Staying the course: monetary policy to avoid persistent ination - Remarks
by Governor Gabriel Makhlouf
04 April 2023 Speech
Remarks at Markets News International Event by Gabriel Makhlouf Governor Central Bank of Ireland
and Member of the Governing Council of the ECB
Good afternoon.
The title of my talk today - 'Staying the course - monetary policy to avoid persistent ination' - reveals much about my
current views on ination and the near term path for monetary policy.
The latest data suggest that the direct effects of the supply shocks we have seen over the last two years are gradually
fading. We see this in the declining rate of headline ination in recent months.
However, indirect effects are still working their way through the economy as the input price increases we saw last year
pass through more slowly into core ination, and domestic cost pressures emerge in the form of wages and prot
margins. Monetary policy must ensure that this does not become a source of persistent ination above our 2 per cent
target.
To achieve this, the Governing Council decided last month to increase the three key ECB interest rates by 50 basis
points. The interest rate applied to our Deposit Facility is now at 3 per cent, up from minus 0.5 per cent last July. This
represents a signicant tightening of the monetary policy stance, commensurate with the challenges to price stability
we have been facing.
The scale and pace of interest rate increases - up 3.5 percentage points in just nine months - is unprecedented. For
comparison, previous rate hiking cycles in the euro area in 1999-2000 and 2005-07 saw rates rise by 2.25 and 2
percentage points over a 13 and 21 month period, respectively.
Today I will highlight my view on the key factors that will inuence the future path of monetary policy. They include both
the data I am monitoring, and how I react to this data when making policy decisions.
The rst is the assessment of the ination outlook in light of the incoming economic and nancial data, as embedded in
the economic narrative underlying the quarterly projections. The second is the dynamics of underlying ination, as a
cross-check on how the projections compare with the evolving data. And the third is the judgement as to the strength of
the transmission of monetary policy to date.
Let me begin with a review of the drivers of core and headline ination.
The path of headline and core ination
The sharp increase in headline ination throughout 2022 stems from both supply and demand factors. On the supply
side, overlapping negative shocks from pandemic bottlenecks and the war in Ukraine led to higher costs for rms. On
the demand side, the re-opening of the economy after the pandemic boosted consumer demand at a time when supply
was already constrained. The build-up of pandemic savings in parallel with pent-up demand also meant that higher input
costs, as a result of supply shocks, could be more easily passed on to consumers.
The decline in energy prices and the easing of supply bottlenecks in recent months will help ease some of the
inationary pressures as the cost of inputs fall. However, countering this deationary impulse are more domestically-
oriented, demand-related factors. Underlying the ECB staff March macroeconomic projections is an assumption that
above average nominal wage growth will play a central role in ination dynamics through to end-2025. However, some
of this wage growth is expected to be absorbed into prot margins as the conditions that allowed rms to increase
margins during 2022 fade.
Headline ination in the euro area peaked at 10.6 per cent in October 2022 and fell to 6.9 per cent in March 2023.
But, while headline ination has been falling, underlying ination (as measured by core ination, i.e., the headline
measure excluding food and energy) has continued to increase, rising from 5.0 to 5.7 per cent between October and
March. Core is typically more slow-moving than headline measures, and tells us something about the persistence of
ination over the medium term. As Chart 1 (left-panel) shows, measures of underlying ination tracked by the ECB and
the Central Bank of Ireland are either trending higher or remain elevated, with the broader range of measures currently
between 4 per cent and 8 per cent. Similarly, Chart 2 (right-panel) shows that, while momentum in energy prices has
declined sharply in the past two months, momentum of price growth in the food, goods and services components of
HICP remain elevated.
This recent divergence between headline and underlying ination reects two factors: rst, the delayed pass through of
supply-related input cost shocks into core prices; and second, an increasing role for more domestically-driven ination
drivers, such as wages and prots, as I mentioned earlier. Therefore, a prolonged period of higher wage demands and/or
increasing prot margins could drive the persistence of underlying ination in the euro area.
Absent future shocks to energy and commodity prices, the outlook for ination over the medium term - the ECB's 2 per
cent target - will be closely linked to developments in underlying ination.
Let me now discuss the prospects for these dynamics in the context of the broader macroeconomic environment.
Chart 1: Headline and underlying ination factors
Source: Eurostat and Aydin Yakut (2023).
Notes: Trend ination is based on the methodology of Aydin Yakut (2023). Latest observation for HICP, Core and Trend ination
is March 2023, Supercore and trimmed mean is February 2023. Momentum is dened as the annualised 3 months on 3 months
rates, seasonally adjusted data.
Economic outlook and transmission of monetary policy
Given the high uncertainty around the outlook for the economy, my colleagues and I will be especially focused on
incoming data as part of making our monetary policy decisions.
The euro area economy slowed in the fourth quarter of 2022, with economic growth stagnant in the face of falling
private domestic demand. High ination, prevailing uncertainties and tighter nancing conditions dented private
consumption and investment, which fell by 0.9 per cent and 3.6 per cent respectively. However, the ECB staff March
macroeconomic projections envisage a recovery in the next few quarters as supply conditions improve further,
condence recovers, and rms work off large order backlogs. Rising nominal wages and falling energy prices will partly
offset the loss of purchasing power that many households are experiencing as a result of high ination. This, in turn, will
support consumer spending.
