Monday, July 23, 2012

Worry about the euro; not price stability

by Lorenzo Bini Smaghi

Financial Times

July 23, 2012

By assigning to the European Central Bank the task of “defining and implementing the monetary policy of the Community”, the EU Treaty implicitly considers that there should be only one monetary policy for the entire euro area. Yet, looking at a variety of indicators – from short or long term interest rates on a wide variety of assets to the flow of money and credit to the private sector – it is difficult to conclude that monetary conditions are currently uniform across the union.

The central bank typically implements its monetary policy by setting the rate of interest at which it lends to the banking system. Such a rate, which influences asset prices and affects the savings and investment decisions of the private sector, is determined with a view to achieve price stability. A key assumption underlying this operational framework is that financial markets are efficient and support a smooth flow of funds across the union. In other words, the transmission mechanism of monetary policy is expected to be stable and predictable.

This assumption is currently far from being satisfied. The euro area financial market, in all segments and maturities – including the very short term money markets – does not function properly, as banks deposit their excess liquidity with the central bank instead of lending to other banks. Cross-border banking flows have dried up. Households and firms across the union borrow at rates which depend more on the respective sovereign risk — just look at Spain, today, for example — than on their intrinsic creditworthiness. Interest rate decisions made by the central bank are not able to affect monetary conditions in the desired way in a large part of the euro area.


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