Jürgen Stark, member of the executive of the European Central Bank, responsible for DG economics, talked to Jornal de Negócios one week ago after the ECB’s meeting where the possibility of a rate cut in the euro zone was put aside. He explains, why no one can tell when the financial crisis will end and warns that if banks wont auto-regulate, the authorities will act.

In August some voices said this would be a very short term crisis. Then, time passed by, and the expectation was that things would calm down by end of the year. It didn’t. Then the next date was February, March with the full year results of banks. We are in March and problems continue. Do you have an idea of when things might return to normal?

I don’t remember anybody saying it would come to an end in March. What was said is that things might become more transparent when banks published their annual accounts and that is true. This is part of the solution. But we are experiencing a substantial market correction and this is not without a pain. So, central bankers said that this would take at least some quarters in order to correct the excesses of the past. If you only take the subprime market of the US, a large share of this subprime mortgages will be resettled in the first two quarters of 2008. This shows that this is not the end of the story. And we see now that other market segments are affected. This market correction is still on going and nobody can tell you how long it will last.

Mr. Greenspan didn’t put a point in time, but recently said that until the housing market doesn’t calm down and prices keep on falling the markets will not calm down. Do you agree?

It is not the housing market of the US alone. We have to understand better what the reasons of the present current financial market turbulences are. The reasons are more complex. One is the exotic financing of housing in the US. But we also have to take into account that there is a mutual reinforcement of different factors, including securitization and the wide use of the "originate and distribute" model by banks. This has to be reconsidered. There are many, many factors playing a role and we have to understand the interaction between them.

The spill-overs are getting everywhere, including the best quality like the sovereign debt. Looking at the way this is spreading is it possible that it might not affect families and companies?

Sovereign debt is not a benchmark. In that case you also have to consider the different degree of liquidity in various market segments. There are spill-over effects to other market segments reflecting the high degree of uncertainty and this is an ongoing correction in the markets. And as long as the market has not found a new equilibrium we have to live with this high volatility and overshooting.

Are the markets overshooting or are they on their way to new higher equilibrium for spreads?

On the way to a new equilibrium, markets show some signs of overshooting.

Economies with highly indebted private sector and that depend on a lot on funding on international markets like Portugal or Spain are more vulnerable to the current turmoil?

Portugal and Spain traditionally have flexible interest rates. Depending on market conditions the credit standards could tighten further and this could be felt by private households and companies. Other countries, in particular when it comes to the housing sector, depend more on long-term financing and therefore are less vulnerable to current market conditions.

We are now eight months into the crisis. What we have seen is that with this turmoil the monetary policy has found some difficulties in working. For instance the Fed has cut the central rate, but the money market hasn’t reacted proportionally. Can we trust central banks and the ECB to be able do monetary policy?

There is no reason to believe that the transmission mechanism of monetary policy has changed or has been distorted by the tensions in the money market. We have contributed with our money market operations to smoothen the situation. We provided temporally additional liquidity to the money market to ensure that the overnight rate remains close to the minimum bid rate. We are still convinced that the transmission mechanism works.

But my question is more on what you cannot influence. That fact that the longer rates didn’t react. Isn’t that a threat to monetary policy?

What we can influence is the very short end of the interest rates. We also have the 3 months operations but the impact on the 3 months rates is rather limited. What is beyond the very short term segment of the money market is up to markets, not to us. We cannot steer the interest rates over the entire yield curve.

The major risks for inflation the ECB has pointed are prices in food, commodities, some cartels - which I assume is related to oil prices - indirect taxes, and prices in sectors not subject to strong competition. In Germany, an important steel union got 5,3% wage increase and the public sector has refused a 5% offer. Are these values a risk concerning the second round effects you want to avoid?

All the risks you have mentioned constitute risks to price stability. However, the most significant ones are those stemming from commodities prices and those from second round effects. Regarding second round effects, we have a symmetric approach. We do not refer to the development of wages only. We also refer to the price setting behaviour of firms. Furthermore, we do not have a particular country in mind when we discuss risks from second round effects. Until recently, we have seen wage moderation in the euro area.

