SPEECH
Finding the right mix: monetary-fiscal interaction
at times of high inflation
Keynote speech by Isabel Schnabel, Member of the Executive Board
of the ECB, at the Bank of England Watchers' Conference
London, 24 November 2022
Over the past few years, the interaction between monetary and fiscal policies in the euro area has
changed decisively.
In the years before the pandemic, monetary policy faced the challenge of inflation being persistently below
target, while being constrained by the effective lower bound. It became widely acknowledged that
accommodative monetary policy on its own may not be sufficient for inflation to return to target. At the
effective lower bound and with inflation too low, monetary policy needed support from expansionary fiscal
1 ]
policy that would increase aggregate demand and thus inflation.[
It was only with the onset of the pandemic that monetary and fiscal policies started to pull in the same
direction, reinforcing each other. The combination of a strong fiscal response, at both national and
European level, and a forceful monetary policy response proved highly successful in lifting the economy
out of the deepest contraction since the Second World War and in preventing a downward spiral of prices.
But these large-scale policy interventions coincided with a broad shift in the macroeconomic environment.
Persistent constraints on production meant that supply could not keep up with demand, putting upward
pressure on underlying inflation. Russia's invasion of Ukraine fuelled price pressures further, pushing euro
area inflation to double-digit levels in October.
In my remarks today, I will argue that the new macroeconomic environment requires a different mix of
monetary and fiscal policies to effectively fight the current cost-of living crisis, limit the adverse
distributional effects of high inflation, and tackle the long-term challenges facing our economies.
Fiscal policy needs to protect the most vulnerable parts of society from the consequences of the energy
and food price shocks. At the same time, governments must avoid an overly expansionary stance that
fuels inflationary pressures and adds to the historically high public debt burden. They should give clear
priority to reforms and public investments that support potential growth and stabilise debt dynamics in an
environment of higher interest rates. In doing so, governments should preserve relative price signals,
2 ]
which are needed to pave the way towards a greener and more sustainable economy.[
Unfortunately, this is not what we are seeing today. Many of the fiscal measures taken so far have not
been targeted, they have been directed towards consumption rather than investment, and they often
weaken the incentives for businesses and households to reduce energy consumption.
In any case, fiscal policy needs to observe intertemporal budget constraints. Broad-based debt-financed
transfers, subsidies or public consumption today imply higher tax rates or lower expenditures tomorrow.
Credible commitments preserve fiscal sustainability and help to anchor medium-term inflation
expectations, supporting monetary policy.
Central banks, for their part, must remain determined to bring inflation back to target in a timely manner,
so as to prevent current high inflation from becoming entrenched in expectations. Doing so requires
raising interest rates further for as long as needed to put inflation back on a sustainable path towards 2%.
Monetary-fiscal interaction at the zero lower bound
The years before the pandemic were characterised by an environment of persistently low real interest
rates and below-target inflation.
Structural forces, such as globalisation, digitalisation and demographic change, were putting persistent
downward pressure on both real interest rates and underlying price dynamics.
Monetary policy aimed to tackle low inflation by stimulating demand, first by lowering interest rates and,
when getting closer to the effective lower bound, by embarking on unconventional monetary policy
measures.
However, historically accommodative financing conditions did not stimulate aggregate demand as
expected. This was mainly because they failed to spur public investment, which remained at the low levels
reached after the sovereign debt crisis (Slide 2).
As a result, despite the unprecedented expansion of central banks' balance sheets, inflation remained
stubbornly low, and years of subdued price pressures threatened to become entrenched in longer-term
inflation expectations.
It was increasingly acknowledged that monetary policy on its own could not lift the economy out of the low
3 ] 4 ]
inflation trap.[ Instead, monetary and fiscal policies needed to reflate the economy together.[ When
monetary policy is constrained by the effective lower bound, fiscal policy is more effective, as a boost to
aggregate demand does not immediately trigger expectations of tighter monetary policy in an environment
of persistently low inflation.
