | 112 | 79 | 84 |
| Sweden | 105 | 114 | 94 | 121 | 94 | 105 |
| U.K. | 94 | 101 | 87 | 103 | 105 | 78 |
50. By contrast, services prices vary widely across countries, and there is a clear tendency for prices to be lower in the relatively poorer countries. The prospective convergence in price levels as these economies catch up with the more advanced economies will necessarily imply divergence in inflation rates. Another way of expressing the same point is that convergence on absolute PPP necessitates temporary deviations from relative PPP.
51. Table 5 provides some illustrative calculations of how average inflation rates might differ across the euro area over the next 10-20 years, depending on the how fast the remaining differences in price levels are reduced. This exercise should be taken with a grain of salt—for instance, it is possible that geographically remote Finland could maintain high indirect taxes and retail prices despite intensified pressures for harmonization. Nonetheless, the results are broadly corroborative of the previous approach and lends support to the notion that trend inflation rates could vary from around 1-1¼ percent in Germany and France to 2-3¼ percent in Portugal, Greece, and Spain.
Steady State Inflation Rates Based on Convergence in Price Levels
(aligned to 1.5 percent for the euro area)
Steady State Inflation Rates Based on Convergence in Price Levels
(aligned to 1.5 percent for the euro area)
| Half-life (years) | |||
|---|---|---|---|
| 10 | 15 | 20 | |
| Austria | 1.3 | 1.3 | 1.4 |
| Belgium | 1.3 | 1.3 | 1.4 |
| Finland | 0.6 | 0.9 | 1.1 |
| France | 1.2 | 1.3 | 1.3 |
| Germany | 1.1 | 1.2 | 1.3 |
| Greece | 2.6 | 2.2 | 2.0 |
| Ireland | 1.3 | 1.4 | 1.4 |
| Italy | 2.0 | 1.8 | 1.7 |
| Netherlands | 1.7 | 1.6 | 1.6 |
| Portugal | 3.3 | 2.7 | 2.4 |
| Spain | 2.4 | 2.1 | 1.9 |
| Euro area | 1.5 | 1.5 | 1.5 |
| Max-min | 2.7 | 1.8 | 1.3 |
| St.dev. | 0.8 | 0.5 | 0.4 |
Steady State Inflation Rates Based on Convergence in Price Levels
(aligned to 1.5 percent for the euro area)
| Half-life (years) | |||
|---|---|---|---|
| 10 | 15 | 20 | |
| Austria | 1.3 | 1.3 | 1.4 |
| Belgium | 1.3 | 1.3 | 1.4 |
| Finland | 0.6 | 0.9 | 1.1 |
| France | 1.2 | 1.3 | 1.3 |
| Germany | 1.1 | 1.2 | 1.3 |
| Greece | 2.6 | 2.2 | 2.0 |
| Ireland | 1.3 | 1.4 | 1.4 |
| Italy | 2.0 | 1.8 | 1.7 |
| Netherlands | 1.7 | 1.6 | 1.6 |
| Portugal | 3.3 | 2.7 | 2.4 |
| Spain | 2.4 | 2.1 | 1.9 |
| Euro area | 1.5 | 1.5 | 1.5 |
| Max-min | 2.7 | 1.8 | 1.3 |
| St.dev. | 0.8 | 0.5 | 0.4 |
52. For a broad sample of countries, Barro and Salaî-Martin, 1995 estimate that relative differences in per capita incomes are reduced on average by 3 percent per annum. Using different estimation methods, Björksten, 2000 finds convergence to be more rapid. Applying the range of estimates in the EU context implies that lower income Portugal and Greece should enjoy productivity growth of about 1-1½ percent higher per year than the highest income countries, in which case the half-life of remaining output (and price level) differences would be 15-20 years.
53. Experience from actual monetary unions may also shed light on the issue of inflation differences in EMU. In the monetary union between Ireland and the U.K.—countries with a considerable disparity in economic development—the average difference in annual inflation was a moderate 0.4 percentage points between 1950 and 1978. Between Luxembourg and Belgium, there was no difference on average over the 1950-2001 period.
Implications of enlargement
54. Any enlargement of EMU to include wealthy EU members Denmark, Sweden, and the United Kingdom seems unlikely to broaden the scope for inflation divergence significantly, although pressures for absolute price convergence could keep inflation below average in high-price Sweden and Denmark. However, the EU is conducting enlargement negotiations with ten eastern European countries as well as Cyprus and Malta. Turkey has also applied for membership. The EU aims to conclude the negotiations with those countries that are ready to join by the end of 2002 so that they can accede by 2004, and several others are expected to follow not long thereafter. Some of them seem keen on joining EMU at the earliest opportunity, which could be by 2006 provided they fulfill the Treaty’s convergence criteria.
55. In 1998, the combined GDP of the EU applicant countries amounted to no more than 9 percent of euro area GDP, less than Spain alone (Björksten, 2000). One might therefore surmise that the effect of above-average inflation in the newcomers would have a limited effect on the aggregate. The results in Sinn and Reutter, 2000 imply that 1.5 percent steady state inflation in an enlarged euro area of 21 countries (namely the current 15 EU members plus Poland, Hungary, the Czech Republic, Estonia, Slovenia, and Turkey, but omitting Cyprus, Bulgaria, Romania, Lithuania, Latvia, Malta, and the Slovak Republic due to lack of data) would require a reduction in trend inflation for the existing euro area countries of 0.2 percentage points. While the calculations are based on very short samples, the implied steady state inflation rates for most newcomers would be in range of 3-4½ percent, which is consistent with the estimates in Halpera and Wyplosz, 2001. The latter conclude that inflation rates in Poland, Hungary, the Czech Republic, Slovenia, Latvia, and Romania could be some 3 percent above that in the euro area.
56. However, as real convergence progresses, the weight in the euro aggregates of accession countries would converge on their share in euro area population, which could be as high as one third of an enlarged euro area. To be sure, the speed of convergence and size of the inflation differential would decrease as states neared the advanced-country technology frontier. Björksten, 2000 conducted a simulation in which he assumed: (i) 13 applicant countries joining EMU within 15 years; (ii) average real GDP growth of 2 percent in wealthier countries, (iii) average real growth of 5 percent per year in accession countries until 2010, subsiding thereafter, and (iv) average inflation of 5 percent until 2010, 4 percent during 2010-15, and 3 percent thereafter. If the accession countries all joined the euro, the current members would be obliged to maintain average annual inflation levels below 1¼ percent in order to keep area-wide inflation below 2 percent (and below ¾ percent to keep the area-wide rate below 1.5 percent). After 20 years of convergence, per capita GDP in accession countries would still only be about two thirds of the euro area average, so price convergence could go on for some time after that, even if at a reduced pace.
