By Yannis Stournaras, Governor, Bank of Greece
Inflation has remained far too high for too long. For most of the previous year, it kept surprising us to the upside, month after month. The underlying drivers, at least in the euro area, came mostly from the supply side. These drivers included the supply-side disruptions caused by the successive waves of the pandemic, higher energy prices and Russia’s invasion of Ukraine, which pushed energy prices even higher and was accompanied by trade disruptions. As a result, inflation registered successive peaks until last October, when it reached 10.6 percent. Ina welcome relief, the following five months saw a deceleration in inflation. The questions before us are: Has the October figure defined the peak? Have we finally seen the turning point? My answer is: very likely, yes.
In fact, several factors point to inflation remaining on a broadly declining course in the following months.
- First, the energy shock appears to have eased; gas prices have declined sharply. Oil prices have also retreated by more than 30 percent since the summer.
- Second, supply-side bottlenecks have strongly subsided. The global supply-chain pressure index, set up by the New York Federal Reserve, has fallen sharply from its peak in December 2021 and is now hovering close to its historic mean.
The reopening of the Chinese economy should further contribute to the unwinding of bottlenecks in global supply chains.
- Third, high inflation has suppressed households’ real disposable incomes on top of the terms-of-trade effects produced by the energy shocks. Reduced demand will contribute to declines in profit margins, translating into lower inflationary pressures.
- Fourth, money-supply growth has fallen sharply, from 12.5 percent in January 2021 to 3.5 percent in January 2023; money supply is a strong predictor of inflation in high-inflation regimes.1
- Fifth, financial-market conditions have already tightened. Bank-lending conditions—both banks’ willingness to lend and businesses’ willingness to borrow—have been sharply curtailed. Risk aversion in the financial sector due to recent events will further weigh on credit flows to the economy, thereby restraining economic activity even more and contributing to a quicker return of inflation to its target.
- Sixth, the recent appreciation of the euro will also put downward pressure on (imported) inflation in the coming months.
- Finally, strong energy-related downward base effects have already started kicking in this year, while second-round effects remain limited.
All the above paint a somewhat optimistic picture of a prospective disinflation process toward the European Central Bank’s (ECB’s) objective. Our March projections confirm this picture and provide some comfort that inflation will come out significantly lower than previously thought this year and closer to our target by the end of the projection horizon. In fact, a headline inflation rate of 5.3 percent is projected for 2023, revised downward from the 6.3-percent rate foreseen in the December exercise, while risks are now assessed as more balanced.
Although we can take comfort in the fact that we are winning some battles, we cannot declare victory yet. Two factors require careful monitoring.
- First, we need to remain wary of the drivers of persistently high prices. Although there are no signs of a wage-price spiral, stronger-than-the-current wage growth would not seem consistent with our medium-term inflation target, even when accounting for trend improvements in productivity.
- Second, we need to ensure that inflation expectations remain well-anchored. This is true for both market-based and survey-based longer-term inflation expectations. Survey-based measures, such as the ECB’s Survey of Monetary Analysts (SMA) and the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters (SPF), indicate a 2-percent inflation rate in the long run. (According to the March SMA, expected inflation stands at 2.0 percent for 2025. The SPF forecasts inflation for 2025 at 2.1 percent.) Market-based measures of longer-term inflation expectations have become quite volatile in recent weeks but nevertheless have subsided to levels close to 2.3 percent recently.
During the past decade, the Eurosystem navigated uncharted waters of too low, even negative, inflation levels and embarked on a negative interest-rate policy and a series of unconventional monetary-policy measures. In a similar vein, the Eurosystem is currently unwinding its accommodative stance in the face of the highest-ever inflation levels since the introduction of the euro—which brings me to the overarching question:
What is the best approach to tackle inflation?
To tackle inflation in the euro area, at the Governing Council, we tightened our monetary policy gradually and, at the same time, decisively.
- The adjustment of our monetary-policy stance started in December 2021, when we announced the stepwise reduction in net purchases under our asset purchase programmes (both the Asset Purchase Programme [APP] and the Pandemic Emergency Purchase Programme [PEPP]).
- Net asset purchases were discontinued during 2022 (as of the beginning of April for securities under the PEPP and as of the beginning of July for securities under the APP).
- In July 2022, we raised our policy rates, ending an eight-year era of negative rates. Since then, rates have increased further by a total of 350 basis points.
- The policy rate impulses are reinforced by the balance-sheet decline, stemming from both the progressive repayment of the third series of targeted longer-term refinancing operations (TLTROs-III)—especially following the adjustment of their terms in October 2022—as well as the reduction of the Eurosystem’s holdings of APP securities that started this March.