The measures taken during the pandemic showcased the powerful interplay between monetary and fiscal
policies. The ECB introduced a new asset purchase programme - the pandemic emergency purchase
programme (PEPP) - and offered new targeted longer-term refinancing operations at highly favourable
rates. Fiscal policy, meanwhile, supported demand through job retention schemes and broad support
measures at national and European level.
Expansionary monetary and fiscal policies reinforced each other, successfully countering the sharp decline
in demand and swiftly lifting the economy out of the deep recession.
A shifting macroeconomic environment
Yet, these large-scale policy interventions coincided with fundamental structural changes in the global
economy.
As the recovery of supply was held back by persistent disruptions to global supply chains, labour
shortages and social distancing measures, demand started to outpace supply, putting upward pressure on
prices.
Inflationary pressures were then reinforced by Russia's invasion of Ukraine, which led to a surge in energy
and food prices. Over time, inflation broadened substantially, creeping into most goods and services, and
pushing up underlying inflation to historically high levels, with no clear signs of reversal so far (Slide 3).
ECB staff analysis suggests that both demand and supply have made a significant and broadly even
contribution to the recent rise in underlying inflation in the euro area (Slide 4).
These price pressures are unlikely to dissipate quickly. Even if the deterioration in the euro area's terms of
trade and the significant loss in purchasing power will dampen private consumption and investment, the
current macroeconomic environment differs from that before the pandemic in at least four key aspects.
First, excess savings accumulated since the start of the pandemic remain significant in both nominal and
real terms (Slide 5, left-hand side). Second, due to supply constraints, firms in the manufacturing sector
continue to have full order books with a backlog of more than five months (Slide 5, right-hand side). Third,
euro area firms continue to add new jobs, and unemployment rates remain at record low levels despite
elevated risks of a technical recession in the winter.
Finally, there is increasing evidence that the pandemic and the energy crisis may have more permanent
negative effects on current and future potential output, implying that inflationary pressures may persist if
5 ]
demand does not slow down accordingly.[
Potential output growth may be constrained through different channels.
The first is labour scarcity. A significant share of euro area firms continue to identify labour shortages as a
major factor limiting production in manufacturing and the services sector (Slide 6, left-hand side).
Research shows that the pandemic has led to lower labour participation in sectors where it is hard to work
6
from home[ ], and that those sectors are likely to experience some scarring, facing a loss in their trend
7 ]
output (Slide 6, right-hand side).[ This development reinforces pre-existing trends, driven primarily by
demographic change.
The second channel works through the capital stock and productivity growth. The energy crisis is likely to
have hit investment and total factor productivity, especially in energy-intensive sectors. Higher energy
prices devalue part of the existing capital stock, curbing production or raising the number of insolvencies
due to higher costs and lower profitability.
The car industry is a case in point. Since the summer of 2021, the extraordinary increase in energy costs
has gradually become the most important factor holding back motor vehicle output (Slide 7, left-hand
side). Demand-side factors, by contrast, continue to support production.
More generally, ECB staff analysis shows that a persistent increase in energy prices significantly and
8 ]
persistently lowers potential output across euro area countries (Slide 7, right-hand chart).[
In fact, for more than two thirds of euro area countries potential growth projections for the period 2022-27
are below their long-term average from 1999 to 2021, a period that itself was already characterised by
subdued growth in many countries (Slide 8, left-hand side).
Potential output has only been revised up in some of the high-debt economies. In part, this probably
reflects the fact that allocations under the Recovery and Resilience Facility are tilted towards countries
with lower GDP per capita and higher public debt ratios, thus advancing convergence and reducing
macroeconomic imbalances (Slide 8, right-hand chart).
In sum, the important role of both positive demand-side and negative supply-side shocks in spurring
inflation clearly shows that the current macroeconomic environment differs from the one before and during
the pandemic, when downside risks to price stability called for an expansion of both monetary and fiscal
policy to support risk-sharing and counter weakening demand.