However, the situation seems to change in particular against the background of very likely wage increases in a major country. This will have a significant impact on the euro area as a whole. We would like to make it very clear that market participants should not start second round effects that could lead to a wage-price or price-wage spiral. We are well prepared to prevent broadly based second round effects.

It was quite easy for the central bank to keep inflation low since the creation of the ECB due to downward pressure of import prices in some products. That effect has gone and now you have the impact of commodities prices. Are the easy days of keeping inflation down over?

What is important for a central bank is, given the time lags, to detect in real time the risks to price stability in the medium term. It has never been easy to take the appropriate decision on the basis of the information that is available. In the current circumstances the uncertainty is unusually high which makes it even more difficult. In the past maybe our task was made a bit easier due to the fact that manufactured good prices declined due to globalization effects. We have seen the supply side effect of globalization, now we see the demand side. At the same time, it would be too simple to say that it was only due to the globalization in the past that led to low inflation rates. The institutional setting we have achieved globally is at least of equal importance. Thirty years ago there were only two or three central banks that were independent. Now it is more or less state of the art and this is an important factor in explaining why we have achieved globally price stability for many years.

The phenomena such as banking disintermediation process, securitizations, credit derivatives, too complex instruments, too little information and information asymmetries have created problems that have become very visible now. Will this change the way central banks will operate in the future? The ECB has said for instance that more transparency will be needed?

Over the last 20 years financial innovation changed the behaviour of market participants and it is up to all participants to understand better how markets function. We said we need more transparency by individual institutions to disclose their losses in certain market segments. We didn’t want to have a week by week approach of the losses but rather a clear statement regarding the overall losses due to the financial turmoil. And we were right in doing so. In my view, financial institutions should promptly and fully disclose risk exposure on and off balance sheet. However, it turned out that they sometimes had problems to identify off balance sheet risks.

You have no doubts that for the future will banks need to be more transparent regarding on-sheet and off-sheet disclosures and that it might be necessary for NCB to act?

This is absolutely crucial. Transparency is an important principle. However, we know that there is an optimal transparency level. We do not ask for a maximum but we ask for an optimum. International organisations, governments and the European Commission are working very hard in this direction asking for market led solution and there are some. But I am absolutely sure that if such market led initiatives for a higher degree of transparency and disclosure will not work, in the end a more prescriptive, regulatory approach will be put in place.

The threat to the Economy comes from further tightening in credit standards

You say the economy is robust, that the fundamentals are solid, credit is growing and money aggregates are growing. On the other hand the inflation rate has almost doubled from August until now and the ECB staff mid point projection is of an inflation rate of 2,9% for 2008 and above 2% for 2009. The ECB is not acting, why is that?

The economic analysis shows that the inflation rate will clearly remain above 2% in 2008. We expect, although it is not that clear, that towards the end of the year we will come closer to 2%. Our monetary analysis gives clear indications that there are upside risks to price stability in the medium term. The fact that inflation is that high and is expected to remain at an elevated level for a couple of months is our major concern. We are not happy with this situation. At the same time, we believe that the current monetary policy stance will contribute to achieve price stability over the medium term and ensures that inflation expectations remain well anchored. However, given the current uncertainties we will assess in the coming months on an ongoing basis whether the current policy stance still contributes to achieving price stability.

In August you had these risks and the rates were supposed to go up. Is the ECB not wanting to be too aggressive or held responsible for a possible downturn in the euro area economic growth in the months to come? Is it a defensive way to be regarding the risks?

Our staff projections point to moderating but ongoing economic growth in the euro area. The growth rate in 2008 will be somewhat lower than in 2006 and 2007 when we had growth rates above potential. However, we have a clear mandate and it says that our primary objective is to maintain price stability in the medium term. Our stance has to be assessed in the context of still high growth rates in monetary aggregates and in credit and loans to the private sector. Regarding the latter, we so far see only limited effects from the tightening in credit standards in some market segments. We also have to take into account that we have tightened monetary conditions by having increased the short term interest rate from 2% to 4% since December 2005.

In October you said the impacts on the euro area economy could come through two doors: one the financing conditions, the other the domestic demand. Domestic demand has fallen QoQ in the end of 2007. Is the major risk now an effective tightening of financial conditions affecting families and companies?