The substantial tightening of our policy has significantly affected the euro area’s financing conditions. The smooth transmission of monetary policy has been supported by flexible reinvestment under the PEPP and the announcement of the Transmission Protection Instrument (TPI) last July.
The transmission of our restrictive monetary policy to real output and inflation has also started to materialise. Our restrictive monetary policy decisions since December 2021 are estimated2 (according to the median of a suite of models employed by the ECB) to have lowered euro area inflation by around 0.2 percentage points year-over-year in 2022. Given the considerable lags with which monetary policy affects inflation, a larger impact on inflation is anticipated to materialise this year and next year. Inflation is estimated to be around 1.2 percentage points year-over-year (YOY) lower in 2023 and 1.8 percentage points YOY lower in 2024. Regarding the economic outlook, the negative impact on real GDP growth is estimated to be around 1.5 percentage points (YOY) on average over the 2022-24 period.
Although some uncertainty surrounds these results, they provide a good estimate of the efficiency of our monetary policymaking.
The unprecedented supply-side shocks that hit our economy have posed an unparalleled challenge for policymakers. All else remaining the same, the shocks had the effect of reducing output while raising inflation. They also led to unprecedented uncertainty. This uncertainty has been amplified by the most recent financial tensions. The events led to heightened volatility in financial markets, raising fears of global contagion risks and sending stocks tumbling around the world.
An expression originally attributed to Aristotle is: “The whole is greater than the sum of its parts”. Recent developments in financial markets have illustrated that pockets of risk in the financial system exist and that their totals can be substantially larger than the sum of their parts. This is because financial risks can accelerate and amplify at breathtaking speeds, reverberating through the financial system. Such pockets of risk require vigilance on the part of monetary policy as rates enter the restrictive territory.
The euro area’s financial system is resilient, with strong capital and liquidity positions. And the Governing Council of the ECB has shown that it can—and will—act, if necessary, with prudence and reassurance to fend off further risks of contagion to the euro area’s financial system. For this reason, at our last monetary policy meeting in March, we reinforced the importance of the data-dependent approach and further explained the mechanisms of our reaction function.
The three elements that guide our future decisions are: 1) the assessment of the inflation outlook in light of the incoming economic and financial data, 2) the dynamics of underlying inflation and 3) the strength of our monetary-policy transmission.
Clearly, financial-market risks pose challenges for monetary policy, which has to tread the thin line between facilitating the intended effects on still-high inflation while not adding to financial volatility. Of course, monetary policy must remain inseparable from its objective, which is to restore price stability without jeopardising financial stability.
In this context, the decision of the ECB Governing Council during its last monetary policy meeting in March to proceed with a further interest-rate hike to combat inflation was warranted.
At the same time, by not pre-announcing future rate hikes and reinforcing the data-dependent approach, the Governing Council has the potential to smooth adverse developments on the financial-stability front. In any case, our policy toolkit is fully equipped to provide liquidity support to the euro area’s financial system if needed and preserve the smooth transmission of monetary policy.
Going forward, and given the high prevailing uncertainty, we must remain flexible and keep all options open to act promptly and effectively should conditions change unexpectedly. Monetary policy must proceed with careful steps, without pre-commitments to specific interest-rate increases, based on a meeting-by-meeting approach depending on available data.
At the same time, fiscal policy needs to work in line with monetary-policy efforts to restore price stability. To achieve this, fiscal support for the most vulnerable groups of people suffering from inflation has to be temporary, targeted and tailored so that it does not excessively fuel demand.
I wish to conclude with the following observations. The ECB Governing Council faces a series of challenges:
- First, monetary policy is not well suited to deal with supply-side disruptions.
- Second, monetary-policy actions are subject to long and variable lags.
- Third, and related to my previous points, if policymakers overreact to the inflationary impulse of the supply shock, we risk pushing our economy into a severe recession.
- Fourth, we need to minimise uncertainty by stabilising expectations.
- Fifth, our decisions have to ensure financial stability.
During this event, we followed a steady-handed approach. We began to tighten policy progressively at the end of 2021. Our aim was—and still is—to prevent the rise in inflation from becoming entrenched while avoiding a sharp drop in output and financial distress. Our decisions have managed to strike the right balance between doing too much and doing too little. Just as we managed to escape a recession, safeguard confidence and financial stability, and maintain inflation expectations near our objective until now, I am certain we will continue to do so. Our future decisions will confirm this prudent and well-balanced approach.
1 Bank for International Settlements (BIS): “Does money growth help explain the recent inflation surge?”, Claudio Borio, Boris Hofmann and Egon Zakrajšek, 2023, BIS Bulletin 67.
2 European Central Bank (ECB): “The euro area hiking cycle: an interim assessment,” speech by Philip R. Lane, February 16, 2023.