15.02.2023
Latest monetary policy developments in the euro area
Consejo Empresarial Alianza por Iberoamérica (CEAPI)
Madrid
Pablo Hernández de Cos
Governor
Ladies and gentlemen, let me begin by thanking Consejo Empresarial Alianza por
Iberoamérica for inviting me to address you all. Today I will focus on recent and future
monetary policy developments in the euro area. In the first part of my address, I will explain
the rationale behind the monetary policy decisions that we adopted in our European Central
Bank (ECB) Governing Council meeting earlier this month. In the second part, I will lay out
a number of factors that will require close monitoring going forward.
Our February monetary policy decisions
In order to explain the rationale behind our February decisions, it is useful to first go back
to our decisions and communication at our December monetary policy meeting. As you may
recall, in that meeting we raised our key interest rates by 50 bp. More importantly for the
purpose of my address today, we also announced that interest rates would still have to rise
significantly at a steady pace to reach levels that are sufficiently restrictive to ensure a timely
return of inflation to the 2% medium-term target.
The ECB Governing Council's assessment of the inflation outlook is based on a wealth of
information, in which the ECB/Eurosystem staff's macroeconomic projections - prepared
on a quarterly basis - play a prominent role. Compared with those published in September,
the December staff projections contained an appreciable upward revision in the average
inflation rates for 2023 and 2024 to 6.3% and 3.4%, respectively, and also envisaged
inflation averaging 2.3% in 2025 (the last year of our projection horizon), above our 2%
medium-term target.
Importantly, the ECB/Eurosystem staff projections incorporate a number of financial
indicators that reflect market expectations of our future monetary policy. A key indicator
here is the risk-free yield curve, which is strongly influenced by investors' views on the future
path of our key interest rates. The risk-free yield curve also plays a central role in the
transmission of monetary policy to the economy, because the financing conditions of
economic agents (households, firms, governments) are often linked to medium and
longterm risk-free interest rates. This is why the staff projections use as an input the path of both
short and long-term interest rates implied by the curve. It is also why the ECB, like many
other central banks, typically accompanies its decisions on (short-term) interest rates with
communication on how it intends, or expects, to set the latter - and other policy instruments
- in the future, as this improves its ability to steer the yield curve and thus attain the desired
overall monetary policy stance.
Therefore, the inflation path in the December staff projections was a clear indication that the
financial conditions prevailing before that meeting were inconsistent with a timely return of
inflation to our 2% target. In other words, we needed to act and communicate in order to
tighten financial conditions further, including by shifting up the interest rate path expected
by markets. Thus, we raised our rates by 50 bp and, more importantly, we signalled our
intention to continue raising them significantly at a steady pace to reach sufficiently
restrictive levels, and to keep them there for some time.
Indeed, after our December communication, there was an upward shift in the risk-free (OIS)
forward curve.1 In particular, the day before our February meeting, the 10-year OIS rate was
0.27 basis points (pp) higher than before the December meeting, while the 3-month OIS rate
was 0.51 pp higher. Equally important, in real terms the 10-year OIS rate was 0.51 pp higher
than in December, once adjusted for market inflation expectations. And the euro had
simultaneously appreciated by 2.88% against the dollar in the same period.
Our February decision represents a continuation (i.e. "staying the course") of the policy
tightening path that we signalled in December. Continuing this path was based both on our
updated assessment of the inflation outlook and on the financial conditions prevailing in
capital markets at that time. Let me address each element in turn.
As regards the inflation outlook, at our February meeting we did not have the benefit of a
new round of staff macroeconomic projections. But as I said before, our assessment of the
inflation outlook is based on a wealth of information, which also includes survey-based and
market-based indicators. In particular, according to the flash estimate,2 inflation was slightly
lower than expected and stood at 8.5% in January, down from 10.1% in November.
Furthermore, the strong fall in gas prices, the easing of global supply chain disruptions, the
appreciation of the euro and tighter financing conditions (the latter reflecting, inter alia, our
policy tightening) also pointed to inflation falling more strongly in the coming months than
envisaged in December. At the same time, the fact that core inflation (5.2% in January,
according to the flash estimate) has held at record high levels was a powerful reminder that
price pressures remain strong, as past energy price rises continue to spread throughout the
economy. All in all, this information led us to assess the risks to the inflation outlook as being
more balanced, especially in the near term.
As regards financial market-based indicators, in the run-up to our February meeting the
riskfree forward curve continued to point to expectations of further interest rate increases in our
subsequent meetings, including 50 bp hikes in both February and March, with a terminal
market rate of around 3.47% (0.6 pp higher than before our December meeting). This was
corroborated by analysts' expectations, as reflected in surveys conducted shortly before
the meeting.
