European Economy. Economic Papers. Germany's growth performance in the 1990's

2. The macro-economic policy mix
2.1 Monetary policy in the 1990s
In order to assess monetary policy one has to take into account its framework, in particular
regime shifts that have taken place in recent years as both the geographical entity and
responsibilities changed. Monetary policy has to be related to the overall situation of Germany
or, from 1999 onward, to its relative position in the Euro-area. The monetary policy stance
could be looked at using Taylor rates and a Monetary Condition Index. Results from these
different analyses could help in assessing monetary conditions in Germany.
2.1.1 Developments in the 1990s
In 1990, inflation was pushed by excessive wage increases and in response official interest rates
were raised on two occasions (Figure 2.1). But the economic performance in 1991 was stronger
than in neighbouring countries and despite the effects of the 1991 tax increases the inflation
outlook had become the main cause for concern. It was this concern that led to a further
tightening of monetary conditions in late 1991. But as monetary growth was approaching the
ceiling of the targeted growth range and inflation exceeded 4%, economic growth came to a
halt. The tightening of monetary conditions in Germany initially increased tensions within the
Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) and had spill-over
effects on monetary conditions in other countries. From the viewpoint of economies where
inflation was lower and unemployment was higher the increase in interest rates did not seem to
be warranted.
In 1992, German short-term rates rose relative to long-term rates (just the opposite of the USA
and Japan). Pressures on prices and wages remained strong as unification strained resources and
led to demands for compensation for tax increases. When it came to addressing internal and
external (ERM) needs, monetary policy concentrated on domestic needs. To fight inflation and
to slow the growth in monetary aggregates the Bundesbank tightened monetary conditions
again. Tight German monetary policy continued to put upward premia on other ERM
economies.
In autumn 1992 the German economy entered recession, i.e. with a certain delay with respect to
neighbouring economies and just a few months after the Bundesbank had raised policy interest
rates again (July 17). On 15 September 1992, one day after the revaluation of the DEM in the
EMS, the Bundesbank started to cut policy interest rates (see Figure 2.1). After the revaluation
of the DEM, monetary policy in Germany continued to ease as the Bundesbank responded to a
weakening economy, the improved inflation outlook and an agreement on the fiscal
consolidation programme. The widening of the ERM bands in August 1993 marked the
beginning of a period of a high degree of interest rate and exchange rate stability due to the
absence of further tensions. Also as a result of the strong DEM, inflation rates came down. The
Bundesbank responded to the decline in inflation rates by lowering the discount rate by 3
percentage points (to 5.25%). This process found support from progress toward fiscal
consolidation putting downward pressure on capital market interest rates and by low wage
increases creating a more favourable inflation environment.
The phase of declining interest rates continued into the recovery of the German economy up to
mid-1994 although monetary growth was already clearly exceeding targets. However, judged by
real short-term interest rates, which were near historical average levels, a relatively strong
DEM, and a yield curve, which - following the global increase in bond yields - had returned to
its more normal slope only shortly before (see Figures 2.2 and 2.3), monetary policy was not
excessively easy. Nevertheless, the stance of monetary policy helped the recovery to become
established and was widely regarded as being broadly appropriate: the output gap closed only
gradually, labour costs were falling due also to labour shedding, fiscal consolidation proceeded
and inflation rates declined firming real interest rates.

---

A further decline
was prepared in
March 1995 when
the Bundesbank cut
the discount rate in
view of a much
slower M3 growth
and a sharp
increase in the
external value of
the DEM. At that
time the DEM
appreciated
significantly
against the USD
and against several
European currencies. This appreciation came on top of earlier rises in the effective value of the
DEM, particularly in 1992, which had to a large extent been consistent with the determination in
Germany’s external position necessary to finance the high level of investment. The
disappointing outcome of the 1995 wage round provided reasons for an end of interest rate cuts
even though subdued inflation and slack in the economy suggested room for manoeuvre to
reduce short-term interest rates further.
In 1996, economic growth slowed further and the outlook worsened. Short-term interest rates
were reduced considerably to help offset recession forces. The repo rate was allowed to fall
below 3.5% in early 1996 and in April the lower ceiling, the discount rate, was reduced to the
historically low level of 2.5%. The absence of inflationary pressures and the depreciation of the
DEM vis-à-vis the USD implied an easier monetary stance in Germany. As a result, nominal
long-term interest rates remained relatively low while those in the US rose.