31.05.2022
The inflationary episode in the euro area and the ECB's monetary
policy normalisation process
Institut d'Economia de Barcelona (IEB) 20th Anniversary- "20 years identifying
problems and finding solutions"
Pablo Hernández de Cos
Governor
Good afternoon. Let me begin by thanking the organisers of this event, l'Institut d'Economia
de Barcelona, for their kind invitation.
Unfortunately, the war in Ukraine and the suffering of the Ukrainian people are dragging on.
The economic implications of the conflict are very uncertain but they will probably be far
reaching. We are already bearing some of the more immediate consequences, such as an
intensification of the high inflation episode and a weaker post-pandemic economic recovery.
Against this backdrop, I will devote my address to the current inflationary episode and the
ECB's monetary policy response.
The causes of the rise in inflation
Inflation rose significantly in 2021 worldwide and accelerated further in early 2022.
Moreover, this surge is proving to be more persistent than initially expected.
In the euro area, inflation surpassed 6% in the first quarter of 2022, exceeding the 4.1% rate
projected by Eurosystem staff last December. In May, inflation reached 8.1%, practically
twice as high as its previous peak in July 2008.
The underlying causes of this increase include, first, the rapid recovery in demand following
the removal of the restrictions to contain the pandemic in an environment characterised by
production constraints.
Second, commodity prices have risen sharply on international markets. In particular, energy
prices have been affected by a decrease in the supply of gas for geopolitical reasons and a
lack of infrastructure maintenance during confinement. The gradual reduction of investment
in fossil fuel extraction as a result of green policies in recent years has also affected energy
prices. These strains have increased drastically in 2022 with the invasion of Ukraine by
Russia and have spread to food.
Third, the recovery of supply has also been delayed by the emergence of bottlenecks. The
speed with which demand has recovered, and higher goods consumption as a result of the
pandemic, have put excessive strains on global production chains, which were still affected
in 2021 by the pandemic restrictions. This has led to input supply problems in industries
such as semi-conductors, plastics, wood and industrial metals, which have been
compounded by serious disruptions in goods transport.
The unevenness of the rise in inflation across countries
Despite the importance of global factors, the impact of the current inflationary episode on
the main world economies has been uneven. The variation in the extent of the rise in inflation
reflects various idiosyncratic factors that differ in nature, such as the differing speed of the
recovery in demand in each region. It also reflects other factors related to the composition
of the consumption basket, productive specialisation, positioning in global and regional
production chains, labour market slack, the anchoring of expectations and exchange rate
fluctuations.
Indeed, demand has been particularly vigorous in the United States, which has resulted in
more intense and earlier underlying inflationary pressures there. At the end of 2021 private
consumption stood more than 4% above its end-2019 level, with a very significant
contribution to this rise coming from consumer durables. In the euro area, meanwhile, it
stood around 3% lower.
PMI suppliers' delivery times show that supply bottlenecks are having a greater impact in
Europe and the United States. Germany has been the most vulnerable euro area country,
given that: (i) it is more integrated into, and occupies a central position in, value chains; (ii)
manufacturing - particularly the automotive industry - accounts for a high share of its
economy; and (iii) its productive processes are heavily reliant on imports of commodities
and inputs. In this regard, since summer 2021 more than 50% of German industrial firms
have reported the shortage of material and/or equipment as a factor limiting production, as
compared with 25% in Spain.
Higher energy prices are having a more acute impact on inflation in the advanced economies
and, especially, in the euro area. The greater contribution of the energy component to euro
area inflation is largely a result of this component accounting for a higher relative share of
the consumption basket in the euro area (10.9% of the total versus, for example, 7% in the
United States). Moreover, the euro area's high dependence on external energy sources has
been compounded by the depreciation of the euro in 2021 and the outbreak of the war in
Ukraine, which has also driven up the cost of the energy component of consumption.
