FEATURE - Deflation debate has implications for ECB policy
07:26 a.m. Jul 02, 1998 Eastern
By Nick Antonovics
BRUSSELS, July 2 (Reuters) - If a central bank has as its goal the
achievement of ''price stability,'' but nobody knows what that is, what
should it do?
This is the dilemma facing the governing council of the European Central
Bank as it prepares to meet on July 7 to consider the indicators it will
use to guide monetary policy.
At the centre of the issue is the well-documented theory that official
consumer price data could overstate real inflation and hide the that
fact prices are falling.
European central bankers are well aware of the argument, hinting it may
be one factor prompting them to promote another indicator, probably a
money supply measurement such as M3, as the public face of their policy
road map.
''What does an inflation target mean?'' asked Luxembourg Central Bank
Governor Yves Mersch in an interview with Reuters last week. ''Do you
take consumer prices, unit labour costs, look at asset inflation? Then
there is the debate in the United States about what really is inflation
and underlying inflation and the problem of time lags.''
The argument is that the measurement of changes in prices of goods which
are constantly improving, such as electronics, do not fully reflect the
changes in their quality.
A study from the Deutsche Bundesbank in January estimated that official
German consumer price data may overstate inflation by 0.75 of a
percentage point.
''The by far largest contribution to this overall bias stems from
difficulties in measuring prices in the event of quality changes,''
wrote Bundesbank researcher Johannes Hoffmann.
The Bundesbank study echoed the findings of a report in the U.S. by
Michael Boskin for the Senate Finance Committee released in December
1996.
Given that headline inflation in Germany was running at 1.1 percent in
May, according to harmonised data released on Thursday by the European
Union statistics office Eurostat, the margin of error is substantial.
IS EU INFLATION DATA RELIABLE
The Eurostat data showed that inflation in May in the 11 countries due
to take part in economic and monetary union (EMU) from next year, when
the ECB will assume responsibility for monetary policy, averaged 1.4
percent.
If the same margin of error in measuring inflation was true at EU-level
the implication would be clear: interest rates do not need to rise
anytime soon if, as analysts expect, the ECB defines price stability
unofficially as a headline inflation rate of between one and two
percent.
But Eurostat, which has made no study along the lines of the Boskin and
Bundesbank reports, says the issue is not clear cut.
''As the Boskin report illustrates, the problem is not generally
understood and many observers share the mistaken impression that no
allowances are made for improvements that have occurred in product
quality,'' it said in an October 1997 report.
Privately, the statisticians are more forthright.
''The Boskin report was biased from the start,'' one said. ''It did not
look at areas like clothing, where we are almost certain there is an
under-estimation of inflation, rather than an over estimate. And there's
still a lot more money spent on clothes than computers.
''I personally would not like to bet any money on whether the bias is up
or down,'' he added. ''The real problem is that there is no satisfactory
definition of inflation except the index that you chose to measure it
with.''
For example, two EU regulations due to be adopted next Monday to improve
the common index of goods and services used as the basis for the EU data
could have an upward or downward impact on CPI when they take effect
from December 1999, he said.
WILL EMU EXACERBATE ASIA EFFECT?
The statistics issue is not the only cloud on the outlook for prices,
and hence interest rates in ''Euroland.''
Analysts noted also the ongoing impact of the Asia crisis has had on
commodity prices, most notably oil, and the as yet unquantifiable impact
on European inflation from a wave of cheap goods imports from Asia.
The arrival of EMU itself could also pervert the picture, some say, with
the cost of some products being driven down by competition from
cross-border trade arising from the new transparency in prices.
The actual process of converting prices from national currencies to the
euro could also play a role.
''I believe there will be a tendency to round (converted) prices down
rather than up,'' said Henrik Kroner, Secretary General of the European
retail industry association EuroCommerce.
''In April when there was an increase in German value added tax there
was no effect on prices or inflation because there is too much
competition. It's basically the same (for EMU),'' he said.
Analysts said EMU's direct impact may be muted.
''I would agree that from next year we will probably see further
downward pressure on prices due to the single currency and transparency
in cross-border prices but the impact will be marginal,'' said JP Morgan
euro area analyst Ellen van der Gulik.
''If I live in Holland I am not going to travel to Italy to buy my
bread,'' she said.
In the longer term, the impact on prices arising from the liberalisation
of European utility markets would probably play a much bigger role in
keeping down inflation, she said.
In any case, European core interest rates at around 3.30 percent were
presently too low for the EMU area as a whole, she said. JP Morgan
estimates that if European short-term interest rates were to converge on
this level it would represent a monetary easing for the euro area
equivalent to almost half a percentage point.
''We are arguing that if you start (EMU) with interest rates at 3.75
percent you keep monetary policy for the region as a whole broadly
unchanged,'' van der Gulik said.
Europe's central bankers have so far given no hints about where interest
rates may be at the end of the year, but have flatly rejected the
hypothesis that deflation could be just around the corner.
''(Deflation) is not a topical danger but it's something which is
possible and must be kept in mind,'' ECB Chief Economist Otmar Issing
told the European Parliament in May, echoing comments made by his fellow
ECB board members.
''Neither inflationary pressure nor deflation risks (in Germany) can be
expected for the near future,'' outgoing Bundesbank Vice-President
Johannes Wilhelm Gaddum said on Monday. ''Inflationary legacies for the
ECB can also not be identified in other countries of the future monetary
union.''
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