Pulling together in a high inflation environment
In the current high inflation environment, monetary and fiscal policies should pull together rather than
9 ]
working against each other.[
Fiscal policy needs to be targeted and future-proof
Fiscal policy needs to focus on two types of measures: first, protect the most vulnerable households and
firms from the energy price shock in a targeted way; and second, foster potential growth and energy
10 ]
independence through public investment and structural reforms.[
Regarding the first point, targeted support to low-income households is important, from both a
macroeconomic and a distributional perspective. Low-income households are not only more
liquidityconstrained and have less room to buffer sharp increases in their cost of living, but also face significantly
higher effective inflation rates than high-income households. The difference between the effective inflation
rate in the lowest and highest income quintiles increased to 2.2 percentage points in October 2022, its
highest level since 2006 (Slide 9, left-hand chart).
This inflation gap between poorer and richer households is mainly driven by relative price increases for
energy and food (Slide 9, right-hand chart). Monetary policy can do little about such relative price
changes. Even tighter monetary policy, leading to lower headline inflation, would not have prevented such
uneven effects across households.
Only governments have the mandate and tools to address distributional issues.
As regards the second type of measure, governments must address the underlying sources of the
supplyside shocks that are likely to affect the structure of the economy more persistently.
This requires public investment and decisive structural reforms that foster potential growth and, at the
same time, help to dampen inflationary pressure over the medium term by reducing supply-side
11 ]
constraints.[
12 ]
In this regard, the Next Generation EU programme offers a historic opportunity.[ Disbursements under
the Recovery and Resilience Facility (RRF) are expected to stay at high levels over the coming years. A
swift and efficient implementation of the key investment projects and reforms envisaged in the national
13 ]
plans under the RRF is key for boosting investment and potential growth.[
So far, governments have often not followed the above prescriptions. They focussed mainly on a
combination of untargeted measures, fossil fuel subsidies and government consumption to soothe the
damages inflicted by the energy crisis.
Only a small share of the temporary fiscal measures implemented to alleviate the burden of rising energy
prices target low-income households (Slide 10, left-hand side). Rather than cutting taxes for vulnerable
households or providing transfers to those in need, governments have mostly resorted to broad-based tax
cuts or subsidies, or to outright energy price caps.
In addition, many measures support short-run fossil fuel consumption, thereby working against efforts to
move away from fossil energy sources. In terms of their budgetary impact, only 1% of the total measures
contribute directly to the green transition. Tax cuts and subsidies for fossil fuels, unless properly designed,
14 ]
incentivise neither the efficient use of energy nor investment in energy-saving technology.[
Moreover, public investment will remain subdued this year and next. It is only expected to pick up in 2024
and 2025, mainly reflecting increased defence spending, which helps to support our security, but has a low
contribution to potential growth (Slide 10, right-hand side).
As a result, fiscal policy measures hardly help to accelerate the green transition or tackle the sources of
supply-side constraints, while contributing to aggregate demand and high inflation, making it more difficult
for the ECB to deliver on its mandate.
Indeed, ECB staff simulations suggest that war-related support and energy measures may dampen
inflation in the short run, especially if they directly affect energy prices, but will contribute positively to
HICP inflation over the medium term.
Sound fiscal policy helps to anchor inflation expectations
Sound fiscal policy is also a key factor for stabilising debt dynamics.
The fiscal support measures taken during the pandemic resulted in a sharp increase in public debt ratios,
which were already elevated before the pandemic started. Euro area public debt as a ratio to GDP has
increased by around 20 percentage points from 2007 to 2019, and by around another 10 percentage
points by 2021.
Initially, higher inflation had a beneficial effect on debt-to-GDP ratios, due to a temporary windfall from the
15 ]
boost in nominal growth (Slide 11, left-hand side).[
However, an inflation increase due to a supply-side shock cannot be expected to significantly alleviate the
debt burden over the medium term. ECB staff simulations show that the resulting decline in real growth,
higher interest payments and deteriorating primary deficits would increase public debt ratios over longer
horizons (Slide 11, right-hand chart).
