Interview with Athanasios Orphanides, Governor of the Central Bank of Cyprus, conducted on 22 November 2007 by Gabi Thesing
On financial markets:
Clearly we have had a disturbance in financial markets since August that complicates the situation. Uncertainty is much greater. We have a lot of news still coming out on financial markets that is not that straight-forward to digest. So in that sense the uncertainty is much greater than was the case in July.
On monetary conditions:
One might interpret what has been happening in financial markets as a tightening of financial conditions, taking everything else as equal, and this is clearly one of the reasons why the ECB decided to take the policy decisions it has taken since then. It is much more valuable to wait and gather additional information before taking actions in situations like this. Uncertainty is greater and the risks are not in their most common configuration. We have a supply shock, so we have inflation risks on the upside with risks to growth on the downside. This is not the most comfortable situation for a central bank to be in.
Risks on inflation are clearly on the upside. On growth, they were not on the downside earlier but now risks are on the downside because of the situation in financial markets as well as the possible influences of the increases in oil and commodity prices on the economy. So these are elements that have increased the downside risks.
Balancing these risks is not a straight-forward thing to do. Luckily, and this is important, we're on this side of the Atlantic, not the other side, so it's much more straight-forward to formulate policy by being focused on the risks to price stability in the medium term. This makes it much clearer to see which way policy should go when there is a fine balance between the alternatives.
This is important because we all know that price stability is the most important way a central bank can contribute to economic welfare in the long run. It's very useful to be able to focus on this as opposed to situations in some other central banks where you may have more short-term influences and questions about what the objective of the central bank should be. That might actually complicate the decision-making process.
ECB mandate versus the Fed:
In terms of the stated, legal mandate, I think the ECB's mandate is by far superior. The ECB's mandate was created after observing the monetary experiences around the world over time and incorporates lessons from these experiences. In contrast, in the United States, the Fed's mandate dates back to 1977, which arguably is before it was appreciated how important it is to stress price stability as a central bank’s primary mandate.
This is in terms of the written, formal mandate. If you talk about actual central bank practice, I recall in my reading of many speeches and testimonies by Chairman Greenspan that he would stress the important role of price stability and its predominance in the long run. So operationally, the distinctions may not have been as big as they sound when you look at it in terms of the written mandate.
On the Fed's Rate cuts:
I do not see in their interpretation of the economy any inconsistency with maintaining inflation in their definition of price stability with the recent policy moves.
You have to remember that we had a de facto tightening in financial conditions in the money market. In the U.S. money market, that tightening could have been as much as 75 basis points in the last few months. So under these conditions, the lowering of the Fed funds target rate by 75 basis points pretty much left the money market rates where they were at the beginning of August. So it's not clear that there's been any dramatic easing of policy.
On European money markets:
I think the spreads in money markets in Europe are somewhat lower, but they are significant, and sure, that is one of the many elements in the equation of what I see the governing council taking into account in reaching its decisions. These decisions are multi-dimensional, there are numerous elements that come into play that need to be balanced.
On growth:
Despite the difficulties we have had in financial markets, in the euro area, so far the indications are that growth remains quite good. According to recent projections, growth is still pretty much in line with the economy's trend growth in the long run. So in that sense we have not seen yet any evidence of weakness.
On 'accommodative' and 'neutral':
I personally have a lot of difficulty in defining in real time what the level of interest rates is that will be such that the economy might overheat or might not grow fast enough. I think this is an impossible task. Based on some work I've done in the last few years, I've convinced myself that these so-called neutral rates are impossible to measure in real time. So I don't think that's very useful language to use to describe the monetary policy problem. In my view it's much more useful to look at the inflationary outlook and at inflationary expectations. This provides more directly useful guidance than trying to assess what the level of the so-called neutral rate is.
Inflation:
I think here you need to separate between the immediate future, which could be the next many months, and the horizons beyond that. It is definitely true that the adverse developments we've seen, especially in energy, commodity and food prices, have contributed to a rise in inflation. We can expect this increase in inflation to remain for several months. This is why President Trichet has talked about an inflation 'hump', and indeed in the last several weeks it has got a little bit bigger and a little bit longer.
The inflation numbers are not going to look as good as I wish they did for the next several months. But looking beyond that, I see that expectations, particularly those of professional economists, appear to remain quite well anchored. Beyond the first year, I'm relieved to see that expectations remain anchored, and when I look at the longer run as well, over the five-year horizon, those expectations are quite well behaved so far. I believe this is significant.
