Structural reforms and monetary policy

by Mr. Serge Kolb, Director of the Banque centrale du Luxembourg

at the conference on “THE POLITICAL ECONOMY OF THE LISBON AGENDA", 12 and 13 april 2005 in Luxembourg

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Over the past years, the Governing Council of the ECB has constantly stressed the need to press ahead with structural reforms in the goods, services, capital and labour markets . Central banks are convinced that “structural reforms are crucial to a better performing EU economy, i.e. an economy with higher potential growth, more employment opportunities and greater resilience to shocks."  Progress in structural reforms “will also help to bolster consumer and business confidence over a shorter horizon" .

The benefits of structural reforms in the context of monetary policy

Structural reforms, in addition to their impact on the real economy, may be of relevance for the transmission of monetary policy. They may even facilitate the single monetary policy and augment its effectiveness.

Structural reforms may contribute significantly to an improved economic performance in terms of adjustment to shocks, in particular by raising price and wage flexibility. As prices and wages become more sensitive to market conditions, they adjust faster than before - when rigidities prevailed - to changing economic conditions. The higher flexibility avoids the accumulation of past shocks, stabilises the economy and simplifies the issues which monetary policy must face.

Structural reforms can therefore have significant consequences for the transmission of monetary policy decisions to final demand and prices. In less flexible economies changes in policy interest rates feed through to prices only after a longer time. Empirical studies on the effects of monetary policy in both the euro area and the United States show that the impact of monetary policy on prices is much faster in the US. One explanation for this finding could indeed be that prices react more flexibly in the US .

More flexible labour and product markets result in an improved adjustment to economic shocks and a swifter response to given policy impulses. Hence, increased labour and product markets flexibility may clearly entail that monetary policy actions can be of a lesser magnitude and a lower frequency. For instance, increased flexibility in labour markets might mitigate second-round effects as adverse supply shocks are adjusted to with a muted increase in inflationary pressures over the short-term.

The higher flexibility brought about by structural reforms accelerates the speed of the adjustment from the “Keynesian" short run (adjustment via quantities rather than prices) to the “classical" long run. Accelerating the adjustment to the long run has the advantage that the economic adjustment is increasingly shifted to the price and wage side of the economy. Under such circumstances, monetary policy can achieve price stability with a lesser impact on the real variables such as output and employment.

More concretely, empirical observations show that an increase in competition resulting from the implementation of structural reforms in the euro area has as a consequence, among other things, that the Eurosystem’s monetary policy becomes indeed more effective, because the sacrifice ratio (i.e. the cost in foregone output required to reduce inflation by 1 percent) decreases considerably. Monetary policy is clearly easier to implement if output losses stemming from the compression of inflation are modest. This gain in effectiveness of the monetary policy arises from the fact that enhanced competition reduces the monopolistic power of both producers and workers, and hence these actors’ ability to confine their respective supplies in order to increase prices and wages .

Price stability - the primary objective of monetary policy - provides guidance to economic actors as to a better allocation of production factors towards alternative uses. Price stability thus assists the structural reform efforts to realise their intended welfare-increasing effects. Also, the acceptance of structural reforms is likely to be higher when the purchasing power is maintained. And, a decrease in relative prices in some sectors ensuing from structural reforms becomes more perceptible, fostering public approval of these reforms. Price stability is thus the most important contribution of monetary policy to the structural reform process.

Prices and inflation reflect by and large the competitive situation in labour and product markets. More competition in both these markets will lower relative prices and diminish wage and price pressures. This holds in particular in the services industries, which account for a major part of the economic activity in the euro area. For instance, reforms in the telecommunications sector have resulted in substantial decreases in consumer prices for telecom products . More structural reform efforts in the services industry can further ease price pressures, while establishing conditions favourable to moderate wage developments in line with productivity gains.

Finally, the individual euro area Member States cannot use monetary (or exchange rate) policy anymore in order to absorb asymmetric shocks since a single monetary policy is conducted for the euro area as a whole. This entails that such shocks must be absorbed by reallocating resources within the euro area countries concerned and that the burden of adjustment is shifted to other economic policies than monetary (or exchange rate) policy. Hence, the single monetary policy by itself has increased the case for implementing structural reforms in the individual euro area countries.

Challenges resulting from structural reforms

Structural reforms may constitute a tricky issue for monetary policy as they might alter the fundamental relations that govern the functioning of the economy and hence also the monetary policy transmission mechanism. Changes in long-run trends in macroeconomic variables, which can only be spotted after some time, increase the degree of uncertainty surrounding the economic context in which monetary policy decisions are taken.

However, a forward-looking monetary policy has to be aware of changes in potential GDP growth because of their bearing on the equilibrium real interest rate and on the adjustment path towards such a rate. Unfortunately, both potential output and the equilibrium interest rate cannot be observed and their estimates are surrounded by a high degree of uncertainty. The Governing Council’s monetary policy decisions are therefore based on a two-pillar approach designed to ensure a full analysis of the risks to price stability, which takes account of all relevant information, in both the economic and the monetary pillar.

Conclusions

A double conclusion can be drawn from the above reflections, namely that the best contribution the Eurosystem’s monetary policy can make to the structural reform process is to contribute to maintaining a stable macroeconomic environment which is favourable to carrying out structural reforms, while such reforms in turn can facilitate a successful stability-oriented monetary policy by increasing the responsiveness of the economy to given policy impulses.

References:

• Introductory statements to the ECB press conferences published since 1998.
• Introductory statement to the ECB press conference of 4 November 2004.
• Introductory statement to the ECB press conference of 2 December 2004.
• Gert Peersman and Frank Smets, “The monetary transmission mechanism in the euro: more evidence from VAR Analysis", ECB Working paper series, no. 91, December 2001.
• Bayoumi, Laxton and Pesenti, “Benefits and spillovers of greater competition in Europe: A macroeconomic assessment", ECB Working paper series, no. 341, April 2004
• ECB report “Price effects of regulatory reform in selected network industries", March 2001.

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