57. The prospect of enlargement strongly underlines the need for the Eurosystem’s target for inflation to allow scope for variation in trend inflation across countries.7 Variation in trend inflation rates—while probably not as large with the current country composition as suggested by applications of the Balassa-Samuelson model—may affect the smooth functioning of EMU if nominal rigidities hamper price and wage adjustment at near-zero inflation. It is to this issue that we turn next.
Inflation as a lubricant in price and wage adjustment
58. The idea that a moderate level of inflation may “grease the wheels” of relative price and wage adjustment in an economy where agents are averse to nominal wage or price cuts was revived in the 1990s as inflation rates returned to low levels.8 Downward rigidities may stem from elements of money illusion, entrenched perceptions about “fairness”, and employer concerns about the impact of wage cuts on worker morale. A seminal paper by Akerlof, Dickens and Perry 1996 argued that steady-state unemployment (in the U.S.) would be higher at rates of inflation below 3 percent, and especially below 2 percent. On the other hand, the coexistence of low inflation and falling NAIRUs in a number of industrialized economies in the 1990s—including the U.S., the U.K., and several euro countries—suggests that the reduction in inflation to roughly 2 percent has not had any detrimental impact on the smooth functioning of labor markets. The issue is briefly explored below for product markets, and at greater length for wages.
Product markets
59. Evidence from euro-area price indices suggests nominal price cuts are not as uncommon as is often believed. For instance, the fraction of the euro area HICP that displayed negative year-on-year inflation rates in March 2002 (when headline inflation was 2.5 percent) was 11 percent. In December 1998, when inflation 0.8 percent, one fifth of all categories exhibited negative inflation.
60. If goods and services markets were characterized by downward nominal rigidities, one would expect the distribution of price changes to alter shape and exhibit more zero changes as the inflation rate falls. Figure 6 shows the distribution of year on year price changes in the HICP at six discrete points in time, and reveals no obvious signs that the distribution is affected by the median inflation rate. Figure 7 charts the median and the skewness of the distribution since 1990 (upper panel), and a cross-plot of the median vs. skewness (lower panel). There is little to suggest that lower inflation in the euro area has affected the skewness of the distribution, as would have been expected in the presence of downward rigidities.9 (Similar conclusions were reached for the United Kingdom by Yates, 1998 and King, 1999).
Euro Area: Distribution of Annual Price Changes Among CPI Components
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Sources: Eurostat; and staff estimates.
Euro Area: Distribution of Annual Price Changes Among CPI Components
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Sources: Eurostat; and staff estimates.Euro Area: Distribution of Annual Price Changes Among CPI Components
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Sources: Eurostat; and staff estimates.
Euro Area: Median and Skewness of the Distribution of Price Changes
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Sources: Eurostat.
Euro Area: Median and Skewness of the Distribution of Price Changes
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Sources: Eurostat.Euro Area: Median and Skewness of the Distribution of Price Changes
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Sources: Eurostat.Labor markets: downward nominal wage rigidity
61. While not conclusive, the cumulated evidence on downward nominal wage rigidities (Box 2) points to such rigidities being quite pervasive in the primary sector of the labor market in industrial countries, in the sense that cuts in base pay for given worker effort are much more rare than if there were no nominal rigidity. Out of concern for worker morale, wage cuts are enacted almost exclusively in conditions of severe distress (Bewley 1999). At the same time, however, variations in hours worked and bonuses provide substantial flexibility in companies’ wage bill. Moreover, the secondary sector of the labor market, where turnover is high and part-time and temporary jobs are common, exhibit much more flexibility in nominal wages than does the primary sector (Bewley 1999).
62. Much less is known about the effects of downward nominal wage rigidity for aggregate employment and wage outcomes. Akerlof, Dickens and Perry 1996 used a simulation model of the U.S. economy—in which a random distribution of wage changes across employers was truncated so that firms cut back employment instead of cutting wages for workers whose marginal revenue product had fallen—to argue that steady-state unemployment is higher at very low rates of inflation. Their results suggest that average inflation of 2 percent in the U.S. would result in a permanent increase in unemployment of around 0.2 percentage points compared to the natural rate of unemployment obtaining at inflation rates of 3 percent or more. An inflation target of 1 percent would add an additional ½ percentage point to the steady-state unemployment rate.10 On the other hand, Groshen and Schweitzer 1999—who take account not only of inflation’s “grease” effects in aiding relative wage adjustment but also its “sand effects” in distorting price signals—found little or no increase in unemployment at low inflation rates. Using a high-quality establishment data set they established that modest inflation has a positive but small and statistically insignificant impact on the labor market, but that sand effects exceed grease effects at inflation rates over 5 percent.
63. In judging the importance of this issue for the euro area, questions arise as to the extent to which U.S. considerations apply to Europe, given the very different labor market institutions in place there. It is widely accepted that real, not nominal, wages are more rigid in Europe than in the United States, even if such rigidities relaxed in the 1990s. In the euro area, there is little to suggest that wages adjust quickly to local or occupational supply and demand conditions in the manner of the U.S. labor market (see, e.g., Prasad, 1999 on “the unbearable stability of the German wage structure”). If relative wage rigidity largely reflects wage-setting institutions and the impact of government regulations, inflation above a certain level is unlikely to do much to speed up wage adjustment.
