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The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of the Euro Area published on 14 January 2009.
The priority for all member states is to find responses to the financial crisis and ensure their swift implementation.
The euro area achieved a high degree of macroeconomic stability over the first decade of economic and monetary union. The end of exchange rate turbulence and realignments within the euro area has proved to be a major asset. However, the financial market turmoil since the summer of 2007 and the intensification from mid-September 2008 is having a major adverse impact on the world economy. Although the immediate cause of the turmoil lay in the US subprime mortgage market, euro area financial institutions and markets were part of the prolonged credit cycle of recent years, and have been hit by heightened financial market stress. The current turmoil is the first financial crisis the euro area has had to face. Today’s priority for all member states is to find responses to the financial crisis and ensure their swift implementation. In reacting to these developments, policy actions that would undermine longer term objectives should be avoided. The necessary response to the possibility of financial instability touches many areas of policy making. It involves financial regulators, supervisors, central banks and finance ministries.
Financial turmoil has helped to push the economy into recession. Economic growth is expected to remain weak until 2010.
Economic activity began to slow in the early part of 2007 and has steadily lost momentum, with output declining in both the second and third quarters of 2008. The previous five years had seen a sustained upturn in activity, boosted by strong export and investment growth. With demand tending towards capacity, monetary policy was tightened from December 2005. The euro appreciated steadily and, by mid-2008, was 30% higher in nominal effective terms than in mid-2002. It remains at an elevated level despite recent declines. Since growth began to slow, the euro area has been hit by three major macroeconomic shocks: energy and food prices have risen sharply, the global credit cycle has turned, leading to prolonged and severe turmoil in international financial markets, and the housing cycle has peaked in several countries. The aggregate effect of these shocks has begun to be felt in the euro area, despite the cushioning impact of the euro appreciation on import prices, the lower oil intensity of output, the less pronounced housing cycle, the relatively strong household balance sheet position, and greater distance from the financial activities at the heart of the crisis. The latest OECD projections suggest that output will decline further in the fourth quarter of 2008 and the first half of 2009 before recovering gradually. Growth is not expected to move above trend rates until the latter half of 2010.
Despite the recent substantial cut in policy rates, financial conditions are not particularly accommodative.
Monetary policy was tightened between late 2005 and July 2008, with the policy rate increasing from 2 to 4¼ per cent to address upside risks to price stability. Policy rates were reduced by 50 basis points in October 2008 in co-ordination with six other central banks, reflecting declining commodity prices, moderating inflationary pressures, and diminishing inflation expectations. An additional 50 basis point cut was made in early November. Furthermore, the intensification of the financial turmoil in the second half of September 2008 has augmented the downside risks to growth and diminished further the upside risks to price stability. Ex ante real rates now appear to be close to or below their long-run average. But credit spreads remain elevated due to the financial market turmoil and bank lending standards are tighter than before the turmoil, although the pace of credit expansion to the non-financial sector has slowed only gradually. The nominal exchange rate appreciated substantially, although it has fallen back somewhat since the spring of 2008. Despite the recent substantial cut in policy rates, financial conditions are not particularly accommodative.
Monetary policy should be ready to react should long-term inflation expectations become unanchored.
Inflation rose substantially from the early part of 2007, reaching 4% in mid-2008. It had previously remained close to, but above the European Central Bank’s definition of price stability. The sharp increase in inflation was largely due to an unanticipated surge in global energy and food prices, over which domestic monetary policy has little influence. Core inflation (excluding energy and food) has remained below 2% and services inflation has been steady at around 2½ per cent. This suggests that broad-based second-round effects have remained limited so far, although unit labour cost growth has risen, suggesting that underlying price pressures remain. Higher energy costs also dampen potential growth. Headline inflation has declined since July 2008 and if the recent weakening in commodity prices is sustained, it could drop well below 2% during the course of 2009 according to the OECD projections. With weak output growth, sizeable economic slack may develop, provided potential growth does not slow excessively, moderating underlying wage and price pressures. Given these baseline projections, room for further easing of monetary policy would emerge. However, there is an unusual amount of uncertainty surrounding this baseline scenario. If financial conditions were to be more severe than anticipated, or activity to drop particularly rapidly, deeper interest rate reductions could prove necessary. On the other hand, if inflationary pressures are stronger than anticipated, room for manoeuvre will be constrained. Monetary policy should be ready to react should long-term inflation expectations become unanchored.
The ECB has developed a sophisticated framework for setting monetary policy but could do more to enhance communication of its forecasts and monetary analysis.
The euro has successfully established itself as a stable currency and the ECB has developed a sophisticated framework for setting monetary policy. Over the first ten years of monetary union, inflation has been close to, but just above, 2% on average and has been relatively stable around that level both compared with past experience and the performance of other developed economies. This achievement has been underpinned by the ECB’s two-pillar strategy. Clear communication is an important part of this success, although further enhancements should be introduced. It is recommended that the ECB publishes forecasts showing to the public quarterly profiles sufficiently far into the future for first-round effects from shocks and policy changes to be completely absorbed, as they may help shape expectations about future inflation. However, any enhancement of the current projections should be done in full accord with the ECB’s two-pillar strategy which already links medium-term inflation expectations to monetary developments. In this context, more detailed and regular explanation of analysis under the monetary pillar of the ECB’s framework could provide more information to the public about the implications of current monetary growth for future inflation and the basis on which policy rates are set. The decision of the Governing Council of the ECB from 2007 to further enhance its monetary analysis along a number of well-defined avenues should help to address the need for further information.
The ECB has used its operational framework to enhance market liquidity and contain the increase in market interest rates, although these remain higher than before the turmoil began.
The current episode of financial instability has seen marked turmoil in the money markets. The difficulty of assessing the value of exposures related to the US subprime mortgage market made banks reluctant to lend to each other. As a result, money market interest rates rose sharply. The ECB and other central banks provided liquidity to the banking system through various types of refinancing operations. Although greater liquidity provision contained the increase in spreads on money market lending during the first phase of the financial turmoil, the intensification of financial stress in September and early October of 2008 caused spreads to increase dramatically. This in turn has brought about further co-ordinated liquidity injections from the ECB and other central banks. The ECB has needed to make relatively few changes to its operational framework as a wide range of collateral was already accepted, many institutions had access to its monetary operations, and banks are required to hold relatively high levels of reserves, which are remunerated. The ECB has used the flexibility of its framework to enhance market liquidity, particularly since the intensification of financial turmoil in mid-September 2008. For example, the ECB introduced a fixed rate tender with full allotment for its main refinancing operations and widened its list of eligible collateral. Action and communication by the ECB helped to contain the increase in market interest rates, although these remain higher than before the turmoil began. Consideration should be given to the lessons that can be learnt from this episode for collateral pricing and risk control.
How to obtain this publication
The complete edition of the Economic survey of the Euro Area 2009 is available from:
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.
For further information please contact the Euro Area Desk at the OECD Economics Department at firstname.lastname@example.org.
The OECD Secretariat's report was prepared by Nigel Pain, Jeremy Lawson, Sebastian Barnes and Marte Sollie under the supervision of Peter Hoeller. Research assistance was provided by Isabelle Duong.