Pankinjohtaja Sinikka Salo: 14th International Banking Congres

Puheet ja haastattelut Puhe keskiviikko 1.6.2005, 0.00
Inflation control – European experience and implications for Russia

European experience in winning inflation

A remarkable feature in the economic development of the EU countries has been the con-vergence of inflation rates from a high and divergent level in the early 1980s to a consis-tently low and stable level achieved by mid-1990s and maintained thereafter. This im-provement of monetary stability must be regarded as a major achievement, especially as it has been accompanied by the virtual disappearing of chronic balance-of-payments problems which destabilized most European countries for decades.

The convergence of European inflation rates was in part related to a worldwide process. In-flationary policies pursued in many European countries in the 1970s turned out to be unsuc-cessful and detrimental, especially in the context of increasing capital mobility. While Ger-many had led a relatively strict anti-inflationary monetary policy for long, a pivotal point in the reform of monetary policy was the adoption of a strict anti-inflationary monetary policy line by the Federal Reserve in the United States in the early 1980s. At the same time, the benefits of independence of central banks - à la German Bundesbank – with price stability as the primary goal of monetary policy started to be increasingly recognized both in aca-demic and policy circles.

At the background, the perception of high costs of inflation for sustainable growth and wel-fare gained ground. The benefits of price stability were understood. Price stability – credibly low inflation – improves transparency of relative prices and thereby helps markets to allo-cate resources more efficiently; with price stability, the inflation risk premium of interest rates is reduced and there is also less need for costly hedging operations; price stability re-duces distortions of the tax system; it prevents arbitrary redistribution of wealth and income, and so on. A consensus also emerged that inflation in the long-term is a monetary phenome-non and that efforts to ”buy a little bit more employment” in exchange of ”a little bit of in-flation” (a so-called Phillips -relation) are deemed to be short-termist and usually illusory. It was finally accepted that monetary policy cannot solve problems that originate outside the monetary sphere. Therefore, monetary policy should concentrate on one goal, namely main-taining price stability and trust in price stability.

A particular European feature in the convergence of inflation rates was economic and mone-tary integration. Before the creation of the euro in 1999, the European Monetary System, which included the Exchange Rate System ERM, provided the framework for most EU member states' efforts to achieve lower inflation. While in the ERM all currencies were formally pegged to the synthetic currency ECU within narrow fluctuation bands, in practice the Deutschmark played the central role as the anchor currency of the system. This was es-sentially because both markets and policy makers were attracted by the good credibility of the Bundesbank, which had pursued monetary targeting as its monetary policy strategy and managed to keep inflation rate relatively low in Germany. In order to benefit from German credibility, most other EU countries had adopted fixed exchange rate policies, and tried to keep the central rate of their currencies fixed against the Deutschemark. Initially, the ex-change rate discipline in the system was not very stringent, but gradually the convergence of participating countries economic performance made progress and thereby increased mone-tary stability – in terms of inflation performance – throughout the area.

The EMU project, launched by the Maastricht treaty of 1992 gave a very powerful addi-tional incentive to aim for price stability. The key criteria for the participation in the EMU set in the Maastricht Treaty – concerning stability of exchange rates, inflation, sustainability of public finances and convergence of long-term interest rates – were in fact designed to highlight price stability as a goal and thus to facilitate the task of common monetary policy to be adopted in maintaining it. In most countries the fulfilment of these criteria meant tighter of both monetary and fiscal policies, although in the end, governments benefited a lot from the reduction of their interest rate burden.

In the EU, expansion of foreign trade and financial flows as well as internationalization of enterprises have clearly increased competition and diminished domestic inflationary pres-sures. The voluntary discipline necessary for success in a monetary union have become more and more widely accepted both among entrepreneurs and labour unions. Both price and cost developments have become more moderate.

As a result, disinflation process in Europe progressed – in 1980 inflation in most European countries was double-digit, except for Germany, but thereafter inflation slowed down rather uniformly towards the end of 1980s. Since the beginning of the EMU, average inflation rate in the euro area has been around 2 percent, and the difference between the highest and low-est inflation rates among the euro area countries less than 2 percentage points on average.

Can some lessons be drawn for Russia from the EU experience?

Russian economy is depending to a large extent on exports of raw materials, notably oil. The current high price of oil is of course beneficial for an oil-producing economy but it also poses challenges for monetary policy: there is a genuine difficulty to control liquidity and inflationary pressures. Nevertheless, controlling inflation is crucial. Failure there would no doubt cause large economic losses in the longer run, which would take away benefits cre-ated by high oil prices.

For the time being, Russian authorities have succeeded in controlling liquidity despite high oil revenues. In particular, fiscal policy has been quite disciplined. In this respect, authori-ties' decision to establish the Russian Oil Stabilisation Fund at the beginning of 2004 was particularly important as the government's savings in the Fund help to curb excessive money supply and, hence, to control inflation. Needless to say, the fund is also useful in improving Russia's standing in the credit markets.

Liquidity management by the Russian central bank has been facilitated also by capital out-flows. In a sense capital outflow is normal in a country with huge current account surplus. But no doubt, Russia would need to keep capital home for more and better investments in domestic production capacity and infrastructure.

It may also be that underdevelopment of Russian financial markets has also so far repressed domestic demand and contained inflationary pressures in that way. Therefore, the expected development and expansion of domestic financial markets – necessary for domestic invest-ment - may in the beginning add susceptibility to inflation of the Russian economy, as credit will become even more available to wider borrower groups.

Despite above factors, due to its exchange rate policy – targeted at maintaining the exchange rate of the rouble broadly stable vis-à-vis US dollar – the Russian Central Bank has been obliged to buy large amounts of foreign exchange, which in its part has increased domestic liquidity – and given support to higher inflation. Lately, Russian inflation has hovered around 10 % and above, which is high compared with not only industrial countries but also with most emerging economies. Inflation of this size is harmful for any country, and it does not disappear by itself.

To what extent there are similar factors as in the EU countries in the past to strengthen disinflation process in Russia. The answer is: only partly

It seems that Russia is not quite ready to open up its economy to the same extent that EU-countries have been. There are restrictions on competition from abroad. This being the case, the need for own, anti-inflationary economic policy is even more urgent.

Russia of course lacks the benefit of the kind of external fixed point for its monetary policy that the countries wanting to join the EMU had in the 1990s. In fact, currently Russia seems to have several goals, as authorities try to strike a balance between inflation and the nominal appreciation of the rouble, to avoid excessive real appreciation, and hence, the loss of price competitiveness. Coping with so many targets is evidently a big challenge and hardly possi-ble without a strong support from fiscal policy. However, the authorities understand well the problems related to the current monetary policy set-up as the ongoing discussion about mov-ing to inflation targeting shows.

Russia obviously has had to commit itself to combat inflation. Many countries have through their own policies and by establishing credible institutions succeeded in achieving low infla-tion. Clarifying the objectives of an independent and accountable central bank is part of the solution. Setting an explicit definition and goal for price stability is a good start.