Inflation rate is one of the indicators that central banks observe and make decisions regarding monetary policy changes. However, why economic growth is associated with the increased industrial output due to higher prices and devaluation of currency instead of increased productivity? Moreover, what is the relationship between the inflation rate and nominal currency rate and the importance of the conventional target of healthy inflation of 2 percentages?
The considerations will be made by taking changes of the monetary policy of the ECB made on 2 May 2013 as an example. According to the introductory statement to the press conference of the Governing Council of the ECB released on 2 May 2013, the real GDP contracted by 0.6% in the fourth quarter of 2012, following a decline of 0.1% in the third quarter. The statement also revealed the decline of output for five consecutive quarters and the decline of annual HICP inflation of euro area to 1.2% in April 2013 compared to the 1.7% in March. According to the monetary analysis section, the annual growth in broad money was 2.6% in March compared to the increase of 3.1% in February and the annual growth rate of the narrow monetary aggregate, M1, increased slightly further to 7.1% in March, reflecting the continued preference for the most liquid instruments in M3. Moreover, while deposits with the domestic money-holding sector continued to grow further in most stressed countries in March, the annual growth rates of loans (adjusted for loan sales and securitisation) to non-financial corporations and households have remained broadly unchanged since the turn of the year, standing in March at -1.3% and 0.4% respectively. So, the decision of the Governing Council of ECB to lower the interest rate on the main refinancing operations of the Eurosystem by 25 basis points to 0.50% and the rate on the marginal lending facility by 50 basis points to 1.00% was related to the attempts to encourage development in the euro area. However, do the expectations of keeping inflation rate close to 2 percentages define a healthy investment environment?
The ECB measures the stability of domestic currency as the nominal effective exchange rate of euro which is calculated as weighted averages of bilateral euro exchange rates against 20 trading partners of the euro area. According to the statistical data of the ECB, the daily nominal effective exchange rate of the euro in May 2013 lost its strength by 10% during the last five years and is close to the average of 10 years (euro value is up by 1.5%). However, considering the relationship between the inflation rate and nominal currency rate during the last five years it appears that correlation was -0.398. Moreover, healthy investment environment may be considered the one in which the nominal interest rate is higher than inflation, id. est. in order the investment generated returns inflation should be lower than the remuneration of debt securities. The estimated annual inflation rate of euro area was 1.2% in April while data of the euro area yield curve revealed market remuneration rates on government debt securities with the maturity of one year in range of 0.020% to -0.006%.So, declined inflation rate might be treated as market’s self-regulation mechanism in the context of economic constrains. Slowing demand is a signal to producers and suppliers of services to review the demand of production and services as well as pricing policies those may end to the intensified consumption after the cut of costs and prices.
Consequently, could the inflation target of 2 percentages be released instead of cuts of interest rates?