Evidence on Downward Nominal Wage Rigidities
The clearest evidence of downward wage rigidities come from studies that rely on firm-specific, contract, or interview data and focus on base pay rates in the primary sector of the labor market. Using firm-specific data, Wilson 1999 found 0.1 percent and 0.0 percent of jobstayers suffered wage cuts in two large U.S. service sector firms; Fehr and Goette 2000 found wage cuts in 1.7 percent and 0.4 percent of cases in two large Swiss firms; and Altonji and Devereux, 1999 found that only 0.5 percent of salaried workers and 2.5 percent of hourly workers received wage reductions in a large U.S. financial corporation, almost all of which were associated with changes in part time/full time status or performance-related incentives. There is no guarantee that these firms are representative, but the presumption that they may well be so is bolstered by extensive interview studies of employers (notably Bewley, 1999, but also Shafir, Diamond, and Tversky 1997; Blinder and Don Choi 1990; Agell and Lundborg 1995) which without exception confirm that wage cuts are uncommon. Bewley, however, reports that wage flexibility is much more pronounced in the secondary sector of the labor market for part-time and temporary jobs. Finally, Akerlof, et. al., 1996 found negative pay changes in about 2 percent of cases in telephone surveys, and Fortin 1996 and others confirm that negotiated wage cuts are rare in contract settlements.
A growing number of papers have examined the existence of downward nominal wage rigidities using household panel data (including for the U.S. Kahn, 1997 and Card and Hyslop, 1996; for the U.K. Smith, 2000; and for Germany Decressin and Decressin, 2002) or employer-supplied data (e.g. Groshen and Schweitzer, 1999 and Lebow et.al. 1999 for U.S. establishment data; Nickell and Quintini, 2001 for the UK; and Beissinger and Knoppik, 2001 for German social security data). These studies generally find some bunching of wage changes around the zero mark for workers who stay in a given job in a manner consistent with downward nominal rigidity. (They also indicate that surprisingly high numbers of wage earners suffer nominal wage cuts in an average year (spanning 15-25 percent of non-job changers) which may owe much to the inclusion of overtime pay, bonuses, and other flexible elements (e.g. night shifts, perks) in the measure of remunerations, as well as to reporting errors.)1
For the purposes of this paper, the most important aspect of these studies concerns the tests performed of how the wage change distribution is affected by the level of inflation (as argued in Decressin and Decressin 2002, reporting error lowers the power of such tests but does not invalidate them). The tests carried out for the euro area’s largest economy by Beissinger and Knoppik 2001 and Decressin and Decressin 2002 find that the level of inflation affects the distribution of wage changes. The zero mark is binding more often at very low inflation rates so that real wage adjustments could be hampered in Germany. (Similar results were found for the UK by Nickell and Quintini; for the U.S., Groshen and Schweitzer, 1999 pinpoint declining grease effects during low inflation periods). Decressin and Decressin 2002 judge the effect to be too small to make a compelling case for the ECB to adopt a higher inflation target but also note that the presence of a nominal rigidity at the zero mark for base wages suggests pushing inflation much below 2 percent could bear risks. Based on similar analyses Beissinger and Knoppik suggest the ECB should aim at the upper bound of its target.
1For the U.S., there is some direct evidence of such errors: a validation study of the Panel Study of Income Dynamics (PSID) suggested only 44.2 percent of respondents reported their wage correctly, and the standard deviation between the log wages of the survey responses and the actual wages (as measured by establishment data) was 16.7 percent (discussed in Akerlof et.al. 1996, p. 13). In a similar vein, Shea 1997 noted that in a sample of workers of which only 1.3 percent received actual wage cuts, 21 percent reported cuts in the household survey.64. Moreover, bearing in mind the effects of productivity growth, relative wage growth can vary significantly across workers even at low inflation rates. If average long-term hourly wage growth in the area was 3½-4 percent, consistent with average hourly productivity growth of 1½-2 percent and trend inflation just below 2 percent, relative wages across occupations could in principle vary to the tune of, say, 7-8 percent a year, if some workers got zero increases, and others were at the top of a broadly symmetric distribution (Svensson, 2000). Considering how slowly the wage structure in most European countries has responded to differences in unemployment rates across skill levels and regions, inflation rates of 1½-2 percent would not seem to constitute an obstacle to efficient relative wage changes within countries (even if some of them may experience slightly below-average trend inflation). This view is in line with the studies of the interaction of inflation with nominal wage rigidities quoted in Box 2.
Aggregate wage flexibility
65. An additional dimension arises because of the occasional need for relative wage adjustment among EMU countries in response to asymmetric (country-specific) shocks.
66. Nominal wage rigidities may give rise to non-linearities in Phillips curve relationships at low inflation, whereby the money wage responds more to a positive shock to * labor demand than to a negative shock of equal magnitude.11 Price rigidities of the “menu cost” or “staggered contracts” types may also flatten the slope of the short-run Phillips curve at low inflation rates, implying that a larger shift in unemployment produces a smaller change in the rate of inflation. (Ball, Mankiw, and Romer, 1988 showed that less frequent price adjustments in a regime of low steady state inflation flattens the slope of the short-run output inflation trade off; for a more recent application see Begg et.al. 2002).
67. The weight of the evidence is suggestive of non-linearities in the Phillips curve. Laxton et.al., 1995 find that the inflation-output trade-off is non-linear in pooled data from the G7 countries. In contrast, Turner, 1995 finds that the Phillips curve is linear in the euro-area countries studied, and non-linear in only three OECD economies, namely the United States, Japan, and Canada. As Laxton et.al. 1997 note, however, standard tests will be biased toward the linear model. Pyyhtiä, 1999 find strong evidence of nonlinearity in the Phillips curves of many euro countries, and that the deflationary impact of a negative output gap is very small and not significant as a rule. According to his results, the Phillips curve has been especially asymmetric in Germany, Italy, Spain, the Netherlands, and Finland.
68. At the level of individual euro countries, the issue is whether low inflation among euro partners will prolong the time it takes to regain competitiveness following an adverse shock. This may be illustrated using a simple example: suppose that a country needs to improve its competitiveness relative to euro area partners by 10 percent, and that trend inflation in the area were at 2 percent while trend productivity per hour is also 2 percent. In that case, hourly wages may grow at a trend rate of 4 percent per year for the area as a whole. If our hypothetical country managed to keep wage growth at zero (and productivity growth was unaffected), it could restore its competitiveness within two and a half years. If, however, the downward nominal rigidity is such as to make it difficult to reduce average nominal wage growth below, say, 2 percent, then regaining competitiveness would take five years.12 If the average inflation target was, say, 1 percent it would take longer to restore competitiveness and profitability, namely 3-3½ years with zero wage growth, and 7 years if wage growth could not be reduced below, say, 1½ percent.
69. An example of how this type of process works in practice is given by Germany’s adjustment relative to euro-area partners in the first three years of EMU’s existence (Table 6). Germany managed to keep annual unit labor cost growth some 1½ percent below its partners, gaining competitiveness to the tune of 4 percent over three years, in an environment of 2 percent average inflation.
