Inflation-Targeting, Flexible Exchange Rates and Macroeconomic Performance since the Great Recession. CEPS Working Document No. 394, March 2014

Has inflation targeting (IT) conferred benefits in terms of economic growth on countries that followed this particular monetary policy strategy during the crisis period 2007-12? This paper answers this question in the affirmative. Countries with an IT monetary regime with flexible exchange rates weathered the crisis much better than countries with other monetary regimes, predominantly countries with fixed exchange rates. Part of this difference in growth performance reflects differences in export performance during the initial years of the crisis, which in turn can be explained by real exchange rate depreciations. However, IT seems also to confer other benefits on the countries above and beyond the effects from currency depreciation.

Addressing weak inflation: The European Central Bank's shopping list. Bruegel Policy Contribution 2014/05, May 2014

There are clear benefits to price stability. High inflation can distort corporate investment decisions and the consumption behaviour of households. Changes to inflation redistribute real wealth and income between different segments of society, such as savers and borrowers, or young and old. Price stability is therefore a fundamental public good and it became a fundamental principle of European Economic and Monetary Union. But the European Treaties do not define price stability. It was left to the Governing Council of the European Central Bank (ECB) to quantify it: "Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%"[1]. The Governing Council has also clarified that it aims to maintain inflation below, but close to, two percent over the medium term, though it has not quantified what 'closeness' means, nor has it given a precise definition of the 'medium term'[2]. The clarification has been widely interpreted to mean that the actual target of the ECB is close to, but below, two percent inflation in the medium term.

So far apart and yet so close: Should the ECB care about inflation differentials? Bruegel Policy Contribution, Issue 2014/10 September 2014

Inflation rates can differ across regions of monetary unions. We show that in the euro area, the US, Canada, Japan and Australia, inflation rates have been substantially and persistently different in different regions. Differences were particularly substantial in the euro area. Inflation differences can reflect normal adjustment processes such as price convergence or the Balassa-Samuelson effect, or can reflect the different cyclical position of regions. But they can also be the result of economic distortions resulting from segmented markets or unsustainable demand and credit developments fueled by low real interest rates. In normal times, the European Central Bank cannot influence such developments with its single interest rate instrument. However, unconventional policy measures can have different effects on different countries depending on the chosen instrument, and should be used to reduce fragmentation and ensure the proper transmission of monetary policy. The new macro prudential policy tools are unlikely to be practical in addressing inflation divergences. It is crucial to keep the average inflation rate close to two percent so that inflation differentials are possible without deflation in some parts of the euro area, which in turn might endanger area-wide financial stability and price stability.

Developing an underlying inflation gauge for China. Bruegel Working Paper 2014/11, 9 October 2014

This paper develops a new underlying inflation gauge (UIG) for China which differentiates between trend and noise, is available daily and uses a broad set of variables that potentially influence inflation. Its construction follows the works at other major central banks, adopts the methodology of a dynamic factor model that extracts the lower frequency components as developed by Forni et al (2000) and draws on the experience of the People’s Bank of China in modelling inflation.

Inflation and Unemployment In EMU and the United States. ACES Working Papers No. 10, 2008

The original purpose of this paper was to see why the Phillips Curve numbers seem to be so much worse for the EMU countries than the United States since EMU was began operation in 1990. The problem is that there is no evidence of a Phillips curve relationship in EMU or in the United States during this seventeen year period. As can be seen in Figures 1 and 2, it just is not there. In about half the years unemployment and inflation moved in the opposite direction, as Phillips would predict, but in other half of the years they moved in the same direction. This may be a matter of time lags, with unemployment lagging inflation, but it seems clear that the Phillips curve is a poor tool for explaining these year to year outcomes in Europe or the United States.

Determinants of Growth and Inflation in Southern Mediterranean Countries. MEDPRO Technical Report No. 10/March 2012

Despite significant economic reforms in many Southern Mediterranean EU neighbour countries, their growth performance has on average been subdued. This study analyses the differences in growth performance and macroeconomic stability across Mediterranean countries, to draw lessons for the future. The main findings are that Southern Mediterranean countries should benefit from closer ties with the EU that result in higher levels of trade and FDI inflows, once the turbulence of the ‘Arab Spring’ is resolved, and from the development of financial markets and infrastructure. They will also benefit in keeping inflation under control, which will depend in great part on their ability to maintain fiscal discipline and sustainable current accounts. One of the main challenges for the region will be to implement structural reforms that can help them absorb a large pool of unemployed without creating upward risks to inflation.