The contribution of energy to the rise in inflation in the euro area is particularly important in
Spain and, to a lesser degree, Italy, given the larger contribution of the electricity
component. In Spain, energy, and electricity in particular, account for a larger share of the
consumption basket. While Spanish households devote 11.7% of their budget to energy,
the euro area average is 10.9%. Regulatory and price-setting mechanisms are another
factor responsible for the notable unevenness in the pass-through to retail prices of the
higher wholesale electricity price in euro area countries. For instance, in Spain around 40%
of households opt for a dynamic pricing system, characterised by the high frequency of
price revision, which explains the higher volatility of the electricity component of inflation
and, thus, the faster and stronger pass-through.
The rising inflation is also having an uneven impact on households and firms. In particular,
in recent months, low-income households have experienced higher inflation because staple
goods, whose prices have shown the highest relative increase in recent times, account for
a larger share of their spending.
The spread of the inflationary episode across products
Consumer price inflation has gradually spread across the board since the summer of 2021.
Thus, underlying inflation, which excludes the most volatile components, has risen rapidly,
exceeding 4% by mid-2021 in the United States and 2% since end-2021 in the euro area.
In April, the underlying inflation rate (excluding energy and food) reached 3.5% in the euro
area (its highest level in the history of the monetary union) and 3.4% in Spain (the highest
rate since 2003). According to the preliminary estimate, underlying inflation in the euro area
climbed to 3.8% in May.
This has led to a significant rise in the expenditure items in the households' usual
consumption basket with a very high inflation rate. In February, around 30% of the
expenditure items in households' usual consumption basket experienced inflation above
4% both in Spain and in the euro area. The proportion of consumption basket components
recording inflation rates above 2% has increased significantly, from 30% in June last year
to 80% in April. Meanwhile, the percentage of items showing year-on-year price falls is at a
15-year low, in contrast to past episodes, such as the 2008 financial crisis.
The inflation outlook and its determinants
Looking ahead, the available forecasts indicate that euro area inflation will remain high in
the coming months, slowing gradually thereafter towards levels compatible with the ECB's
2% medium-term inflation target.
According to the latest European Commission projections, inflation will peak in the second
quarter, and will remain high until the end of 2022, followed by a substantial moderation. In
line with the most recent forecasts of other institutions and analysts, inflation will average
around 6% in 2022, moderating in 2023 to levels somewhat above 2%, and reaching levels
close to 2% in 2024.
However, inflation forecasts have been revised upwards systematically in recent months,
since these projections are subject to very high uncertainty. Consumer price dynamics will
depend on a number of factors, including developments in the conflict in Ukraine and
economic policies. Let me now elaborate on some important determinants of the inflation
outlook in the euro area.
First, the inflation path will much depend on the evolution of cost pressures, mainly energy
costs and those related to the global supply chain disruptions. In particular, these
projections assume a certain decline in energy commodity prices, in line with futures on
international markets, and a gradual disappearance of bottlenecks in the coming months.
Nevertheless, the dynamics of these variables over the coming quarters will largely depend
on the scale and persistence of the disruptions caused by the war in Ukraine, and the broad
trade sanctions imposed by the western world on Russia and Russian reprisals.
Indeed, the war is creating new commodity price tensions and further disruption in the
logistics and supply of essential intermediate goods and commodities. Volatility in
commodity prices has been very high and futures prices are discounting extreme
uncertainty in the form of risk premia.
The spread of COVID cases in China and the severity of the containment measures adopted
by the Chinese authorities have also exacerbated production bottlenecks in recent months.
In this respect, the latest European Commission survey shows that the number of euro area
firms citing the shortage of material and/or equipment as a factor limiting production is still
extraordinarily high. In April, 55% of the manufacturing firms surveyed reported supply
restrictions. In Germany, this figure was 85%.
Second, turning to economic activity, the war in Ukraine has triggered large downward
revisions to euro area GDP growth forecasts for 2022.