Relative Wage Adjustment Within EMU, 1999-2001
(annual average growth; percent)
Hourly compensation in manufacturing.
Nominal compensation per employee; total economy.
Relative Wage Adjustment Within EMU, 1999-2001
(annual average growth; percent)
| Germany | Rest of Area | Differential | Euro Area | |
|---|---|---|---|---|
| Hourly wages, industry 1/ | 3.0 | 3.3 | 0.3 | 3.2 |
| Compensation per head 2/ | 1.3 | 3.2 | 1.9 | 2.6 |
| Unit labor costs | 0.8 | 2.2 | 1.4 | 1.7 |
| Real unit labour costs | 0.1 | -0.2 | -0.3 | -0.1 |
| GDP deflator | 0.7 | 2.3 | 1.6 | 1.8 |
| Private consumption deflator | 1.4 | 2.3 | 0.9 | 2.0 |
Hourly compensation in manufacturing.
Nominal compensation per employee; total economy.
Relative Wage Adjustment Within EMU, 1999-2001
(annual average growth; percent)
| Germany | Rest of Area | Differential | Euro Area | |
|---|---|---|---|---|
| Hourly wages, industry 1/ | 3.0 | 3.3 | 0.3 | 3.2 |
| Compensation per head 2/ | 1.3 | 3.2 | 1.9 | 2.6 |
| Unit labor costs | 0.8 | 2.2 | 1.4 | 1.7 |
| Real unit labour costs | 0.1 | -0.2 | -0.3 | -0.1 |
| GDP deflator | 0.7 | 2.3 | 1.6 | 1.8 |
| Private consumption deflator | 1.4 | 2.3 | 0.9 | 2.0 |
Hourly compensation in manufacturing.
Nominal compensation per employee; total economy.
An illustrative simulation
70. The need for cross-country relative wage adjustment in EMU will depend on the frequency, nature and size of asymmetric shocks in EMU. The occurrence of such shocks is inherently difficult to predict in part because of the endogenous nature of the optimal currency area criteria (Frankel and Rose 1998, and Issing 2001). Nonetheless, the experience of the quasi-monetary union between Germany, Austria, and the Netherlands since the early 1980s suggests that considerable movements in relative wage levels, unit labor costs, and prices may continue even among highly integrated economies (Figure 8).
Germany, Austria, Netherlands: Relative Wages and Prices 1/
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Sources: European Commission; IMF; and staff calculations.1/ Indices, expressed in common currency, relative to Germany, 1999=100.
Germany, Austria, Netherlands: Relative Wages and Prices 1/
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Sources: European Commission; IMF; and staff calculations.1/ Indices, expressed in common currency, relative to Germany, 1999=100.Germany, Austria, Netherlands: Relative Wages and Prices 1/
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Sources: European Commission; IMF; and staff calculations.1/ Indices, expressed in common currency, relative to Germany, 1999=100.
Ex Post Real Short-Terra Interest Rates, 1961-2001
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: IMF, European Commission.Note: PC Deflator refers to the deflator of private consumption.
Ex Post Real Short-Terra Interest Rates, 1961-2001
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: IMF, European Commission.Note: PC Deflator refers to the deflator of private consumption.Ex Post Real Short-Terra Interest Rates, 1961-2001
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: IMF, European Commission.Note: PC Deflator refers to the deflator of private consumption.71. The interaction of the average inflation target with relative wage adjustments within and across countries in the presence of wage rigidities has been analyzed in a stochastic, multi-sector simulation model by Holden 2002. Such simulations are clearly dependent on the calibration of shocks and response parameters for which there is limited hard evidence, and the results are merely indicative given the stylized nature of the model. Nonetheless, they illustrate that country-specific shocks may increase the fraction of workers who become unemployed when market-clearing real wage adjustments would require a nominal wage cut, thus giving rise to additional unemployment at low inflation rates. The simulation results recaptured in Table 7 indicate little difference between inflation rates of 2 percent and above, but reducing inflation to 1½ percent or below could entail significant, lasting costs.
Euro Area: Long Run Inflation and Unemployment Rates
(percent)
Euro Area: Long Run Inflation and Unemployment Rates
(percent)
| Inflation target | Unemployment rate | Proportion of wage cuts |
|---|---|---|
| 0.0 | 9.5 | 8.2 |
| 0.5 | 9.3 | 4.6 |
| 1.0 | 8.6 | 3.1 |
| 1.4 | 7.8 | 0.4 |
| 1.9 | 7.1 | 0.1 |
| 2.5 | 6.9 | 0.1 |
Euro Area: Long Run Inflation and Unemployment Rates
(percent)
| Inflation target | Unemployment rate | Proportion of wage cuts |
|---|---|---|
| 0.0 | 9.5 | 8.2 |
| 0.5 | 9.3 | 4.6 |
| 1.0 | 8.6 | 3.1 |
| 1.4 | 7.8 | 0.4 |
| 1.9 | 7.1 | 0.1 |
| 2.5 | 6.9 | 0.1 |
72. A final important issue concerns the extent to which observed behavior during past periods of moderate to high inflation will change in the price stability regime of EMU (cf. the Lucas critique). Mainstream menu-cost theories predict the appearance of downward nominal rigidities at positive inflation that would disappear in a regime of price stability (Ball and Mankiw, 1995). If downward wage rigidity were binding in a low inflation environment, there would be quite strong incentives to get around the restriction by extending bonus and profit-sharing systems, for the benefit of both workers and firms. Nevertheless, a number of reasons suggest that it should not be taken for granted that downward wage flexibility would easily develop. The examples of Switzerland and Japan maybe instructive: Fehr and Goette 2000 found a large degree of wage rigidity and no tendency for the proportion of wage cuts to rise in Switzerland even after an extended period (seven years) in which inflation was close to zero and productivity growth low. Nominal wages are currently stagnating or falling in Japan, but not by much: WEO expects -0.1 percent for hourly compensation in manufacturing in 2002, the fourth year of deflation. In the euro area, moreover, the downward rigidity rooted in employers’ concerns about the impact of wage cuts on worker morale is reinforced by labor laws governing contract renegotiations and employment protection, which give workers a stronger hand in rejecting pay cuts, and which may not easily be changed. Because economies have operated for so long with positive inflation, it would likely take a long time for downward wage flexibility to develop.
