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ATHANASIOS ORPHANIDES
Governor, Central Bank of Cyprus
Monetary policymakers must always be ready to face difficult challenges, and sometimes we need to quickly map an appropriate response even when precise guidance from historical experience may be lacking. As Cyprus was preparing to adopt the euro when I joined the Central Bank, it was clear that possible challenges would not pertain only to our economy and banking system, but also relate to the economy and monetary policymaking of all the euro area. However, I never imagined that I would be confronted with challenges such as the ones recently encountered.
In broad terms, the euro area macro economy has faced two very different challenges over the past two or so years. The first was an inflationary threat, an adverse supply shock, associated to a large extent with a sharp increase in energy costs and the prices of other key commodities. Subsequently, though, this inflationary threat subsided and indeed we have experienced a reversal of much of the earlier increase in energy costs during the past several months.
But it was the second challenge that proved more vexing and more threatening for the worldwide economy. This initially manifested itself as a financial turbulence that erupted suddenly in August 2007, and continues to this day. Although it threatened our financial system, prompt policy action initially contained the impact of this turbulence on the real economy until last September. Following the collapse of Lehman Brothers in the U.S. last September, this turbulence evolved into a full blown international crisis, one so severe that it eludes comparison with anything experienced worldwide in the post-World War II era. This crisis had a severe adverse effect on confidence worldwide, and evolved into a synchronised severe economic downturn, causing an unprecedented collapse in industrial production and world trade.
The rollercoaster ride of the past two or so years can be described in numerous ways and is evident in many financial indicators and data. The macroeconomic environment has been associated with extreme uncertainty and poor visibility, a most unfriendly environment for anyone daring to forecast the future. I note as a pertinent illustration the wild swings we have experienced in inflation over the past two years in the euro area, with HICP inflation registering both its highest and its lowest readings recorded in the 10-year history of the euro area (Figure 1). Following several years of relative stability, when HICP inflation fluctuated within just a few tenths of a percentage point around 2%, we have experienced over the past year a new peak exceeding 4% last July and a new low at 0.6% in the past two months, and cannot exclude negative readings in the months ahead.
Just how difficult has it been to forecast inflation during these times? The last year-ahead forecast that can be evaluated with available data is the forecast made in the 2008Q2 survey for the 12-month period ending in March 2009. The mean forecast was 2.1%, while the actual inflation reported was 0.6%, a difference of 1.5 percentage points.
Figure 1 also presents the evolution of longer-term inflation expectations from this survey, specifically the expected rate of inflation 5 years. Despite the unprecedented challenges in the economic environment and unusually violent swings in inflation over the past two years, long-term expectations have remained remarkably stable and in line with the ECB objective of keeping HICP inflation close to but below 2% over time.
I present this evidence as confirmation of the credibility of the ECB in achieving its mandate even under the challenging circumstances experienced over the past year or two. Well-anchored inflation expectations are of the essence not only to facilitate attainment of the ECB’s primary objective to maintain price stability, but also to allow the flexibility that monetary policymakers can have to alleviate the adverse effects of financial disturbances as well as shocks to the real economy.
Economists sometimes find it useful to decompose economic disturbances into “aggregate demand” and “aggregate supply” shocks. This is also useful for understanding differences in how policy might respond to different challenges. Recognising the risk of oversimplification, it may nonetheless be instructive to categorise the two challenges mentioned above in this manner. The first challenge could be seen as an adverse supply shock that tends to put upward pressures on inflation while also dampening aggregate demand. The policy response is not straightforward and depends on a number of factors. If inflation expectations are well-anchored and there is no threat that second round effects on inflation could potentially materialise, then monetary policy could ease slightly, thus dampening the drop in economic activity. But if threats of second round effects on inflation appear on the horizon, then a tightening of policy is appropriate to ensure that inflation expectations will not become unmoored. In this manner, monetary policy secures price stability over time and the sustainable growth in economic activity that comes with it.
The experience with the evolution of short-term forecasts of the euro area during the second half of 2007 and the period prior to the Lehman collapse in 2008, suggests the pattern of an adverse supply shock. As can be seen in Figure 2, in successive quarters from 2007Q4 to 2008Q3, the outlook for inflation deteriorated, with inflation projected to exceed significantly 2%, while at the same time growth prospects also deteriorated somewhat in successive forecast rounds. But expectations beyond the very short-term horizon remained well-anchored and the ECB Governing Council decided it was appropriate to adjust monetary policy only very slightly during this period, a 25 basis points increase in its policy rate on 3 July 2008. As shown in Figure 1, for the longer-term forecasts, and confirmed by the pattern of convergence towards the ECB’s definition of price stability shown in the forecasts of Figure 2, this slight policy adjustment succeeded in maintaining inflation expectations in the medium and longer-term well anchored.
Looking more closely at the most recent survey results, from the 2008Q2 survey, although the inflation forecast for 2009 is well below the ECB’s price stability objective, forecasters expect a sizeable pick-up in inflation for next year. In addition, inflation expectations five years ahead remain at 1.9%, which is in line with the ECB’s definition of price stability. A protracted period of inflation below our definition of price stability could risk unmooring inflation expectations on the downside, with all the associated adverse consequences.
Seen in the light of the deterioration in the economic outlook experienced over the past several months, it is easy to understand why the Governing Council of the ECB thought it was appropriate to proceed with a series of decisive monetary policy easings. Since October 2008, the main policy rate has been cut drastically, with the latest decision bringing it down to an all-time low level of 1%. Similarly, the deposit facility rate is at a historic low 0.25%.
When policy rates are close to the zero lower bound, they may no longer suffice as the best indicators of the monetary policy stance and of how expansionary monetary policy may be. In these circumstances, non-standard policy measures acquire an elevated role. To evaluate policy, it is important to look at the complete policy package, accounting both for standard and non-standard policy easing. In this light, the Governing Council has implemented a series of non-standard policy easings since October 2008, and further expanded upon those at the recent policy meeting. All in all, the present level of monetary accommodation should be considered appropriate, taking into account the information and analysis available at the last policy meeting.
I cannot avoid but reiterate the extreme uncertainty we still face at the moment and the need to remain alert and ready to react appropriately to incoming information. Needless to say, in addition to data releases it would remain of interest to keep monitoring the evolution of forecasts.
Excerpts from a speech given by Athanassios Orphanides at the CFA Society of Cyprus annual forecast event in Nicosia on May 14.
