Olli Rehn: Monetary policy in the emerging post-pandemic context
Opening remarks by Mr Olli Rehn, Governor of the Bank of Finland, at the Bank of
FinlandSUERF Joint Conference "Monetary policy approaches: a comparative appraisal", 19 October
2021.
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Ladies & Gentlemen, Dear Friends,
Good afternoon and welcome to this conference on Monetary Policy Approaches: A
Comparative Appraisal, which is jointly organized by the Bank of Finland and the European
Money and Finance Forum SUERF.
Our collaboration with SUERF in organizing biennial conferences has a long and successful
history, for which we are very grateful. I wish to extend my thanks to all those colleagues and
friends who have contributed to making today's conference possible.
We are honoured to have some of the leading experts in the field to address us at this
conference, including the panellists Philip Lane, Andrew Levin, and Patricia C. Mosser. The
organizing committee have done an excellent job in putting together a high-quality programme for
today.
In my opening remarks, I will discuss monetary policy in the emerging post-pandemic context as
seen from the perspective of the euro area. Let me first make a few remarks on growth and
inflation outlook, and then discuss the recent strategy review of the European Central Bank.
The euro area economy has rebounded significantly this year on the back of the re-opening of the
economy and strengthened policy support. According to the ECB's September staff projections,
real GDP is projected to grow by 5.0% this year, 4.6% next year and 2.1% in 2023.
Not surprisingly, we have seen some inflation peaks in the recent months. On both sides of the
Atlantic and globally - and last week in the IMF annual meetings - one is bound to witness an
intensive debate on "back to the 70s stagflation", and whether the recent rise in consumer price
inflation is of transitory or permanent nature. Let me give you my take on this.
We have a saying in the European Union: "Nothing is more permanent than something called
'transitory'."
By experience, that is often true, but it is somewhat more complicated this time round. As you
know, the debate is particularly heated in the US. However, there is still plenty of slack in Europe,
which is in another phase of recovery and behind the cycle compared to the United States.
Yes, we have seen some inflation peaks in Europe, as well. Last month consumer price inflation
rose to 3.4%. Annual inflation is forecast to reach an average of 2.2% this year, supported by
temporary factors, such as the strong base effects caused by the rapid rises in energy prices,
especially electricity and gas, and the cost pressures arising from more persistent shortages of
materials and equipment than previously thought. In 2022, inflation is projected to moderate to
1.7%, as the factors now deemed temporary should start to fade away, and projected to stay at
1.5% in 2023.
In my view, euro area inflation is still mostly transitory, even if some of its components are partly
more persistent than previously expected. However, we need to recognize that
the micro experience of the ordinary people is quite different from the macro reading of the
economists and central bankers. If this state of elevated inflation were to last much longer, it
would likely have a more significant effect on inflation expectations.
Indeed, the selling price expectations (3 months forward) of both the industrial and retail sectors
have started to rise amid these temporary price pressures. Moreover, the short-term inflation
expectations derived from the market information (i.e. inflation swaps) has increased to 1.8 -
1.9%.
However, the counterevidence speaking for the transitory interpretation is quite convincing. When
looking at the longer-term expectations, there is no upward trend: The probability distributions of
market inflation expectations have strongly concentrated between the levels of 1.5 - 2.5% and
the probability of inflation higher than 2.5% is very small. Core inflation in the euro area is still
subdued, the latest reading being 1.9%, and it is projected to stay at 1.5% in the medium term.
So far, there is no major evidence of second-round effects through wages. Wage growth is still
below pre-Covid average, despite significant sectoral labor shortages.
So, we may ask: where does the euro area stand when facing the classical monetary policy
dilemma of not overreacting to the supply-side shock, on one hand, and engineering a reduction
of stimulus without de-anchoring inflation expectations, on the other hand?
When answering this question, we should do so against the backdrop of the ECB's new
monetary policy strategy, which is built on a symmetric 2% inflation target and on a reaction
function that tolerates temporary overshooting. As core inflation is at 1.5% in the medium term
and the latest reading of long-term inflation expectations (5y/5y) was at 1.9%, we may conclude
that the trend in euro area inflation is now in line with the ECB's strategy. Logically, on the basis
of this data and in line with its revised strategy, the ECB leans on the side of not overreacting.
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Let me now turn more specifically to our strategy review, which was concluded in July.
Highquality analysis and extensive dialogue between research and policymaking were crucial for
reaching substantive, pertinent conclusions going forward. You may compare the strategy review
exercise to a major research project with dozens of in-depth seminars, covering key issue areas
relevant to the making of monetary policy.
We reviewed the definition of price stability, monetary policy instruments and their effectiveness,
as well as our communication practices. We also assessed the importance of digitalization,
financial stability, globalization, monetary and fiscal policy interactions, and climate change from
the perspective of monetary policy.
The most important revision to our strategy is the new definition of price stability and how it will
be applied in our future decision-making. According to the new strategy, price stability is best
maintained by aiming at a 2% symmetric inflation target over the medium term.
The old aim of 'below, but close to 2%' was less precise and very much open to interpretation. In
particular, the former definition had probably a certain feel of asymmetry, and its ambiguous
wording appeared more of a ceiling than a symmetric central target.
The new 2% inflation target is genuinely symmetric, unambiguous, and easy to communicate.
