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The following OECD assessment and recommendations summarise Chapter 2 of the Economic Survey of the Euro Area 2005 published on 12 July 2005.
Monetary policy is expected to remain accommodative as long as the medium-term inflation outlook remains favourable
With the output gap narrowing only progressively and the impact of the hike in oil prices waning, inflation is projected by the OECD to fall below 2% during 2005 and decline to 1¼ per cent in 2006. But substantial uncertainties surround this inflation outlook. On the one hand, activity is sluggish and the exchange rate strong. On the other hand, inflation has responded little to widening slack, and money and credit growth is buoyant, stimulated by the low level of interest rates. So far the European Central Bank (ECB) has adopted a “wait and see attitude”. It has kept its main policy rate on hold at 2% since the start of the recovery in June 2003. Over the same period, long-term interest rates have fallen significantly. It would thus be reasonable for the ECB to hold its rate stable as long as the outlook remains in line with price stability over the medium term. Monetary policy would need to act, if the medium-term outlook for price developments were to change. A significant appreciation of the exchange rate or a substantial weakening of activity that were to change the medium-term outlook for price stability, could lead to a reassessment of the monetary policy stance. At the same time, the ECB should continue to be vigilant to upside risks to price stability, such as those stemming from excess liquidity or second round effects from the oil price increases.
Short-term real interest rate and monetary conditions index (1)
1. Weights used in calculation are 1 for the real interest rate and 0.15 for the real
effective exchange rate.
Source: OECD, Economic Outlook 77 database.
Monetary policy has to take inflation inertia into account
Seen in a longer term perspective, inflation performance in the euro area has clearly improved. As the credibility of monetary policy was quickly established, inflation expectations have become – and remain – firmly anchored to the ECB’s objective of keeping inflation below but close to 2 per cent over the medium term. However, in the recent downturn inflation has failed to come down decisively, and this has limited the scope for monetary policy to support economic activity in the short run. Moreover, the monetary transmission mechanism has been less effective in those countries where secondary mortgage markets play only a minor role. Services, which have a large weight in consumption, show a particularly high degree of inflation inertia. This inertia is linked to the lack of integration and competition in the internal market for services. There is also evidence of higher wage inertia in the euro area than in other economies, which may be due to high minimum wages, administrative extensions of wage agreements, catch up clauses in collective agreements and de facto indexation of wages. These sources of rigidity should be removed, not only to lift potential growth, but also to provide more leeway for pursuing an effective monetary policy, and strengthen the area’s resilience to adverse shocks. However, further liberalisation of and innovation in mortgage markets must be accompanied by prudent financial market regulation and surveillance to ensure financial stability.
Inflation responsiveness to output (1)
In per cent
1. Inflation is gauged by the rate of change of the CPI in the United States
and the HICP in the euro area.
Source: OECD Economic Outlook No. 77 Database.
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A printer-friendly Policy Brief (pdf format) can also be downloaded. It contains the OECD assessment and recommendations, but not all of the charts included on the above pages.
Ein Policy Brief auf deutsch kann als pdf Datei heruntergeladen werden. Es enthält die Gesamtbeurteilung und Empfehlungen der OECD auf den Seiten oben.
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For further information please contact the Euro Area Desk at the OECD Economics Department at webmaster@oecd.org. The OECD Secretariat's report was prepared by Paul van den Noord, Boris Cournède, Line Vogt and Alexandra Janovskaia under the supervision of Peter Hoeller.
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