Looking ahead, with record low unemployment expected to hold steady at 6.7 per cent, the ECB staff's current
projections embed a signicant degree of real wage catch-up, with wages returning to 2022 levels in real terms by end-
2025. Nominal wage growth projections of 5.0, 4.4 and 3.6 per cent in 2023, 2024 and 2025 are signicantly above
historic averages.
For wage developments, much will depend on ongoing levels of labour market tightness. While the number of job
vacancies in the euro area have started to recede gradually since the turn of this year, the number of job openings
relative to unemployed remains at a historic high. Meanwhile, despite the weaker PMI (Purchasing Managers' Index)
data we saw towards the end of 2022, employment expectations remained in signicant positive territory (Chart 2, left
panel). This suggests that some degree of labour hoarding is taking place, likely reecting rms' expectations of a
transitory weakness in demand, as well as their ability to absorb higher costs through increased mark-ups (a point I will
return to).
Recent data shows that wage growth accelerated throughout 2022 (Chart 2, right panel). According to Eurostat, wages
in the euro area increased by 5.1 per cent in the nal quarter of 2022. A wage tracker jointly developed by colleagues in
the Central Bank of Ireland and Indeed shows that hiring wages are growing strongly, with euro area wage growth
averaging 4.9 per cent in the three months to end-December. The ECB's negotiated wage tracker, which incorporates
information on wage agreements in the euro area, shows an average for agreements signed towards the end of 2022 of
4.8 per cent.
Chart 2: Labour Market Developments
Source: Renitiv, S&P Global, CBI Calculations; Eurostat, Indeed and Central Bank of Ireland wage tracker
Notes: Eurostat data is year-on-year growth and is available quarterly. Indeed data is the three-month moving average and is
available monthly.
There is potential for prot margins to absorb some of this near-term higher wage growth. As Chart 3 shows, labour
costs have not risen by anything close to the same extent as prots in most sectors. For some sectors, the gap between
growth in unit prots and unit labour costs during 2022 is very large, for example in agriculture, manufacturing and
contact intensive services.
To the extent that prots and labour costs are a key driver of domestic price pressures, which in turn determine underlying
ination, I will be closely monitoring developments in both areas. The current economic narrative in the March
projections is for a slowing of growth in wages and prot margins over the next three years. If this turns out not to be
the case - for example, if we end up in a situation where staggered price and wage-setters engage in back-and-forth
attempts to fully offset real income declines (i.e., a wage-price spiral) - it would call for a stronger monetary policy
response in order to mitigate against the risk of this even more persistent ination.
Chart 3: Sectoral wage and prot developments during and after the pandemic
Source: Arce, Hahn and Koester (2023) . Unit prots correspond to gross operating surplus over real value added. Contact-
intensive services include trade, transport, accommodation and food services as well as arts, entertainment, recreation and other
services. Latest observations: 2022 Q4.
While price and wage-setting will contain a backward-looking element, especially after a supply-driven surge in ination,
it is important that the forward-looking component remains close to our ination target in order to avoid an
entrenchment of higher ination in expectations amongst the public. So far, there has been no indication that
expectations have become de-anchored from our ination target. This is true for both survey and market-based
measures of longer-term ination expectations.
With regards to the transmission of monetary policy, the pass-through into nancial conditions is well underway.
Interest rates on loans to rms and households increased sharply since the beginning of 2022 (Chart 4). The composite
cost for borrowing for households was 3.1 per cent in January, up from 1.3 per cent at the same time last year. For rms,
the composite cost of borrowing rose from 1.4 per cent to 3.6 per cent over the same period. Lending rates have also
declined, with the growth in loans to households falling from 4.5 per cent (year-on-year) in July to 3.2 per cent in
February. For rms over the same period, the decline in growth rates was from 7.6 per cent to 5.7 per cent.
Meanwhile, we must remain alert to the longer lags in the transmission of monetary policy to growth and ination. It will
be important to assess how monetary policy decisions to date are working through the economy when calibrating
further decisions.
Chart 4: ECB policy rates are being passed through into lending rates
Source: Eurostat. Lending rates are the composite rate, incorporating all loan types and lengths, for both households and
corporates.
Conclusion
The Governing Council has increased interest rates in order to counter the increase in ination brought about by
successive and over-lapping supply shocks.
Looking ahead, the ECB staff's latest (March) macroeconomic projections see headline ination at 2.1 per cent and core
ination at 2.2 per cent in 2025. This shows that our monetary policy tightening is taking effect, but we must remain
steadfast, and ready to act as required, to ensure we reach our target over the medium-term.
Policy rates will need to be kept at a restrictive level to dampen demand. This will help to re-set the balance between
supply and demand in the economy and bring down ination.
I am monitoring closely recent nancial market volatility, but I am also condent that the banking sector is more resilient
to a wide range of potential adverse shocks. Short-term volatility in nancial markets does not translate into risks for the
macroeconomic outlook, as monetary policy is concerned with achieving price stability in the medium term.
Nevertheless, the Governing Council will be mindful of developments in the banking sector, and nancial stability more
broadly, as we continue to assess our monetary policy stance.
Ultimately, the primary goal is to ensure our price stability mandate is met. Interest rates will remain the main tool to
achieve this mandate. Decisions on interest rates will be made on a meeting-to-meeting basis, with the path calibrated
in-line with the incoming data, notably on underlying ination trends, and evidence on how the tightening of monetary
policy is transmitting to economic activity.
Acknowledgments
I would like to thank Gillian Phelan, Neil Lawton and Reamonn Lydon for their assistance with this speech.
©2023 Central Bank of Ireland