Taking these two elements together, I can conclude that, at the time of our February
meeting, the risk-free forward curve - together with all the other factors influencing markets'
and experts' inflation expectations - could be seen as compatible with a return of inflation
to the 2% target in the medium term. And we acted and communicated in accordance with
this assessment. First, we reiterated our determination to stay the course of raising interest
rates significantly at a steady pace and keeping them at levels that are sufficiently restrictive
to ensure a timely return of inflation to its 2% medium-term target, in a manner consistent
with our December communication. Second, we approved a 50 bp rate hike that had already
been discounted by the market. Third, we announced our intention to raise rates by another
50 bp in March, again, as widely expected. Fourth, we indicated that we will evaluate the
subsequent path of our monetary policy in March. Indeed, two weeks after our February
meeting, financing conditions remain at levels that are very close to those observed before
that meeting.
Beyond March: assessing the inflation outlook and the appropriate policy path
Our February announcement stopped short of providing specific indications about our
policy intentions beyond March. At our March meeting, we will benefit from a new round of
ECB staff macroeconomic projections, including a comprehensive reassessment of the euro
area inflation outlook. We will then be in a better position to judge the most appropriate
policy path, in a manner consistent with our data-dependent approach.
In the remainder of my address, I would like to lay out a number of factors that I see as
playing a crucial role in our ongoing assessment of the euro area inflation outlook and,
therefore, in our future policy path.
The degree of pass-through of the (dis)-inflationary shock to core inflation
A critical determinant of the potential persistence of the current inflationary process is the
degree of pass-through of the inflationary shock to core inflation. While our understanding
of this aspect has improved, more evidence is clearly needed.
Our estimates at the Banco de España suggest that in the latter part of 2022 around 30%
of the deviation of euro area core inflation from its historical average was explained by
energy prices, another 30% by demand pressures and around 10% by supply-side
disruptions or bottlenecks3. The upward effects of energy and food commodity prices could
still be significant in 2023. In the case of food commodities, the transmission of increasing
costs along the supply chain, i.e. from farm-gate and wholesale commodity prices to
producers and retailers, may take up to a year.4 In the case of gas prices, the pass-through
from wholesale prices to final retail prices for consumers varies significantly across countries
depending on the regulations in place, the types of contracts used in each national retail
electricity market, and the profit margin developments in the face of rising energy input
costs. The analysis at the Banco de España finds that indirect effects from a gas price shock
are quite persistent, peaking after one year5. Considering this historical evidence for the
euro area, even if gas prices have returned to levels close to those at the start of the war in
Ukraine, the upward effects of gas prices on core inflation could still be significant in the
short term.
However, if the significant reduction in gas prices continues, it should be expected to
gradually begin to trigger reverse transmission effects. Consequently, at the current
juncture, we could well be at some sort of crossroads, where the lagged effects of the past
increases in commodity prices would still be present, but diminishing, and the first effects
6
of the most recent decreases would be emerging and on the rise. In this regard, the
symmetry of the downward response is also an open question.
Some support for this hypothesis can be found in recent developments in upstream stages
of the price formation process. In particular, non-energy industrial consumer prices are still
accelerating (as the flash estimate for January shows). However, industrial producer prices
(excluding energy) have decelerated significantly since last spring and this deceleration is
rather widespread among components.
In any case, the transmission and broadening of inflationary pressures is occurring at
different speeds and intensities across expenditure components. Pressures on underlying
inflation have so far been highly concentrated in particular expenditure items like household
equipment and maintenance, transport, and activities involving more social contact. Some
of their prices are more cyclically sensitive, others are more directly affected by the increase
in the cost of energy, food prices or bottlenecks, while, in general, a fast pass-through has
been facilitated by particularly strong demand during the pandemic (especially in the case
of durable goods) and the reopening phase (notably in the case of services). These items'
prices continued increasing very strongly in December, in both year-on-year and
month-onmonth terms, pointing to strong underlying inflationary pressures.7 Excluding these items
8
from the basket, core inflation stood at 2.8% in December, with a slight upward trend that
also points to an incomplete and slow pass-through.
In addition, it is also worth mentioning that fiscal measures, which help moderate the
inflation path this year, will have countervailing effects when they are withdrawn, which
could make the inflationary episode more persistent. Indeed, this is the main reason why
our December projections revised inflation upwards in 2024 to 3.4%. However, some of the
measures approved by governments to shield consumers from excessive energy price
increases take the form of price caps and, therefore, their effects depend on the magnitude
of the energy increases. In a context of lower energy prices, the ceiling on prices may not
become operative; the downward impact of these measures in 2023 would therefore be
lower and, subsequently, the upward impact of their reversal in 2024 would be lower as well.