There are several factors to be observed. We have ongoing job creation and markets expect that this will continue, leading to a further reduction in the unemployment rate. This positive development will contribute to higher private consumption. Although, at the same time, high inflation will weigh on the purchasing power of consumers and this might be an impediment for higher private consumption in some regions of the euro area. However, also investment is expected to continue to increase. These factors will contribute to GDP growth in 2008 despite the fact that net exports will likely make a smaller contribution than in 2006 and 2007, which is mainly due to the fact that some of our major trading partners are slowing down. Regarding the exchange rate developments, it is important to note that the diversification of export destinations has increased.

Given your assessment the major risk to economic growth is actually what is going to happen to credit growth to households and companies?

The major risk to economic growth is coming from the potential impact of the financial market turmoil particularly via a further tightening of credit standards. But we also have to take into account other risks, including the sharp increase in commodity prices that might have a dampening effect.

What can explain the fact that in the quarterly surveys banks answer they are tightening their credit standards, but still credit growth keeps vigorous?

Credit growth is still going on. As far as we can see, it has not been hampered by the financial turmoil. So far, the tightening of credit standards is not that significant, even when it is compared to the situation we had in 2001. It is really striking to see that the credit growth to the non financial corporate sector is growing by 14% annualised. All in all, this might reflect an optimistic mood and confidence of investors.

The ECB says that the major contribution it can give to growth in the medium term is keeping inflation down. However when we compare the growth rates on both sides of the Atlantic, the growth rates have been higher in the US despite the fact that they have a more flexible stance on inflation. Some people say that the ECB has too much of a German fear of inflation. What do you say about this?

It was not due to monetary conditions that growth rates in the euro area were lower in last ten years than those in the United States but due to diverging productivity developments. The US were more successful in this field until recently. In the recent past productivity has declined in the US and it is still low in the euro area. We have to work hard to improve. The ECB’s contribution to sustainable growth in the euro area is to safeguard price stability. In the medium to long-term the inflation rate must be in line to what we have defined as price stability, that is below but close to 2%. Inflation is never an instrument to allow for higher growth. And we know from monetary theory that in the end higher inflation will not allow for higher growth or job creation.

But in Europe there is a more strict approach to price stability compared to the US. Putting the other away around, there is no evidence that higher inflation has dampened growth in the US. Would it make such a difference if instead of the 2% you would have a 3% or a 2.5% as an objective?

I doubt very much whether you can exploit a positive trade-off between economic growth and inflation in the short term. In the long-term there is evidence that higher inflation might even have negative effects on real growth. We currently have 3 % inflation and I believe many, many people are not happy with this development. In Europe, the preference for price stability can be explained by the experience with high inflation rates in the first half of the 20th century. The US made their experience during the Great Depression. We have cultural differences and so we should not compare directly what we are doing here to what other central banks are doing.

It is the dollar that is weak and not the euro that is strong

You recently said that exchange rates should be taken into account by monetary policy only to the extent that they have a medium term influence on prices. How damaging is the strong euro to your objectives? It not a problem at all, or is it?

Exchange rates should always reflect economic fundamentals and high volatility is not helpful for economic growth. As far as our mandate is concerned, the strong euro helps to mitigate the price pressures stemming from the strong increase commodity prices, in particular from energy prices. We should also have in mind that the focus on bilateral exchange rate developments is to narrow. What you have defined as a strong euro is, from this perspective, a weak dollar, because many currencies have appreciated against the US dollar. However, as regards the impact on the euro area economy, the development of the effective exchange rate is much more important.

But the euro has also appreciated against most currencies?

But not in the same amount. This is the only comment I would like to make.

The ECB has frequently recalled that mr. Bush and Mr. Henry Paulson have said that a strong dollar is important for their economy. What is the ECB saying? What can they actually do in this regard?

We say we appreciate what the US authorities have said.

Mr Strauss-Khan, managing director of the IMF which aims to be the watch-dog of world exchange rates, has recently said that the ECB is not as sensitive to the euro-dollar as it could be and that the ECB has probably too much power in that regard. What do you think about this?

It was surprised to hear such a remark from the top official of the IMF. I think the managing director of the IMF is well aware of the institutional setting and the mandate given to the ECB. His statement was first unfounded and second not very helpful.