73. Even if downward flexibility were to develop, falling prices and wages may not necessarily stabilize the economy in the short run—a debate which goes back to Keynes. In a closed-economy context DeLong and Summers 1986 showed that while lower prices and wages do ultimately increase output, the process of getting there via declining inflation causes the real interest rate to rise, and the latter effect may well swamp the former—in fact, the increasing degree of nominal rigidity in Western economies in the last century coincided with a dramatic decrease in cyclical volatility. In the open and highly integrated economies of EMU, improved competitiveness will strengthen the equilibrating effects of lower wages and prices, but such processes may still be slow.
74. Whereas downward rigidities may help to forestall deflationary risks in the economy, we next examine whether low inflation and interest rates might compromise the ability of central banks to avoid deflation in the face of large, negative shocks.
Zero bound on nominal interest rates
75. A positive rate of inflation may be preferable to absolute price stability if it reduces the chances that countercyclical monetary policy becomes constrained by the zero floor on nominal interest rates.13 The significance of hitting the zero floor depends also on whether monetary policy retains some potency through other transmission channels (e.g., exchange rate intervention and expansion of the money base), on fiscal policy reactions, and on possible self-equilibrating forces in the economy (real balance effect). Two approaches to studying the importance of the zero interest rate constraint are explored in the following: the first is to look at the historical incidence of negative real interest rates; the second is stochastic model simulations.
Historical experience of the euro area
76. Zero nominal interest rates have been rare in the industrialized post-war world, with the important exception of Japan since 1998. High inflation in 1970s and 1980s made the zero floor for nominal rates an irrelevancy, and the higher rate of potential growth as well as widespread quantitative limits on credit expansion in the 1950s and 1960s limit the relevance of the experience from those low-inflation decades for today’s conditions.
77. Summers, 1991 reported that ex post real interest rates in the United States had been negative about one third of the time since World War II. However, the more relevant concept is the ex ante short-term real interest rate (King, 1999). Using one-year-ahead survey expectations and interest rates observed at half-yearly intervals, King found that ex ante real interest rates in the U.S. had been negative only in three brief episodes (the second half of 1976 and the first half of 1977, and the first halves of 1980 and of 1993, comprising roughly 5 percent of the observations). In three of those half years the real rate was barely different from zero, while one observation was around -½ percent. Results for the U.K. show one instance of negative real rates over the same time span, which was, however, quantitatively insignificant.
78. Figure 10 uses historical IMF forecasts as a proxy for inflation expectations to calculate ex ante real short-term interest rates in Germany, France, Italy, and the United States since 1961. On this measure, real ex ante interest rates were negative only on few occasions and only when there was a run-up in inflation, especially around the 1974 oil shock. Too low real interest rates on this instance arguably constituted a policy error, which fed subsequent high inflation. Overall, there is little in these experiences to suggest that real interest rates may need to become negative in the face of adverse demand shocks at low inflation.
Ex Ante Real Short-Term Interest Rates, 1962-2001
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: IMF, European Commission.Note: Inflation expectations are based on May WEO forecasts of the current year change in the GDP deflator. WEO forecasts were not available for the 1960s. For each country, the inflation forecast series over the 1971-2001 was regressed on lagged and actual inflation, and expectations during the 1960s were retropolated by assuming the same degree of foresight then as in 1971-2001.
Ex Ante Real Short-Term Interest Rates, 1962-2001
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: IMF, European Commission.Note: Inflation expectations are based on May WEO forecasts of the current year change in the GDP deflator. WEO forecasts were not available for the 1960s. For each country, the inflation forecast series over the 1971-2001 was regressed on lagged and actual inflation, and expectations during the 1960s were retropolated by assuming the same degree of foresight then as in 1971-2001.Ex Ante Real Short-Term Interest Rates, 1962-2001
Citation: IMF Staff Country Reports 2002, 236; 10.5089/9781451812985.002.A001
Source: IMF, European Commission.Note: Inflation expectations are based on May WEO forecasts of the current year change in the GDP deflator. WEO forecasts were not available for the 1960s. For each country, the inflation forecast series over the 1971-2001 was regressed on lagged and actual inflation, and expectations during the 1960s were retropolated by assuming the same degree of foresight then as in 1971-2001.Simulations of stochastic models
79. Historical data covering periods with high inflation or high potential growth rates do not provide conclusive evidence on how binding the ZIF is likely to be in today’s environment. Recent years have seen a proliferation of studies that explore the issue in stochastic model simulations. Most have focused on the United States but qualitative implications may be drawn for other countries. The following surveys the results, first for standard Taylor policy rules, and subsequently for alternative (more aggressive) policy rules, and adds some new evidence for the euro area.
(i) Simulations based on standard Taylor policy rules
80. Table 8 shows the probability that interest rates might hit the zero bound in three different model applications under different assumptions about the inflation target. The models range from small-scale new open macroeconomics models (Orphanides and Wieland, McCallum) to large-scale models (Reifschneider and Williams) with considerable variation in price and output dynamics and monetary transmission. The shocks and structural features of the models have been calibrated to U.S. rather than euro-area conditions, or, in the case of McCallum 2001, to a more generic “standard” open economy.
Probability that Interest Rates Become Zero Assuming Policy Follows a Standard Taylor Rule.
Small calibrated U.S. model, and a neutral real rate of 1 percent.
FRB/US model, assuming a neutral real rate of 2.5 percent.
Small calibrated model, and a neutral real rate of 2.5 percent.
Note: some entries have been interpolated from neighbouring observations.
Probability that Interest Rates Become Zero Assuming Policy Follows a Standard Taylor Rule.
| Inflation target | ||||
|---|---|---|---|---|
| 0.5 | 1 | 1.5 | 2 | |
| Orphanides and Wieland, 19981/ | 6 | 2 | 1 | 0 |
| Reifschneider and Williams, 1999 2/ | 11 | 9 | 7 | 5 |
| McCallum, 20013/ | - | - | 11 | 8 |
Small calibrated U.S. model, and a neutral real rate of 1 percent.
FRB/US model, assuming a neutral real rate of 2.5 percent.
Small calibrated model, and a neutral real rate of 2.5 percent.
Note: some entries have been interpolated from neighbouring observations.
