Eurosystem safeguards price stability, even under difficult conditions

With inflation averaging just over 2%, the euro area has experienced a period of sustained low inflation over the past ten years (see chart 1). Since its introduction in 1999, the euro has therefore proved to be a stable currency on a par with the D-Mark. This means that favourable monetary conditions have been created for growth and employment. However, there are no grounds for complacency.

The Eurosystem has succeeded in maintaining price stability in what has often been a difficult setting. In the ten years since the euro was introduced, numerous external “shocks” such as the sharp rise in oil and food prices have had a strong impact on short-term price developments (see chart 2). To start with, “administered” prices and indirect taxes have been raised significantly numerous times – VAT in Germany being just one example. Furthermore, the price of oil rose from approximately USD 10 in 1999 to more than USD 140 in mid-2008, which was a key factor in the sharp increase in euro-area inflation rates, especially over the past year. Since then price pressure has eased markedly mainly as a result of the perceptible price corrections in the international commodity markets. The steep price increase that continued into the summer of 2008, which was closely followed by an easing price pressure, means that inflation rates – measured as their year-on-year change – will be comparatively low in the coming months. However, the inflation rate is likely to accelerate again somewhat in the medium-term; as things currently stand, deflationary effects can be ruled out in the euro area.

Monetary policymakers cannot usually counteract unexpected price shocks in the short term because a change in central bank lending rates affects price developments only with a time lag of several quarters. A particular danger is posed by “second-round effects” where external price surges lead individuals and enterprises to expect a sustained rise in inflation and wage bargainers then agree correspondingly higher pay settlements, and enterprises subsequently demand higher prices for their products owing to higher wage costs.  A stability-oriented central bank seeks to prevent such wage-price spirals, wherever possible, by taking prompt and early action. Once such a spiral has been set in motion, inflation expectations can usually only be brought back down to a stability-oriented level at a high cost to the economy as a whole.

It should therefore be rated positively that all surveys for medium to long-term inflation expectations in the euro area have been at just under 2% since the euro was launched in January 1999. This indicates that the Eurosystem was successful in creating and maintaining credibility from the outset. Individuals and enterprises are justifiably confident that the Eurosystem will take resolute action in terms of interest rates in order to combat serious inflationary risks.

Confidence in the euro is based largely on the Eurosystem’s institutional framework, which is very similar to that of the Bundesbank during the D-Mark era. The centrepiece is the Eurosystem’s clear mandate to maintain price stability, its independence of instructions from national governments, and its two-pillar monetary policy strategy.

Some critics counter that price stability in the euro area has less to do with the resolute action taken by the euro’s guardians and more with the advancing process of globalisation. Since the early 1990s, both an accelerated process of globalisation and a worldwide trend decline in inflation rates have occurred. This does not imply a clear cause-and-effect relationship between the two phenomena, however. Instead, the effect of globalisation has been both to dampen prices (through the availability of cheap imports) and to raise prices in the industrial countries (through a rising demand for raw materials). The net impact of these sometimes countervailing shocks is difficult to measure precisely and varies over time. At all events, the globalisation process does not relieve a central bank of its obligation to be oriented to stability. The Eurosystem will therefore continue to pursue a price-stability-oriented monetary policy. This is the most valuable contribution it can make to economic prosperity and to strengthening the outlook for growth in the euro area.