SPEECH
Play defensively, but be ready to strike back: a gradual
easing of monetary policy

== I ) Read aloud I >

'We can continue to, slowly but surely, lift our foot off the brake. In doing so, we
will follow a data-dependent and meeting-by-meeting approach.', said Klaas Knot
in his speech at Analysis Forum, Milan, today. Knot spoke about the outlook for
inflation and monetary policy in the euro area, both in the short and longer term.

Published: 20 June 2024

DNB Qe & &

Date: 20 June 2024
Speaker: Klaas Knot

Location: Analysis, Milan

It's great to be back at Analysis, and it's great to be back in Italy. As some of you may know,
I've had a love affair with your country ever since my time as a student in Pavia, 34 years
ago. Although I must say that it's also a bit of a relief to be away from the Netherlands for a
few days. Because, well... this is more or less what my country looks like right now.

I love football, I really do. But this is a bit too much even for me. Thankfully, we always have
monetary policy to talk about.

Of course, I realise that most of you are probably preoccupied by tonight's game against
Spain. But please spare me your attention for just a few minutes. So let's kick off.

Two weeks ago the ECB decided to lower its policy rate by 25 basis points.

The question everyone is asking: at what pace and up to what point will the ECB continue
its descent from restrictive territory? How will our monetary policy evolve in the short and
longer term?

The simple answer is that we're sticking to our data-dependent approach. The three
criteria that we used when inflation was on the way up will remain relevant on the way
down. They are: the inflation outlook in the light of incoming data; the dynamics of
underlying inflation, and the strength of monetary policy transmission.

Let me go through these three criteria one by one.

First, the inflation outlook. Looking at our latest forecast, inflation is expected to reach our
target of 2% by the end of next year. Forecast errors have also become smaller, which
allows us to be more confident in our outlook. Moreover, inflation data show we are well
underway in the disinflation process. Inflation has come down from a peak of over 10% to
below 3% currently. That being said, the recent uptick in the May inflation figures reminds
us that this process is bumpy and will remain so, at the least for the rest of this year.

Wage growth still elevated

Negotiated wage developments euro area
Annual percent changes, including one-offs

7
6
s

4

Let me now turn to the second criterion that guides our policy, the dynamics of underlying
inflation. Core inflation has come down, again with some hiccups. Meanwhile, most other
indicators of underlying inflation have also eased. At the same time, services inflation and,
related, wage growth, which you can see on the chart, remain above levels consistent with
our 2% inflation target. So here, not all the signs are green yet.

Lending rates and loan volumes point to strong transmission

Interest rate on bank loans Bank loan volumes
Percentage Annual percentage growth, adjusted
for securitisation and cash pooling
6 9
' 8
7
1 6
5
3 2
3
2
2
1 1
i)
I I
jan/22 jan/23 jan/24 jan/22 jan/23 jan/24
-NFCs Households -NFCs ~~ Households

ae

Finally, regarding monetary policy transmission, our 450 basis points of rate hikes have
been transmitted very forcefully into lending rates. You can see this in the graph on the left,
which shows the interest rate on new bank loans for households and businesses. In terms
of transmission there may even still be something in the pipeline, as existing loans are being

refinanced. Also, credit growth has come down substantially and is now hovering around
zero, as you can see on the right.

So, based on these three criteria, we reached our decision two weeks ago to cut our policy
rate by 25 basis points. And these criteria will continue to guide our monetary policy stance
in order to ensure that inflation returns to target in a timely manner and inflation
expectations remain anchored.

This way of conducting monetary policy can be summarised in one short sentence: wait for
incoming data, including new projections, and then decide accordingly. It sounds really
simple. But as Dutch football legend Johan Cruijff once said in his inimitable football Latin:
football is very simple, but the most difficult thing there is, is playing simple football. The
same is true for monetary policy. Because underneath this seemingly simple framework
and its guiding criteria, we are confronted with uncertainties that make forecasting
inflation and calibrating policy far from simple.

For one thing, despite 25 years of institutional history, we have little experience with a
gradual easing of monetary policy following a tightening cycle.

Moreover, every cycle is different, particularly since the global economy has undergone
important structural changes in the macroeconomic, financial and policy domains over the
past decades.

Global uncertainty remains elevated

Uncertainty measures
Indices, 1999=100, quarterly
600

500
400
300

200

99 O01 03 OS OF O98 11 13 15 17 #19 21 23

-- World uncertainty index nn Geopolitical Risk index

pdarenecareiaeI Source: Ahir, Bloom and Furceri (2022) and Caldara and Iacoviello (2022)

Another reason is that we are currently in an environment characterized by high
uncertainty, as you can see in the graph, which makes the assessment of inflation drivers
particularly challenging (see Verwey et al., 2023 (7 and Bloom, 2023 (7 Verwey et al., 2021).
This high uncertainty reflects the high frequency of large shocks, in particular on the supply
side, as well as geopolitical risks and structural changes in the economy that are difficult to


capture in our models. These include de-globalisation, demographics, digitalisation, climate
change. In particular, we need to better understand the dynamics of labour markets and
their drivers.

So what policy conclusions for the short term can we draw from this?

The inflation projections that I just mentioned imply a "soft landing": we expect inflation to
return to target in a timely manner and without triggering a major economic downturn.
Basically, you could say the score is one-nil - we have taken the lead.

With this outlook, monetary policy can "play defensively". Here I mean that our policy
decisions can help facilitate this projected inflation path to materialize, rather than trying
to shift this path in any direction. It's a bit like following the tactics of the legendary
Giovanni Trapattoni.