Can Italy and Spain survive rates of 6-7%? CEPS Policy Brief No. 279, 27 July 2012

The sentiment that the euro is now in real danger is based in large part on the widespread conviction that interest rates of 6-7% are simply unsustainable for both Italy and Spain., After taking a closer look at the fundamentals, however, Daniel Gros concludes in this new Policy Brief that both countries should be able to live with this level of interest rates for quite some time, but only if they mobilize domestic savings, which remain strong in both countries. For Spain, some debt/equity swaps are also needed.

The simple macroeconomics of North and South in EMU. Bruegel Working Paper 2012/12, 30 July 2012

The euro area today consists of a competitive, moderately leveraged North and an uncompetitive, over-indebted South. Its main macroeconomic challenge is to carry out the adjustment required to restore the competitiveness of its southern part and eliminate its excessive public and private debt burden. This paper investigates the relationship between fiscal and competitiveness adjustment in a stylised model with two countries in a monetary union, North and South. To restore competitiveness, South implements a more restrictive fiscal policy than North. We consider two scenarios. In the first, monetary policy aims at keeping inflation constant in the North. The South therefore needs to deflate to regain competitiveness, which worsens the debt dynamics. In the second, monetary policy aims at keeping inflation constant in the monetary union as a whole. This results in more monetary stimulus, inflation in the North is higher, and this in turn helps the debt dynamics in the South. Our main findings are: •The differential fiscal stance between North and South is what determines real exchange rate changes. South therefore needs to tighten more. There is no escape from relative austerity. •If monetary policy aims at keeping inflation stable in the North and the initial debt is above a certain threshold, debt dynamics are perverse: fiscal retrenchment is self-defeating; •If monetary policy targets average inflation instead, which implies higher inflation in the North, the initial debt threshold above which the debt dynamics become perverse is higher. Accepting more inflation at home is therefore a way for the North to contribute to restoring debt sustainability in the South. •Structural reforms in the South improve the debt dynamics if the initial debt is not too high. Again, targeting average inflation rather than inflation in the North helps strengthen the favourable effects of structural reforms.

Intra-Euro rebalancing is inevitable, but insufficient. Bruegel Policy Contribution 2012/15, August 2012

Greece, Portugal and Spain face a serious risk of external solvency due to their close to minus 100 percent of GDP net negative international investment positions, which are largely composed of debt. The perceived inability of these countries to rebalance their external positions is a major root of the euro crisis. Intra-euro rebalancing through declines in unit labour costs (ULC) in southern Europe, and ULC increases in northern Europe should continue, but has limits because: The share of intra-euro trade has declined. Intra-euro trade balances have already adjusted to a great extent. The intra-euro real exchange rates of Greece, Portugal and Spain have also either already adjusted or do not indicate significant appreciations since 2000. There are only two main current account surplus countries, Germany and the Netherlands. A purely intra-euro adjustment strategy would require too-significant wage increases in northern countries and wage declines in southern countries, which do not seem to be feasible. Before the crisis, the euro was significantly overvalued despite the close-to balanced current account position. The euro has depreciated recently, but more is needed to support the extra-euro trade of southern euro-area members. A weaker euro would also boost exports, growth, inflation and wage increases in Germany, thereby helping further intra-euro adjustment and the survival of the euro.

Options for a Euro-area fiscal capacity. Bruegel Policy Brief 2013/01, January 2013

Europe has responded to the crisis with strengthened budgetary and macroeconomic surveillance, the creation of the European Stability Mechanism, liquidity provisioning by resilient economies and the European Central Bank and a process towards a banking union. However, a monetary union requires some form of budget for fiscal stabilisation in case of shocks, and as a backstop to the banking union. This paper compares four quantitatively different schemes of fiscal stabilisation and proposes a new scheme based on GDP-indexed bonds. The options considered are: (i) A federal budget with unemployment and corporate taxes shifted to euro-area level; (ii) a support scheme based on deviations from potential output;(iii) an insurance scheme via which governments would issue bonds indexed to GDP, and (iv) a scheme in which access to jointly guaranteed borrowing is combined with gradual withdrawal of fiscal sovereignty. Our comparison is based on strong assumptions. We carry out a preliminary, limited simulation of how the debt-to-GDP ratio would have developed between 2008-14 under the four schemes for Greece, Ireland, Portugal, Spain and an ‘average’ country.The schemes have varying implications in each case for debt sustainability