The pass-through of euro exchange rate movements to inflation
Fluctuations in the euro exchange rate have been significant in the last year. In particular,
the euro-dollar exchange rate depreciated significantly in the first part of last year as a result,
above all, of the interest rate differential (hence the different monetary policy response), the
increase in global risk aversion and the fact that the energy shock entailed a deterioration
in the terms of trade in the euro area (not in the United States).
The pass-through of this depreciation may have been faster than in the past taking into
account possible non-linear effects9, since there is evidence that the pass-through is
stronger when the exchange rate fluctuations are relatively large, limiting importers' capacity
to absorb foreign exchange rate shocks.10
However, in the second half of 2022 and so far in 2023 this depreciation has partially
reversed. In this context, this could also be passed through to lower consumer prices. As in
the case of energy prices, this raises two questions. First, how long depreciation will persist.
Second, whether its effects will be symmetric in both speed and amount. This is again an
issue we need to monitor in the coming months.
Developments in labour markets and wage pressures
The evolution of wages and mark-ups will be another key determinant of inflation looking
ahead. In particular, if higher inflation is significantly transmitted to wage increases, this
could lead to further increases in prices, in particular if firms attempt to preserve or even
increase their profit margins.
The Eurosystem December forecast projected wage growth, as measured by compensation
per employee, to increase from 4.5% in 2022 to 5.2% in 2023 before declining to 4.5% in
2024 and 3.9% in 2025 as inflation declines. The latest signals from negotiated wages would
be in line with such projections. In particular, contracts signed during the fourth quarter of
2022 set an average wage increase for 2023 almost 1 pp higher than those agreed during
the third quarter, while an indicator of wage growth in new online job openings11 declined
for two consecutive months to 4.9% in December (from 5.2% in November and 5.3% in
October).
However, looking ahead workers' pressures to regain lost purchasing power might be
significant, especially since upcoming wage negotiations will take place in a context of a
tight labour market. The unemployment rate remained at 6.6% in December, its lowest level
since the euro was launched, and firms' perceived degree of labour shortage has also
stabilised at very high levels in historical terms.
Thus, we should monitor wage and mark-up development to identify the potential
emergence of second-round effects on inflation.
The global context and the reopening of China
Weaker global demand, particularly in key advanced economies, is contributing to the
moderation of commodity prices on international markets and easing inflationary pressures.
Economic growth in the United States continues to slow due to tighter financing conditions.
However, it remains stronger than expected, mainly supported by private consumption, with
households continuing to spend their stock of savings, strong and widespread jobs growth
and unemployment at very low levels.
In addition, the inflation path may be conditioned by the end of the zero-COVID policy in
China and the subsequent reopening of the Chinese economy. Once the surge in infections
has passed, the Chinese economy will foreseeably regain dynamism supported by
consumption, amid a recovery in mobility and the more contact-intensive activities, along
with the release of pent-up demand. Although there is much uncertainty about the extent of
this reopening, in January the IMF revised up China's GDP growth outlook for 2023 by
0.8 pp to 5.4%. This growth will have an impact on global economic activity and inflation.
Increased Chinese demand will boost euro area activity through the exports channel and
thus also drive inflation. In addition, China will exert significant inflationary pressures on
energy commodities and metals, as it is one of the world's largest consumers of these items.
IMF staff estimated that Chinese domestic demand rising by 1 pp of GDP would lead to an
increase in oil prices of almost 10% and in metals prices of between 6% and 12% over a
one-year horizon.12 An increase in China's gas consumption could also have a particularly
strong impact on gas prices, taking into account that China played a very significant
dampening role in 2022, when its demand for liquefied natural gas declined by 20%.
However, China's reopening may temper inflation through its impact on supply bottlenecks.
Indeed, the end of the zero-COVID policy will avert production distortions caused by
restrictions. In the recent past, the COVID-induced production stoppages in China were key
factors behind the bottlenecks and inflationary pressures and, therefore, the reopening
could be seen as net deflationary.
All in all, it is difficult to disentangle the net effects of all these factors on inflation and close
monitoring will be needed.
The resilience of euro area growth and its composition
In the second half of 2022 the euro area economy proved more resilient than expected and
the slowdown in the fourth quarter of last year was less severe than anticipated. This has
occurred in a context on which a significant reversal of previous supply shocks (bottlenecks
and energy prices) was observed, households and firms had plenty of buffers (in particular
the household savings built up during the pandemic), the post-COVID rebound in demand
continued to generate positive effects and monetary policy had not yet been fully
transmitted.
However, there is much uncertainty about the continuity of these factors. In particular, the
sharp decline in European gas prices reflects unusually mild weather, energy-saving
measures and strong inventory levels, which mitigate supply risks for next winter. However,
the tensions in commodity markets during 2022 were caused by the Russian invasion of
Ukraine and, therefore, a prolongation of the war is still a major source of uncertainty for
Europe.