Market pricing in line with optimal policy paths

4

3.5
€ 3
-
a
22.5
27{-realized DFR
= - -€STR fw (June 24 proj.)
Optimal policy range
p Be)
2023 2024 2025 2026

Pee] Source: DNB calculations around the June 2024 Eurosystem staff projections

At the time of the latest inflation forecast, a little under three rate cuts were priced in for
2024 by financial markets. Would such a path make sense? One way to assess this ina
more formal way is to look at so-called "optimal" policy scenarios, shown in the graph,
which are based on analysis conducted by DNB. These optimal scenarios are derived from
models in which monetary policy tries to minimize deviations of inflation from target and
output from its potential. The range in the graph indicates the variation of outcomes
depending on the choice of model and different weights that the central bank attaches to
inflation relative to growth. As you can see in the graph, the rate path priced in by markets
at the time of the forecast (represented by the dashed line), is in fact broadly in line with
these optimal policy scenarios (see Knot, 2024 J ).

Market expectations of the ECB's rate path have shifted around over the past weeks,
reflecting incoming data, but are currently broadly in line with the market pricing at the

time of our projections. These shifts show that the road to our target can be a bit bumpy
but that markets understand our data-driven reaction function.

All in all this means that - based on the information we currently have - we can continue
to, slowly but surely, lift our foot off the break. In doing so, we will follow a data-dependent
and meeting-by-meeting approach. Since the current outlook allows us to reduce rates at
a gradual pace, there is a strong case for using projection meetings to recalibrate our policy
stance, as these meetings allow us to update our assessment based on a richer set of
information. This is particularly the case at the current juncture, given still lingering risks of
higher wage growth.

Looking beyond the short term, now that we are deep into the second half, the natural
question to ask is: what did we learn from this high inflation episode for monetary policy in
the future? How can we best cope with an environment of multiple supply shocks, high
uncertainty, and structural changes? How do we decide on looking through versus pushing
back against supply shocks?

I do not have the answers to all these questions. But let me offer some initial thoughts that
could be explored for monetary policy in the future. The overarching theme connecting my
reflections is the desire to retain a sufficient degree of flexibility in the face of new and
possibly more frequent shocks.

First, when inflation pressures started to mount in the course of 2021 following a prolonged
period of below-target inflation, we decided to wait with tightening our policy until
sufficient evidence was available to suggest that the large inflation shocks were not just
temporary. Once a second inflation shock hit in the spring of 2022, with the Russian
invasion of Ukraine, it became evident that inflation pressures became persistent. Although
that meant we started tightening policy a little bit later than we could have, our forceful
response prevented high inflation from causing a de-anchoring of inflation expectations.

Inflation expectations broadly in line with target

Long-term inflation expectations euro area

Annual percentage
3,5

3

20 21 22 23 24
--Sy5y forward inflation swaps
--Consensus Economics
-- Consumer expectations Survey (ECB)

Source: ECB, Refinitiv and Consensus Economics

And as you can see in this graph, inflation expectations, based on both financial markets
and survey data, have remained broadly in line with our target.

This decision to wait with tightening policy can be seen as reflecting a risk management
approach, whereby we weighed the risk of high inflation becoming persistent if we did not
react strongly against the risk of triggering a hard landing of the euro area economy (Lane,
2024 (7).

Applying flexibility going forward could allow us to look through small deviations from our
target, as long as we respond especially forcefully to larger deviations, either to the
downside or to the upside.

In football terms, this means having your defence in order, let your opponent come slightly
into your half to see what he's up to, and striking back with force in the counter-attack if
needed. Which is exactly what Trapattoni would do.

Second, given the need to counter quickly when shocks do persist, it is important that we
retain flexibility in the use of our instruments. In response to the prolonged period of low
inflation following the global financial crisis, and the subsequent COVID-shock, we resorted
to a combination of low rates and balance sheet policies reinforced by providing forward
guidance on both elements. When inflation increased, we made it clear that any rate hike
would be preceded by a discontinuation of net asset purchases. While such forward
guidance can bolster the effect of our policies and reduce uncertainty for market
participants, too much precommitment can also hamper our ability to adjust our stance
quickly. This trade-off between forward guidance and flexibility is something to be very
much aware of in the future.

And finally, communicating more explicitly about the uncertainty surrounding our
projections, for example in the form of scenarios or confidence bands, could help de-
emphasize the single endpoint of the projection horizon. The range of projections could
correspond to different narratives about the evolution of the euro area economy. In turn,
these narratives could inform different policy choices. A greater use of scenarios around the
baseline could support a risk management approach to monetary policy. This would require
attaching some probability to the alternative inflation scenarios when taking monetary
policy decisions (see e.g. Bullard, 2021 (7).

Some of these topics could return in our interim strategy review, which will take place in
2025.

I hope that you are still with me, and that your minds haven't drifted too much to tonight's
match. Although you would be forgiven if they have. In any case, the most important
takeaway is that, given the current environment we still have to avoid any commitments
ona specific future rate path. We may be one-nil up, but we are playing a tough opponent,
so it's still too early to declare victory. Or as 'il Trap' put it: "Non dire gatto se non ce I'hai nel
sacco." Our data-dependent approach allows us to assess the incoming data and inflation
outlook moving from one meeting to the next and to adjust our policy stance accordingly.

I think I just heard the final whistle so let me just say that I am looking forward to an
insightful discussion. Thank you!

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