Symmetry means that the Governing Council considers both slower and faster inflation to be
equally undesirable.
The symmetric 2% inflation target under the new strategy thus serves as a buffer against
deflationary risks and provides monetary policy with more space to react to a sharp decline in
inflation. Obviously, we also want to rein in the costs to the economy from a too high rate of
inflation. And we have the tools to do it effectively, if and when needed.
This change in the price stability definition is clearly reflected in our forward guidance. As decided
at our monetary policy meeting in September, the Governing Council expects the key ECB
interest rates to remain at their present or lower levels until it sees inflation reaching 2% durably,
and it judges that the progress realized in underlying inflation is consistent with inflation stabilizing
at 2% over the medium term.
Commitment to a symmetric inflation target requires particularly strong or long-term monetary
policy measures when interest rates are close to the zero effective lower bound. This
commitment, which is buttressed by the new forward guidance, is crucial to support the
anchoring of long-term inflation expectations to 2%, but as said it may also imply a transitory
period in which inflation is moderately above target.
A medium-term orientation for the inflation target is baked in into the new strategy, which also
makes it possible, where necessary, to smooth out other economic shocks, such as shocks
related to employment or financial stability. If actual inflation is slower or faster than targeted,
monetary policy will respond to deviations gradually, considering the nature of the economic
disruption. Deviations estimated to be temporary may not be responded to at all, but seen
through.
The symmetric inflation target should help to ensure a stable and predictable price outlook, which
is a key prerequisite for sustainable economic growth and a high level of employment. Price
stability, balanced growth and a high employment rate are mutually consistent goals, and
successful monetary policy improves the well-being of citizens by focusing on price stability. To
this end, targeted monetary policy communication can improve people's understanding of how
monetary policy responds to current and projected economic conditions.
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The strategy review also examined how monetary and fiscal policy can work together during and
after times of crisis. The conventional thinking gives a clear division of labour between the
monetary and fiscal authorities: monetary policy should promote price stability, and fiscal policy
should keep sovereign debt on a sustainable path.
However, in a period of low interest rates, the scope for monetary-fiscal policy interactions is
possibly wider. Counter-cyclical fiscal measures complement monetary policy when key policy
interest rates cannot fall any further. Similarly, low interest rates can keep financing conditions
favourable during and after crisis, thus creating space for fiscal authorities to respond to an
economic downturn and hence stabilize the economy.
Fiscal policy also matters for the transmission of monetary policy in low interest rate
environments. A recent study by Bank of Finland staff, "The Power of Forward Guidance and the
1
Fiscal Theory of the Price Level" , argues that fiscal support is essential for forward guidance
announcements to have the right kind of effect on inflation and output. Fiscal support remains
important at the effective lower bound and before inflation robustly converges to the 2% target.
Moreover, in that context structural reforms are needed to support labour supply and productivity
growth.
Then there is the "Voldemort" or the threat of "fiscal dominance", a scenario in which monetary
policy is linked to the sustainability of public debt. Fiscal dominance scenarios are associated
with high inflation and volatile macroeconomic conditions that could ultimately lead to loss of
central bank independence. Such scenarios are certainly not desirable. It is clear that the ECB
Governing Council has the mandate, the will and the tools to counter and prevent such scenario.
Moreover, the fiscal framework should be such that it first of all ensures debt sustainability in the
long-run, while being sufficiently flexible to allow macro stabilization especially when the
economy is at the effective lower bound.
That is why fiscal rules are of major relevance for monetary policy. Even though the existing EU
fiscal rules have been criticized, and the criticism is to some extent justified, discarding the rules
without a clear alternative would obviously be a major mistake.
Once the rules are reformed, what should the reform look like? They should be made simple and
transparent, like our new definition of price stability. Clarity supports the effectiveness of rules
and enhances accountability.
One good starting point is the proposal by the European Fiscal Board. It includes an expenditure
rule, which could be defined so that it effectively limits expenditure growth also during economic
upswings. There is evidence that broadly these kind of expenditure rules, when complemented
2
with other fiscal rules, have been successfully applied in many countries.
Regarding the design of the rules in general, it is important that they are based as much as
possible on observables, and not on un-observables such as output gap and potential output.
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Last but not least, there is the issue of climate change. While governments and parliaments have
the primary responsibility for climate policy, the ECB, within its mandate, also needs to support
these goals. Among other things, the ECB will expand its analytical capacity to incorporate
climate issues in its economic models and to promote the measurement and disclosure of risks
related to climate change. By thus expanding its analytical capacity, the ECB can effectively
account for climate issues in its risk management analysis, investment activities and monetary
policy operations.
Ladies and Gentlemen,
A warm welcome once more on behalf of the Bank of Finland. I wish you all a productive and
enlightening conference. But before we get going with the first session, let me open the floor for
possible questions.
Thank you.
1
McClung, Nigel, "The Power of Forward Guidance and the Fiscal Theory of the Price Level," International Journal
of Central Banking, (2021, forthcoming)
2
See e.g. Belu Manescu, C and E Bova (2020), "National expenditure rules in the EU: an analysis of
effectiveness and compliance", Discussion Paper 124, European Commission. Till Cordes, Kinda, T., P.
Muthoora, and A. Weber (2015): "Expenditure Rules: Effective Tools for Sound Fiscal Policy?". IMF Working
Paper 15/29.