Probability that Interest Rates Become Zero Assuming Policy Follows a Standard Taylor Rule.
| Inflation target | ||||
|---|---|---|---|---|
| 0.5 | 1 | 1.5 | 2 | |
| Orphanides and Wieland, 19981/ | 6 | 2 | 1 | 0 |
| Reifschneider and Williams, 1999 2/ | 11 | 9 | 7 | 5 |
| McCallum, 20013/ | - | - | 11 | 8 |
Small calibrated U.S. model, and a neutral real rate of 1 percent.
FRB/US model, assuming a neutral real rate of 2.5 percent.
Small calibrated model, and a neutral real rate of 2.5 percent.
Note: some entries have been interpolated from neighbouring observations.
81. The probabilities are not strictly comparable across studies. For instance, the results quoted for Reifschneider and Williams, 1999 refer to the percent of time that the policy interest rate falls to zero in the Simulations, whereas McCallum’s results refer to the number of quarters in which the nominal interest rate is negative in his model. By allowing negative interest rates the latter approach tends to underestimate the severity of the zero bound.
82. There is considerable variation in the results. Orphanides and Wieland (the first paper in this line of research) find low probabilities of hitting the zero floor and conclude that “the consequences of the zero bound are negligible for target inflation rates as low as 2 percent” although the constraint produces a “significant deterioration of the performance of the economy with targets between 0 and 1 percent.” Their simulation assumes an unusually low level for the neutral interest rate, which presumably biases upward the probability of the constraint becoming binding. On the other hand, their model generates unusually low variability of output and inflation, which has the opposite effect.14 Reifschneider and Williams’ results for the U.S. (using the Federal Reserve Board’s FRB/US model) are broadly similar to the results for Japan in Hunt and Laxton, 2001, using the IMF’s Multimod.15
83. The likelihood of hitting the zero target is not equivalent to the probability of ending up in a deflationary spiral, in which falling prices produce higher real rates which farther depress demand and exacerbate negative price pressure. The probability of deflationary spirals is a good deal lower, cf. below. However, whenever the constraint becomes binding there is some loss of output and inflation stabilization relative to an optimal rule.
(ii) Extended Taylor rules
84. The literature has explored modifications to the policy rule which might reduce the likelihood of hitting the zero bound and generally help output and inflation stabilization. Modifications include variations on the parameters in the Taylor rule; addition of the lagged interest rate to the rule; asymmetric responses where rates are lowered more aggressively if inflation nears zero; and inclusion of price level objectives in the rule.
85. Some representative results are reported in Table 9. Relative to the standard Taylor rule, the model simulations do not unanimously point to higher or lower risk of hitting the zero floor—in some cases a more “aggressive” policy rule implies greater interest rate volatility and thus more frequent cases when the zero floor is binding, while in others more active policy has a preventive effect and leads to a fall in the risk of zero interest rates (cf. also Rotemberg and Woodford, 1999; Batini and Haldane, 1999; and Levin, Wieland, and Williams, 1999). Vinals, 2000 represents an outlier in showing zero probabilities of hitting the zero floor even at very low inflation rates. One reason is that his calibration entails a volatility of detrended euro area output of 0.45 percent, which is low relative to the U.S. using the same methods (0.80 percent), and relative to other studies (cf. footnote 14).
Probability that Interest Rates Become Zero Assuming Policy Follows an Aggressive Taylor Rule.
Small calibrated U.S. model, and a neutral real rate of 1 percent.
FRB/US model, assuming a neutral real rate of 2.5 percent.
Small calibrated model, and a neutral real rate of 2.5 percent.
Small calibrated euro area model, and a neutral rate of 3 percent.
Note: some entries have been interpolated from neighbouring observations.
Probability that Interest Rates Become Zero Assuming Policy Follows an Aggressive Taylor Rule.
| -Inflation target- | ||||
|---|---|---|---|---|
| 0.5 | 1 | 1.5 | 2 | |
| Orphanides and Wieland, 19981/ | 23 | 9 | 6 | 2½ |
| Reifschneider and Williams, 1999 2/ | 13 | 9 | 6 | 4 |
| McCallum, 20013/ | 6 | 4 | 3 | 2 |
| Vinals, 20Q0 4/ | 0 | 0 | 0 | 0 |
Small calibrated U.S. model, and a neutral real rate of 1 percent.
FRB/US model, assuming a neutral real rate of 2.5 percent.
Small calibrated model, and a neutral real rate of 2.5 percent.
Small calibrated euro area model, and a neutral rate of 3 percent.
Note: some entries have been interpolated from neighbouring observations.
Probability that Interest Rates Become Zero Assuming Policy Follows an Aggressive Taylor Rule.
| -Inflation target- | ||||
|---|---|---|---|---|
| 0.5 | 1 | 1.5 | 2 | |
| Orphanides and Wieland, 19981/ | 23 | 9 | 6 | 2½ |
| Reifschneider and Williams, 1999 2/ | 13 | 9 | 6 | 4 |
| McCallum, 20013/ | 6 | 4 | 3 | 2 |
| Vinals, 20Q0 4/ | 0 | 0 | 0 | 0 |
Small calibrated U.S. model, and a neutral real rate of 1 percent.
FRB/US model, assuming a neutral real rate of 2.5 percent.
Small calibrated model, and a neutral real rate of 2.5 percent.
Small calibrated euro area model, and a neutral rate of 3 percent.
Note: some entries have been interpolated from neighbouring observations.
86. The simulations sometimes rely on assumptions that may be difficult to achieve in practice—for instance, although adding an element of price level targeting may be helpful for countries that have fallen in a deflationary spiral because it raises inflation expectations, the central bank may find it difficult to convince the public of its ability to deliver on its promise, as well as its willingness to endure inflation after the economy escapes the trap.