Rising interest rates as a result of tighter monetary policy or higher public debt lift up the interest
rategrowth differential for a given rate of potential growth. The negative interest rate-growth differential before
the pandemic helped to contain, or even reduce, debt-to-GDP ratios. The differential still stands near
historic lows but is about to become less favourable (Slide 12, left-hand chart).
Against this backdrop, current circumstances call for responsible fiscal policy. Governments need to be
clear that current budget deficits are backed by future primary surpluses, via either future higher tax rates
or lower spending.
If governments do not credibly signal their commitment to responsible fiscal policies, the private sector
16 ]
may eventually expect that higher inflation is needed to ensure the sustainability of public debt.[ This
would be the case if high unfunded budget deficits ended up eroding the credibility of the central bank to
17 ]
pursue its monetary policy objectives, endangering price stability.[
If, by contrast, the central bank is fully credible - because it has earned a reputation of safeguarding price
stability - monetary dominance prevails, implying that monetary policy is going to tighten by more if fiscal
18 ]
policy is too accommodative.[
Fiscal expansion during and after the pandemic, combined with the activation of the general escape
clause under the Stability and Growth Pact for a period of at least four years, from 2020 to 2023, and the
lack of a functioning EU fiscal framework, risk contributing to higher inflation, by weakening public
perceptions that governments would stabilise public finances by taking the necessary future fiscal
19 ]
adjustments.[
Recent developments in the United Kingdom have served as a wake-up call. They have shown that
expansionary fiscal policy has its limits. Without clear communication about how fiscal spending or
broadbased tax cuts are to be funded, markets are likely to expect higher inflation, higher real interest rates or
both. Abrupt increases in sovereign yields can put debt sustainability at risk and jeopardise financial
stability, as shown by the example of the liability-driven investment funds.
20 ]
So far, in most major economies, inflation is expected to return to target over the medium term.[ In the
euro area, investors do not currently expect high debt levels to cause inflation to persistently deviate from
the target, in spite of an upward shift to levels slightly above 2 percent, speaking in favour of central bank
credibility and monetary dominance (Slide 12, right-hand side).
Monetary policy must stay focused on price stability
Fiscal policy is hence at risk of contributing to inflation at a time when price pressures remain unabated.
Inflation in the euro area has continued to surprise on the upside, and significantly so. While fears of a
technical recession have increased, economic data surprises have recently also turned positive (Slide 13,
left-hand side).
In this situation, monetary policy must remain firmly focused on its mandate and restore price stability as
quickly as possible. Determined policy action by the ECB has already led to a notable tightening of
financing conditions. Euro area real GDP-weighted sovereign yields have increased across the maturity
spectrum since the turnaround in monetary policy in December 2021.
Yet, real rates remain in negative territory for most tenors, meaning policy is likely too accommodative
(Slide 13, right-hand side). Markets' expectations of a "pivot" have recently worked against our efforts to
withdraw policy accommodation, bringing the actual policy stance further away from the stance that is
required to bring inflation back to target.
This raises the risks that first round effects from higher energy and food prices eventually turn into second
round effects. The longer inflation is unacceptably high, the larger the risk that inflation expectations adjust
21 ]
in a way that puts medium-term price stability at risk.[
According to ECB staff analysis, higher perceived inflation appears to have a substantial impact on
households' inflation expectations, and this impact has been rising (Slide 14, left-hand side).
As a result, inflation expectations of households have been on a notable upward trend, and a significant
share of survey respondents expect a sustained period of high inflation (Slide 14, right-hand side).
22 ]
Surveys among professional forecasters yield very similar results.[
Hence, recent financial market developments, broad-based fiscal stimulus and high inflation persistence
call for further determined action to prevent a de-anchoring of inflation expectations. At present, the largest
risk for central banks remains a policy that is falsely calibrated on the assumption of a fast decline in
23 ]
inflation, and hence on an underestimation of inflation persistence.[
In light of this, we will need to raise interest rates further, probably into restrictive territory, so as to ensure
that inflation returns to our medium-term inflation target as quickly as possible and second-round effects
do not materialise.