According to the analysts surveyed by Consensus, GDP growth is currently expected to be
2.7% in 2022, compared with forecasts over 4% a few months ago. This slowdown
essentially reflects the downward revision of global demand, the intensification of the energy
price shock and bottlenecks, the heightened uncertainty and its impact on business and
consumer confidence. There have been very significant revisions, reflecting the euro area's
geographical proximity to the war zone and its strong commercial ties with Ukraine and
Russia, as well as its heavy dependence on external energy sources. These negative effects
of the war on economic growth could ultimately reduce inflationary pressures in the medium
term.
However, in the short term, a combination of factors continues to support economic growth.
The reopening of euro area economies after the latest wave of COVID-19 infections is driving
economic activity and employment in the services sector, as can be seen in the recent
improvement of the services sector PMI. Also, the fiscal measures adopted to offset the
impact of higher energy prices on consumers and businesses and the cushion provided by
private savings accumulated during the pandemic will likely underpin consumption and
economic activity in the short term. Lastly, the deployment of NGEU funds will support
construction and investment.
Third, other factors could also have a significant influence on the duration of the current
inflationary episode. These include, in particular, the potential indirect and second-round
effects on inflation stemming from the latest price increases.
Indirect effects arise when, in an attempt to maintain their profit margins, firms pass through
their higher energy costs to the price of their products. As I mentioned earlier, this effect has
already been reflected to some extent as price pressures have broadened beyond the
energy component of inflation. Profit indicators point to a recovery in 2021 in the euro area,
following the sharp fall in 2020, but they appear to show a lower degree of dynamism in
Spain and, according to various still incomplete sources, actual decreases in the last stretch
of the year and the first quarter of 2022.
In any event, available empirical estimates show that, in the face of a temporary rise in
commodity prices, aggregate demand or the severity of production bottlenecks, the
response of consumer price inflation is quite persistent and extends over several months.
Second-round effects arise when, in an attempt to preserve their purchasing power, workers
demand wage rises in line with inflation, thus driving up labour costs and putting further
pressure on final prices. These effects can set in motion a harmful spiral of price and cost
increases.
According to the latest evidence, significant second-round or indirect effects are not yet
materialising in the euro area. Indeed, the latest data on wage settlements point to
employees bearing a considerable loss of purchasing power in recent quarters.
This limited pass-through of prices to wages could partly be the result of the relatively low
prevalence of wage indexation clauses, following a long period of low and stable inflation.
In 2021, the percentage of euro area private-sector employees covered by indexation
clauses was the lowest in recent decades.
However, if inflationary pressures persist, they are more likely to feed into wage negotiations
and profit margins and, therefore, to trigger second-round and indirect effects on inflation.
In this regard, during the second half of 2021, the percentage of collective agreements
signed in Spain providing wage increases over 3% grew appreciably. Also, in early 2022,
wage indexation clauses - which update minimum wage rates if past inflation exceeds a
certain level - have become more prevalent in sectoral collective agreements.
In the same vein, several surveys suggest that, in the coming months, businesses could
pass through to their product prices part of the higher costs they have borne in many of
their inputs over recent quarters.
These latest developments will have to be carefully monitored in the coming quarters.
Fourth, second-round effects would be more likely to emerge if medium and long-term
inflation expectations were to become deanchored.
Since mid-2021, market and survey-based indicators of long-term inflation expectations
have risen, leaving behind the low levels of the last two years and reaching rates close to,
but slightly above, the 2% target. In particular, according to the ECB Survey of Professional
Forecasters, long-term inflation expectations for 2026 increased to 2.1% in April. The
inflation compensation implicit in the 5-year forward inflation-linked swap rate 5 years ahead
- a common market-based indicator - exceeded the 2% reference level in March and hit
almost 2.4% in April, although it has recently moderated slightly. In any event, discounting
the risk premium, genuine inflation expectations remain close to 2%, albeit with an upward
trend.
In short, so far, long-term inflation expectations remain anchored at the 2% target, but they
require close monitoring. In this regard, the results of the latest Consumer Expectations
Survey (CES) reveal a notable increase in inflation expectations. After remaining firmly
anchored at 2%, median expectations for inflation three years ahead increased one
percentage point to 3% in March.