Implications for the euro area
87. How relevant is the zero bound issue for the euro area? The answer to that question depends in part on the comparative features of the euro area economy with respect to:
The neutral rate: the higher the steady state (or equilibrium) real interest rate in the economy, the lower the probability of the zero interest rate floor becoming binding. The equilibrium real interest rate is primarily determined by the natural rate of growth (the growth of the labor force and the rate of technical progress), and the propensity to save, which in turn hinges on the rate of time preference, the risk aversion of economic agents, government finances, and tax distortions. With global capital mobility providing an equalizing force across countries, the neutral rate in the euro area is likely to be similar to that of other industrialized countries, even if the area’s comparatively modest potential output growth rates might suggest that the neutral rate is lower than, e.g., in the United States.16
Inflation inertia can cut both ways.17 With high inflation inertia, real shocks initially dislocate inflation less, but then the real economy needs to be shifted more to restore inflation to target. In the case of price shocks, the real economy needs to be shifted more to stabilize inflation. Historically, the euro area exhibited comparatively high inflation persistence, in part because of the interaction of oil price shocks with wage indexation and low real wage flexibility, and in part because of monetary policies (in the 1970s and early 1980s) that allowed inflation to become ingrained in expectations. Recent experience suggests inflation inertia has declined in the area.
88. The likelihood of the zero constraint becoming binding depends also on the frequency, severity, and duration of the shocks hitting the economy; structural features of the economy including its openness and the monetary transmission mechanism; expectations formation; and the responses of the monetary authority before the zero bound becomes binding.
89. To explore the issue further, stochastic simulations were run with the euro-area block of IMF’s Multimod.18 Based on a neutral interest rate of 2.7 percent, the results are reported in Table 10 under the assumption that inflation persistence and price shocks remain in line with historical experience. Policy follows an optimal rule which responds more strongly to inflation and output gaps than a simple Taylor rule, and includes an asymmetric objective not to let the price level fall. This approach minimizes the probability of the zero interest rate floor becoming binding in the simulations.
Euro Area: Impact of Average Inflation Target on Probabilities of Zao Interest Rate and Deflation 1/
Based on Multimod simulations and neutral real rate of 2.7 percent.
This statistic is skewed heavily downwards by omitting the solution failures associated with deflationary spirals.
The 1982-2001 standard deviation of the output gap was 1.41
Euro Area: Impact of Average Inflation Target on Probabilities of Zao Interest Rate and Deflation 1/
| -Inflation target- | ||||
|---|---|---|---|---|
| ½ | 1 | 1½ | 2 | |
| Optimal policy rule | ||||
| Probability of zero interest rates | 16 | 11 | 9 | 3 |
| Probility of a deflationary sprial | 10 | 4 | 3 | 0 |
| Standard deviation of output gap 2/3/ | 1.64 | 1.62 | 1.61 | 1.61 |
Based on Multimod simulations and neutral real rate of 2.7 percent.
This statistic is skewed heavily downwards by omitting the solution failures associated with deflationary spirals.
The 1982-2001 standard deviation of the output gap was 1.41
Euro Area: Impact of Average Inflation Target on Probabilities of Zao Interest Rate and Deflation 1/
| -Inflation target- | ||||
|---|---|---|---|---|
| ½ | 1 | 1½ | 2 | |
| Optimal policy rule | ||||
| Probability of zero interest rates | 16 | 11 | 9 | 3 |
| Probility of a deflationary sprial | 10 | 4 | 3 | 0 |
| Standard deviation of output gap 2/3/ | 1.64 | 1.62 | 1.61 | 1.61 |
Based on Multimod simulations and neutral real rate of 2.7 percent.
This statistic is skewed heavily downwards by omitting the solution failures associated with deflationary spirals.
The 1982-2001 standard deviation of the output gap was 1.41
90. The probabilities of the zero interest rate floor becoming binding are in line with the majority of those reported in Tables 8 and 9. Table 10 also reports the probabilities of falling into a deflationary trap over the course of a 100-year period if the economy is subjected to shocks similar to those that occurred during the 1980s and 1990s (a deflationary trap is a situation in which the model does not solve, so that monetary policy acting through the interest rate channel alone cannot restore the economy to equilibrium).19 The probability is nil for an inflation target of 2 percent, rising to a 3 percent chance with an inflation target of 1½ percent, and some 10 percent if the target is zero inflation. These probabilities assume a perfectly credible commitment to generate future inflation under the optimal policy rule.
91. In practice, the persistence in the inflation process as well as the standard deviation of price shocks seem likely to have declined in line with structural reforms enacted in the euro area in the 1990s and the regime shift to EMU which anchors inflation expectations more firmly than used to be the case. In this perspective, the probabilities of being caught in a deflationary spiral have probably decreased for each level of the inflation target.
92. Although the simulated probabilities of deflationary traps are clearly model- and parameter-specific, the cumulated evidence suggests that the risk of the zero interest rate floor becoming binding would be non-negligible if trend inflation rates were maintained significantly below 2 percent. Moreover, even if the probability of entering a deflationary spiral may not be great, Japan’s experience is a sobering reminder that the ability of policy to escape the spiral could be limited. In this connection, prevention is far easier than cure and a high premium should be put on avoiding deflationary traps in the first place.
E. Conclusion
93. The Eurosystem has chosen to provide a definition of its price stability objective which is more specific than some central banks, e.g. the U.S. Federal Reserve and the Bank of Japan, and less specific than traditional inflation-targeting central banks. The criticism of the Eurosystem’s target definition as ambiguous and asymmetric has come primarily from those who favor inflation targeting over other monetary strategies.
94. The differences between the ECB’s current goal specification and those of inflation-targeting central banks are probably less important, and the relative merits of a point inflation target versus the current specification of the Eurosystem’s objective more finely balanced, than acknowledged by many observers. On the one hand, the still-evolving nature of the HICP index argues against too precise a definition of the target, and the ECB is quite right to stress the need for monetary policy to respond flexibly to shocks of varying nature and intensity. Flexible inflation-targeters would not dissent from the latter view, however, and the medium term policy horizon adopted by the Eurosystem would accord substantial flexibility in this regard even with a point inflation target. At the same time, a point inflation target would probably facilitate communication and improve perceptions of ECB policies, and serve as a clearer guide for inflation expectations and policy debate than the current goal specification. Yet, the potential for such gains is modest since medium and long-term inflation expectations appear to be at least as stable and well-anchored in the euro area (at 1.8-1.9 percent) as among prominent inflation-targeters. Moreover, any potential gains from changing the goal specification would need to be weighed against possible credibility costs of doing so.
