The operational target of monetary policy shall be annual consumer price inflation of approximately 2.5 per cent over time. […]” Section 1 of the regulation states that in addition to sustaining the rate of inflation at approximately 2½ per cent over time, monetary policy shall also contribute to stable developments in output and employment. The mandate therefore establishes a flexible inflation target for monetary policy where variations in both output and employment are given emphasis. Since inflation is a monetary phenomenon over time, the level of the inflation target may be chosen by the authorities. A target for output, however, cannot be chosen in the same way. The economy grows over time. This is a result of positive productivity growth and population growth. The level of output that is consistent with stable inflation over time is discussed in economic theory as potential output. The level of potential output cannot be influenced by monetary policy. When the economy grows more rapidly than this level, inflationary pressures will build up in the economy. When the inflation rate becomes high and unstable, self-regulating mechanisms will tend to curb growth. Experience shows that periods of high inflation are followed by periods of contraction. Over time, it will be impossible to maintain output at a level that is higher than the potential output level. Monetary policy’s contribution to stabilising output will therefore be to curb fluctuations around the potential output level. The potential output level cannot, however, be observed. It is also difficult to capture changes in productivity and technology.
Given that the target of imminent euro adoption is gone, and the large euro zone nations do not provide real leadership on fiscal soundness, there is less incentive for some of the new member states to stick to the consolidation of their public finances from today’s deficits above 5 per cent of GDP. The consolidation plans are already too dependent on a continued upturn. Whether in the old or new member states, there is an additional problem, as we are entering a period of intensifying structural changes. Old industrial patterns in Europe are being changed when confronted with both the boost to productivity from IT, as partly realised since the late 1990s in the US, and globalisation and enlargement, all of which supports this process. These trends will eventually help productivity and growth in Europe to start to catch up with the US again. But in the short term the structural changes will lead to higher frictional unemployment as old industries are more rapidly replaced by new ones. In addition, the recent downturn never led to a dramatic increase in unemployment or decrease in employment in the euro area; hence, the upturn is probably also less likely to lead to rapid job creation. Both factors create new incentives for fiscal policy to focus more on short-term job creation schemes and less on long-term fiscal soundness. So from this perspective, too, the hope that the recovery alone will “fix” the European deficit problem might be too optimistic.