European Monetary System
Counter-inflation policy

The gradual removal of exchange controls and the significant reduction in the frequency of realignments in the later years of the EMS can be expected to increase the convergence of nominal interest rates. If these converge more rapidly than inflation rates, real interest rates will diverge, and countries with higher inflation rates will tend to have lower real interest rates. In Discussion Paper No. 649, Research Fellow Michael Artis argues against relying upon inflation's effect on competitiveness to stabilize this perversity in the cross-country ranking of inflation and real interest rates. The credibility of the EMS may compromise its role as a stabilization framework if the competitiveness effect is either too weak to check inflation or strong enough to induce an unstable cycle.

This problem should also be evident in the earlier period of the EMS because exchange rate realignments were deliberately aimed to under-accommodate inflation, which, if understood by investors, would have implied a tendency for interest rates in high- inflation countries to be above those in low-inflation countries by somewhat less than the inflation differential. Countries protected by exchange controls on capital could also maintain their domestic `onshore' interest rate even below the `offshore' level; if the offshore level already incorporated the effects of the `under-indexing' realignment procedure, then onshore rates would stand even lower.

Using cross-country rank correlations of inflation and real interest rates for six EMS member countries during 1979-87, Artis finds that the rank correlations of real interest rates and inflation were predominantly negative in the first sub-period and positive in the second: the predicted inverse correlation is found for the `old EMS' but not for the later years.

Artis cites some explanatory factors: the credibility of exchange rates in the `new EMS' may have been overstated; data measurement errors may be more important at the lower levels of inflation and interest rates ruling in the later EMS. These tests need not indicate a systemic feature, but certain currencies have clearly been plagued by the problem of `excess credibility'. A renewed use of active fiscal policy may be the appropriate instrument to bring their inflation under control.

Counter-Inflationary Policy in the Framework of the EMS
Michael J Artis

Discussion Paper No. 649, March 1992 (IM)