95. While neither this paper nor the economics profession more broadly has come to a clear conclusion concerning the optimal level of inflation in the euro area (or elsewhere) the same holds true for other issues (e.g., monetary transmission) on which the practice of monetary policy nevertheless requires policy makers to take a stance. The reading of the evidence presented in this paper suggests that:
Inflation measurement bias in the harmonized European price indices, while inherently unknowable, may account for a significant fraction of observed inflation; the bias appear to be smaller than in some other cases (e.g. the Bank of England’s RPIX inflation target of 2.5 percent may well correspond to inflation of 2 percent or less in terms of the UK HICP). Formula biases are likely smaller than the widely quoted Boskin estimate for the U.S. CPI, but other elements of measurement bias appear unlikely to be smaller than in the United States.
Balassa-Samuelson and price convergence processes are liable to cause long-lasting differences in trend inflation across EMU members. The analysis here suggests that such differences are likely to be smaller than indicated by estimates of the Balassa-Samuelson model, but high-income countries could still experience trend inflation at ¼-½ percentage points below the euro average, while catching-up countries could be roughly 1 percentage points above; moreover, such differences would become more pronounced in future if EMU were enlarged to include countries with significantly lower GDP per head than current members.
Downward nominal wage rigidities appear quite prominent and could restrain or delay relative wage adjustment across occupations and regions within countries, as well as across countries in response to asymmetric shocks. Inflation may also distort price signals in the labor market, however, and there is little firm evidence to suggest that the upper limit of the ECB’s definition of price stability is too strict to allow such processes to play out. Illustrative simulations suggest that potential costs increase as the target is lowered below 2 percent.
The zero-interest rate floor under nominal interest rates may constrain monetary policy effectiveness if the economy is threatened by deflation; the reading of the evidence presented here suggests that the risks of monetary policy being constrained by the zero-interest rate floor are minor for inflation targets down to 1½-2 percent, with little hard evidence to distinguish between the two, whereas they increase progressively for targets below that level. Although monetary policy may also act through other channels, experience from around the world suggests that prevention is far easier than cure, and uncertainty argues for a risk-averse approach.
96. Whereas the benefits of driving inflation significantly below 2 percent seem either small (e.g., lower shoe-leather costs) or better dealt with through other means (tax reform), the potential costs would appear to rise progressively for rates below 1½-2 percent. Consequently, the analysis suggests that an inflation target toward the upper end of the ECB’s price stability range would strike a judicious balance between reaping the benefits of price stability—including substantial and permanent gains from reduced tax distortions, and reduced ‘sand’ effects in the price mechanism—while allowing inflation to ‘lubricate the wheels’ of price and wage adjustment and safeguard against deflation. Individually, none of the issues discussed is decisive, but collectively the balance of considerations suggests that the inflation target should not be lower in the diverse euro area than for individual countries that have adopted inflation targets.
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Prepared by Mads Kieler (mkieler@imf.org).
The UK’s target is specified in terms of the RPIX retail price index. Given methodological differences between this index and the EU-harmonized index of consumer prices (HICP), the target for RPIX may, on average over time, correspond to 2 percent (or less) for UK HICP.
Arguably, the Eurosystem could retain a considerable and desirable degree of discretion even with a specific inflation target by letting the policy time horizon remain unspecified.
Moreover, the distinction between inflation targeting and price level targeting may be somewhat artificial (King, 1999). Inflation-targeting central banks are ultimately likely to be held accountable against an average outturn for inflation over longer periods which would, in fact, be equivalent to price level targeting.
Arguably, the targets chosen by most inflation-targeting central banks are not very different from what has been suggested by prominent researchers. For instance, Summers, 1991 concluded that “the optimal rate of inflation is surely positive, perhaps as high as 2 or 3 percent”, while Krugman, 1999 argued that the United States and Europe should set a target rate of “at least 2 percent”.
In theory, the Balassa-Samuelson effect is driven by sectoral differences in TFP growth (see e.g. the presentation in Froot and Rogoff, 1995). However, most empirical applications focus on labor productivity. An exception is Swagel, 2002.
It also implies that premature EMU participation would make it difficult for low-income countries to maintain domestic price stability, and their early participation in conjunction with an unchanged definition of price stability for the area as a whole could raise difficulties for economic policy management.
The issue goes back at least as far as Keynes’ “General Theory”, 1936, and was prominent in Tobin’s 1971 AEA address.
On price rigidities, see also Yates, 1998, and Blinder, 1994.
In a subsequent paper, Akerlof, Dickens, and Perry, 2000, argue that unemployment might be lower at very low inflation than at higher inflation rates because some agents are fooled by a small positive inflation to offer more labor than they would in the absence of money illusion. That equilibrium would not, however, be optimal and probably not sustainable.
The short-run Phillips curve may be non-linear also at higher inflation rates in the presence of so-called real rigidities, e.g. if workers resist reductions in the rate of wage increase relative to others.
The existence of multi-level collective bargaining in many European countries (national, regional, sectoral, firm level) in which each layer has to justify its existence may be one mechanism contributing to rigidities above the zero mark (Calmfors 1996).
This proposition was made by Keynes, 1936, and regained prominence in more recent times when taken up by Summers, 1991.
The standard deviations of the quarterly output gap and inflation generated by their model under the Taylor rule (ignoring the zero bound) are 1.0 and 0.7 percent, respectively. By way of comparison, the realized standard deviation of the euro-area output gap is 1.6 percent in quarterly data (1980Q1-2001Q4), and 1.4 percent in annual data (1980-2001). It is highly plausible that inflation variability will be lower in the EMU regime than in the past.
Reifschneider and Williams increase the actual target rates of inflation that appear in the policy rule to compensate for the decline in average inflation outcomes that will otherwise arise in the face of the zero bound constraint. For example, to achieve an average outcome of 0.0 percent inflation, the actual target rate for inflation in the policy rule is 0.7 percent.
Estimates of potential growth in the euro area are 2-2.5 percent (ECB), and 2.3-2.4 percent (IMF, OECD, and European Commission). In a dynamically efficient economy, the neutral interest rate is higher than potential growth in steady state, although it might be lower during transitions from one steady state to another.
Here, inflation inertia denotes the weight on past inflation relative to forward-looking (model-consistent) inflation in determining near-term inflation expectations.
Ben Hunt’s assistance in designing and implementing the Multimod simulations is gratefully acknowledged.
Prominent monetarists have challenged the key assumption that monetary policy will be rendered ineffective at the zero interest rate floor. See also Svensson, 2001 on “A Foolproof Way of Escaping From a Liquidity Trap.”