Incoming data so far suggest that the room for slowing down the pace of interest rate adjustments remains
limited, even as we are approaching estimates of the "neutral" rate.
The extraordinarily large degree of uncertainty surrounding such estimates implies that they cannot serve
as a yardstick to inform the appropriate pace of interest rate adjustments. Instead, policy needs to remain
data dependent.
While interest rates will remain the key instrument for calibrating our monetary policy stance, we will
complement our actions with a measured and predictable normalisation of our monetary policy bond
portfolio. In our December policy meeting, we will lay out the principles for our balance sheet reduction.
At the same time, we continue to stand ready to counter fragmentation in financial markets that is not
justified by economic fundamentals and hampers the smooth transmission of our monetary policy
throughout the entire euro area.
Our toolkit - PEPP flexibility, the Transmission Protection Instrument (TPI) and the Outright Monetary
Transactions (OMT) programme - allows us to swiftly respond to destabilising dynamics in financial
markets. But the use of this toolkit also relies on an effective fiscal framework, making a timely agreement
on a credible European fiscal framework all the more important.
Conclusion
Let me conclude.
In the pandemic crisis, monetary and fiscal policies reinforced each other, preventing a collapse of the
euro area economy.
In the current environment, there is a risk that monetary and fiscal policies may pull in opposite directions,
leading to a suboptimal policy mix. Many fiscal measures that are popular among the electorate, such as
tight price caps or broad-based subsidies, risk fuelling medium-term inflation further, which could ultimately
force monetary policy to raise interest rates beyond the level that would be seen as appropriate without
fiscal stimulus.
Governments need to internalise the effects of their actions on future inflation and monetary policy. They
should support fiscal sustainability and price stability by targeting their measures to the most vulnerable
parts of society, fostering potential growth and accelerating the green transition. Such measures would
dampen inflationary pressures over the medium to long run.
Monetary policy can best contribute to macroeconomic stability and social welfare by ensuring a timely
return of inflation to target, thereby preserving people's purchasing power, and supporting investment by
reducing uncertainty.
Thank you.
Annexes
24 November 2022
Slides
ENGLISH

1.
Schnabel, I. (2021), " Unconventional fiscal and monetary policy at the zero lower bound ", speech at the
Third Annual Conference organised by the European Fiscal Board, 26 February. Reichlin, L., Ricco, G.
and Tarbé, M. (2021), " Monetary-Fiscal Crosswinds in the European Monetary Union ", CEPR Discussion
Paper Series, No 16138, Centre for Economic Policy Research, May.
2.
Lagarde, C. (2022), " Monetary policy in a high inflation environment: commitment and clarity ", lecture
organised by Eesti Pank, 4 November.
3.
Sims, C. (2016), "Fiscal policy, monetary policy and central bank independence", address at the annual
economic policy symposium organised by the Federal Reserve Bank of Kansas City, Jackson Hole, 26
August. Schnabel, I. (2020), " Pulling together: fiscal and monetary policies in a low interest rate
environment ", speech at the Interparliamentary Conference on Stability, Economic Coordination and
Governance in the European Union, 12 October.
4.
For a comprehensive overview and discussion of monetary and fiscal policy interactions in the euro area,
see ECB (2021), " Monetary-fiscal policy interactions in the euro area ", Occasional Paper Series, No 273,
September.
5.
Schnabel, I. (2022), " Monetary policy in a cost-of-living crisis ", speech at the IV Edition Foro La Toja, 30
September.
6.
Fernald, J. and Li, H. (2022), " The Impact of COVID on Productivity and Potential Output ", Working Paper
Series, No 2022-19, Federal Reserve Bank of San Francisco, September.
7.
Bandera, N., Bodnár, K., Le Roux, J. and Szörfi, B. (2022), " The impact of the COVID-19 shock on euro
area potential output: a sectoral approach ", Working Paper Series, No 2717, ECB, September; Aikman,
D., Drehmann, M., Juselius, M. and Xing, X. (2022), " The scarring effects of deep contractions ", BIS
Working Papers, No 1043, October.