Moreover, although the breakdown of euro area GDP growth in the last quarter of 2022 is
not yet available, growth looks to have been sustained by stockbuilding and a positive
contribution from net trade, which mainly reflects a drop in imports. In addition, domestic
demand fell in some of the countries for which fourth quarter data is available - in particular
France and Spain -, a pattern that was also evident in the latest retail sales data for
December, with sharper declines in Germany and the Netherlands. Conversely, the
qualitative data available for the first quarter of 2023 point to an improvement in consumer
and business confidence.
Therefore, we need to continue to monitor domestic demand patterns, which will be key to
modulating the convergence of inflation towards our target.
The transmission of our monetary policy
The current ECB hiking cycle is unprecedented in terms of its speed. Policy rates have
increased by 300 bp in about half a year. The question is whether such aggressive tightening
is enough to ensure a timely return of euro area inflation to 2%. We assess the impact of
our measures based on the historical evidence of previous rate-hiking cycles. Nonetheless,
it can be argued that some of today's macro-financial conditions differ from those prevailing
in previous cycles, especially as a consequence of the long period of expansionary
monetary policy that preceded the current episode. In addition, tightening monetary policy
as sharply and as swiftly as we have could also have potential non-linear effects on the
economy.
Two factors might point to a slower transmission of monetary policy than in the past, both
related to the household sector. The most significant of the two is the increase in the share
of fixed-rate mortgages, which protects mortgagors from interest rate hikes. Between 2011
and 2022, the share of household debt either maturing or with interest rates that reset within
a year fell from 44% to 30%13.
The second factor is the slower pass-through of market rates to retail deposits than in
previous episodes, thus weakening the standard intertemporal channel through which rising
interest rates discourage savers from spending. This slower pass-through partly reflects the
fact that, during the negative rates period, the remuneration of retail deposits was above
market interest rates, as banks were unwilling to reduce it below zero. Therefore, banks
have been reluctant to increase the remuneration of retail deposits until the margin between
market and deposit rates has returned to more normal levels. Additionally, the current ample
liquidity available to commercial banks reduces the pressure on them to increase the
remuneration of retail deposits.14 It should be noted, however, that a slower pass-through
to deposit rates may also have dampening effects on household spending, by slowing down
the increase in savers' financial income.
On the other hand, certain factors point to a potential faster monetary policy transmission
compared to past episodes.
First, the current hiking cycle comes after the negative shock prompted by the pandemic,
which adversely impacted the financial situation of firms by increasing their debt levels. This
leaves them more vulnerable to interest hikes rates and their expenditure decisions may be
more sensitive to monetary policy changes.
Second, there is some evidence that monetary policy tightening is now impacting firms'
financing conditions more forcibly than in the past. In particular, there has been a shift from
bank to bond funding in the last decade, with bond debt increasing from 16% to 24% of
non-financial corporations' total debt. The faster policy pass-through to bond rates than to
bank rates implies faster transmission.
Moreover, loan origination is contracting rapidly judging by the short lag from the first rate
hike. The evidence available shows a strong econometric relationship between Bank
Lending Survey (BLS) credit standards and a so-called credit impulse a couple of quarters
15
later, and likewise between the credit impulse and GDP growth. The first link in the chain
- between the BLS and the credit impulse - is already evident. We should expect to see the
latter link to real activity assert itself soon.
Third, as regards the cash flow channel of monetary policy, we have seen a significant shift
of funds between overnight deposits (with very low remuneration) and time deposits (whose
remuneration is more sensitive to market interest rates). Furthermore, in net terms, money
supply is decelerating rapidly, with M3 growth slowing from around 9% in September to 4%
in January.
Fourth, the housing sector is a key area to watch given the turnaround in financial
conditions, as well as the sharp increase in house prices in some economies over the last
decade. There was significant evidence of exuberance in this market in some countries
before the pandemic, as has been repeatedly emphasised by the European Systemic Risk
Board.16
All in all, it is therefore crucial that we monitor how all these elements may affect monetary
policy transmission in the next quarters.
Conclusion
In sum, recent data on euro area inflation and some of its key determinants are somewhat
encouraging, but the overall situation still requires caution. The evidence so far is very
preliminary and there are several areas that require careful monitoring: the residual pass-
through of past inflationary shocks and the symmetry of the pass-through of recent energy
price declines to core inflation; labour market and wage developments; the possible effects
of the Chinese reopening; the resilience of the euro area economy and the transmission of
ECB monetary policy decisions. All these will have to be assessed as part of the full
projections exercise under way in the run-up to our March meeting.