Of course this also reflects on the ECB's credibility, and the fact that markets and economists do understand when the ECB states that it will do what is necessary to keep inflation expectations well anchored, and thereby keep inflation within its definition of price stability in the medium term. This is very important. It's extremely important especially in situations like this where we have a supply shock that increases headline inflation temporarily, and temporarily in this case could be as long as a year. Starting with the reading we had for September, you could actually have measured inflation above 2 percent for as long as a year, and this is not a comfortable situation to be in. It's extremely important to maintain credibility, to be vigilant on inflation, otherwise you may see this being reflected in wage contract negotiations and getting embedded into second-round effects, which is going to be detrimental to everybody in the euro area.
Given the clarity of the communication from the ECB, everybody should expect the necessary action to be taken.
On what might trigger the ECB to act:
I think it's very hard to identify any single hurdle that would need to be crossed. It’s a multidimensional problem.
One cannot rule out the need for further tightening. It depends on how the situation evolves, and the inflationary situation has become more worrisome. On the other hand, we are watching developments in financial markets. We have had the recent tightening in credit conditions, and we have banking developments that may still worsen.
With these continued surprises, one cannot rule out a deterioration on the real side of the economy either. You have to balance the risks on both sides. One should not rule out anything at a point like this.
This is the most uncomfortable situation for central bankers to be in, with inflation risks on the upside and growth risks on the downside.
On Cyprus:
If we could, we would have raised interest rates at this juncture, because the inflation pressures in Cyprus are worrisome. There will be wage contract negotiations and food and energy prices have increased inflationary perceptions.
On Stagflation:
The signs are correct, but just the signs and not the magnitudes, because if by stagflation we mean something even remotely similar to what happened in the late 60s and 70s in Europe or the United States, then we are very far away from those developments. For a development like that to happen, you need, in addition to a deterioration on the real side of the economy, persistent monetary policy mistakes. Stagflation in the late 60s and 70s happened because central banks in many countries around the world stopped watching inflation closely enough. I can assure you that this is not the case in the euro area today. That is not going to happen.
On the concept of decoupling:
I would assume that growth in the U.S. is very important for the development of emerging markets. The world economy is very well integrated right now and this is why one needs to watch developments everywhere.
On the euro's exchange rate:
I don't form views on the euro per se. I prefer not to take a stand on the currency. The question overall is whether it has affected, or is about to affect, in a major way the economy in the euro area. So far the economy in the euro area has done quite well. It's not clear what interpretation to put on the euro. I don't think we can tell in real time. As I mentioned earlier, for monetary policy it's better to look at the underlying situation in the economy and the underlying situation on inflation.
On Cyprus, the euro, inflation perceptions, rounding of prices:
The recent pickup in inflation, because of the increase in food and energy prices, is a challenge, the public does see these increases and they influence public perceptions. Whoever wants to be negative on the euro will say: "See, it’s the euro". Interestingly enough, when it comes to rounding, we have some supermarket chains in Cyprus who have said they will be rounding prices down. It's a marketing tool. The rounding effect is going to be extremely small. I expect to see some up and some down.
Euro-region growth outlook:
As you know the professional forecasts are not particularly worrisome at this point. The baseline scenario looks fine, but that is just the baseline scenario. What we did not have before the summer, and do have at present, is much greater uncertainty surrounding this baseline scenario, especially on the downside.
On Cyprus and restrictions on euro-denominated deposits:
As of January 1, the euro will be a domestic currency so the supervisory framework will have to take this into account. And by taking this into account the Central Bank has been considering how it would change its guidelines, for commercial banks. With existing guidelines we predicted that without any refinements of our prudential regulations there would be a substantial release of liquidity in the banking sector, and a significant reduction in the reserves that commercial banks would be holding as of January 1.
With that in mind what we have done is drafted a new guideline, which we estimate will still result in the release of liquidity into the banking sector but not as much as would have been the case had we not drafted this new guideline.
What we are considering is to reinstate an overall liquidity provision in the banking sector along the lines of what was in place in Cyprus for many years in the past.
The draft guideline we have sent out to banks for comments would be for a liquidity ratio of 25 percent. This is actually lower than the average liquidity ratio that was in place historically in Cyprus.