8.
Le Roux, J., Szörfi, B. and Weißler, M. (2022), " How higher oil prices could affect euro area potential
output ", Economic Bulletin, Issue 5, ECB.
9.
In a similar vein, the International Monetary Fund has argued that fiscal policy should not work at cross-
purposes with monetary policy. See IMF (2022), " World Economic Outlook ", October.
10.
Research shows that public investment raises the productivity of the physical and human capital stock and
may also encourage new private investment. See Abiad, A., Furceri, D. and P. Topalova (2016), "The
Macroeconomic Effects of Public Investment: Evidence from Advanced Economies", Journal of
Macroeconomics, 50: 224-40.
11.
Fornaro and Wolf (2022) argue in favour of fiscal policy supporting business investment. In fact, in their
model, monetary tightening in response to a supply side shock may be self-defeating, unless it is
accompanied by fiscal policies fostering the economy's productive capacity. See Fornaro, L. and M. Wolf
(2022), " The Scars of Supply Shocks ", Economics Working Papers 1748, Universitat Pompeu Fabra.
12.
For the impact of Next Generation EU on financial integration and public risk-sharing, see European
Central Bank (2022), " Financial Integration and Structure in the Euro Area ", April.
13.
Given the strong complementarity between public and private investment, the funds from the recovery
programme can also pave the way for private investment activities that are at the core of the large
innovation effort required to master the green and digital transitions.
14.
Checherita-Westphal, C., Freier, M. and Muggenthaler, P. (2022), " Euro area fiscal policy response to the
war in Ukraine and its macroeconomic impact ", Economic Bulletin, Issue 5, ECB.
15.
European Central Bank (2022), Financial Stability Review , November.
16.
Leeper, E. (2010), " Monetary science, fiscal alchemy ", Proceedings, Economic Policy Symposium,
Jackson Hole, Federal Reserve Bank of Kansas City, pp. 361-434.
17.
This relates to the fiscal theory of the price level, which was established by Leeper, Sims and Cochrane, in
part expanding the work by Sargent and Wallace, in the early 1980s. See Leeper, E. (1991), " Equilibria
under 'active' and 'passive' monetary and fiscal policies ", Journal of Monetary Economics, Vol. 27, Issue 1,
pp. 129-147; Sims, C. (1994), " A Simple Model for Study of the Determination of the Price Level and the
Interaction of Monetary and Fiscal Policy ," Economic Theory, Vol. 4, pp. 381-399; Cochrane, J. (2005),
" Money as stock ", Journal of Monetary Economics, Vol. 52, Issue 3, pp. 501-528; Sargent, T. and Wallace,
N. (1981), "Some Unpleasant Monetarist Arithmetic", Federal Reserve Bank of Minneapolis Quarterly
Review, Fall, pp. 1-17. See also See Bianchi, F. and Melosi, L. (2022), " Inflation as a Fiscal Limit ", Federal
Reserve Bank of Chicago Working Paper, No 2022-37; Cochrane, J. (2022), "The Fiscal Theory of the
Price Level", Princeton University Press.
18.
Woodford, M. (2003), "Interest and Prices: Foundations of a Theory of Monetary Policy", Princeton, New
Jersey, Princeton University Press.
19.
Gopinath, G. (2022), " How Will the Pandemic and War Shape Future Monetary Policy? ", remarks at the
Jackson Hole Symposium.
20.
Ilzetzki, E. (2022), " Commentary: Inflation as a Fiscal Limit ", remarks at the Jackson Hole Symposium.
21.
Malmendier, U. and Nagel, S. (2016), "Learning from Inflation Experiences", The Quarterly Journal of
Economics, Vol. 131(1), pp. 53-87.
22.
European Central bank (2022), " The ECB Survey of Professional Forecasters ", October.
23.
Schnabel, I. (2022), " Monetary policy and the Great Volatility ", speech at the Jackson Hole Economic
Policy Symposium organised by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, 27
August.
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