Managing Expectations

26^th May 2006

The Malta Independent - Friday Wisdom

One of the trickiest aspects in the Euro changeover project is ensuring that the process will be inflation neutral. Militating against this objective is the natural inclination to expect an impulse of inflation from the changeover.

As often happens, unless such expectations are addressed in a long process of educational information, they tend to become a self-fulfilling. Expectations turn into reality by the very fact they give pricing power to suppliers.

If inflation expectations are allowed to take root and eventually turn themselves into real measured inflation, this could very well prejudice our credentials to proceed with Euro entry as planned in 2008. Lithuania has just been refused entry into the Euro Monetary Union next January 2007 purely because its inflation rate was minutely above the criteria laid down for this purpose in the Maastricht Treaty.

Whilst other criteria for public fiscal deficit and debt levels seem to carry sufficient flexibility in their application and should not therefore be decisive factors regarding our credentials for Euro entry, the inflation criterion is being applied with exaggerated rigidity without any allowance for the exceptional inputs caused by high energy prices.

It is therefore of paramount importance for macro-economic policies to focus obsessively on the inflation score and this can only be done if the consumer is not allowed to harbour undue inflation expectations by the same process for which contained inflation is crucial.

The only way the consumer can be trained against building undue inflation expectations is by having a long period of dual pricing to avoid suppliers building in price hikes to take advantage of the confusion caused by the changeover process.

Obviously there are problems with adopting a long period of dual pricing. The main one is that until there is final agreement with the EU about entry, which can only come this time next year, the rate for conversion remains a target not a binding commitment. And in the absence of a binding commitment the market will keep throwing up a myriad of rates for converting currencies between MTL and EUR.

There are at least five rates published officially every day, one by the Central Bank and four by the commercial banks two for buying cheques and notes and two for selling them. These range from a minimum of Lm0.4113 per Euro to a maximum of Lm0.4426 giving a spread of 7.6%. This is no small stuff considering that the central rate quoted by the Central Bank is fixed at Lm0.4294 without day-to-day risk of fluctuations.

Which means that for dual pricing to be effective as a means of education, it can only start at the point in time when the target rate turns into an immutable commitment. At that point the Central Bank would be constrained to use monetary policy during the preparation period to pitch interest rates at a point high enough to avoid anticipated conversion into Euro, encourage domestic savings, and control excessive demand but not too high to attract destabilising inflows of hot international money searching for additional interest rate returns without exchange risks.

The timing for making such a move has to be left to the final judgment of monetary authorities who have to weigh the benefits of controlling inflationary expectations through effective dual pricing campaign against the risk of stimulating undue capital flows, outward or inward, by the removal for exchange loading charges for conversion between EUR and MTL in the preparation period.

This is complicated enough on its own and need not be complicated further by introducing additional variables. One such variable that is absolutely avoidable is the risk of an election before the changeover.

The risk of electing a new government before execution of the Euro project will cause market instability that will of itself destabilise the project execution. The clear message from the government has to be that elections will follow not precede the Euro changeover date.

Another variable we ought to do without is introducing additional criteria for economic growth performance before the changeover. I most heartedly agree that this country needs at least 4% (probably more) real annual growth to keep employment stability. We need even more to accelerate the convergence with our European peers. Where I differ is the suggestion to make Euro adoption conditional on such growth.

Growth comes from efficient restructuring and new investments and both these aspects are abetted by adoption of the Euro. We need the monetary stability and recognition that come from monetary union at a competitive level in order to achieve the desired growth. One could choose to argue whether the rate for conversion chosen is consistent with preserving international competitiveness. I think we should have done more, but once a decision has been taken international competitiveness has to be sought elsewhere and not through delaying monetary union.