In the current setting, it is crucial for economic agents to understand that the euro area, as
a net importer of energy and other commodities, is suffering a negative shock to its terms
of trade, which translates into an unavoidable loss of purchasing power for the economy as
a whole. Attempts by all economic agents to preserve their purchasing power would trigger
indirect and second-round effects, which would only increase the economic costs from the
shock.
Indeed, this explains why the Banco de España has argued for an incomes agreement. This
agreement would consist of an agreement between firms and workers, under the framework
of social dialogue, to share the inevitable loss of national income that higher commodity
import prices entail. These are goods which we do not have, but which we need for domestic
production and consumption.
Last, but not least, a number of structural forces may also shape future inflation dynamics.
In the past, we have argued that some transformations, such as globalisation, digitalisation
and population ageing, may have contributed to the low-inflation environment during the
pre-pandemic period. However, the pandemic and the war could mark a turning point in this
trend for two reasons.
First, previous globalisation patterns could reverse to some extent in response to the supply
bottlenecks and disruptions that have affected many economies and sectors during the last
few years. The global allocation of production and the functioning of international supply
chains are being re-evaluated by companies and economic authorities in many countries.
Second, the Russia-Ukraine war and the associated geopolitical tensions point to the need
for a faster reduction in Europe's high reliance on fossil fuels, accelerating the green
transition.
Both of these processes could impact domestic consumer prices in the medium to long
term.
Normalisation of the ECB's monetary policy
Since last December, the ECB has embarked on a process of monetary policy normalisation,
from a starting point of a highly accommodative stance. Before the onset of the pandemic,
the ECB maintained very accommodative financial conditions through the asset purchase
programme (APP) and negative interest rates. The aim was to drive inflation, which had
remained persistently below 2%, to levels closer to its target.
During the pandemic, in order to address the risk of financial fragmentation and counter the
downward impact on the medium-term inflation outlook, the ECB deployed very forceful
measures, including a significant improvement in the conditions of its targeted longer-term
refinancing operations (TLTRO) and the creation of the pandemic emergency purchase
programme (PEPP).
These steps have proved essential to maintain favourable financial conditions during the
crisis and to minimise the impact of the crisis on households, businesses and the public
sector across the euro area. This has been particularly important for countries, such as
Spain, with high government debt and budget deficit levels at the outset, which would
otherwise have had less room for manoeuvre to deploy equally forceful fiscal policies. The
flexible use of purchases under the ECB's PEPP has been particularly important for
preventing financial fragmentation problems in the euro area.
The ECB's actions going forward should also be seen in the context of the new strategy that
we approved in June 2021, which established an inflation target of 2% over the medium
term. The ECB's commitment to this target is symmetric, meaning that it considers
deviations above and below the target to be equally undesirable. The medium-term
orientation means that our decisions are not determined by the short-term dynamics of
inflation, but rather by the inflation path projected over a two or three-year horizon.
At the time, this framework was made operational in a new formulation of our rate forward
guidance, which establishes three conditions for the rate rise: 1) projected inflation must
reach 2% "well ahead of the end of our projection horizon", which can be interpreted as the
mid-point of that horizon (about 18 months ahead); 2) it must remain at 2% durably for the
rest of the projection horizon; and 3) developments in underlying inflation must be
compatible with the inflation rate stabilising at 2% in the medium term. Net purchases under
the APP are also linked to these conditions, with the guidance stating that interest rates will
only rise some time after the net purchases come to an end.
Given this strategy and in the current context, a gradual withdrawal of the extraordinary
monetary stimulus is appropriate: inflation expectations over intermediate horizons and in
the medium term stand at around 2%, underlying inflation is clearly above 2% and there are
risks of upside deviations from the projections.
Thus, last December we announced a step-by-step reduction in the pace of asset
purchases. The first step was the decision to discontinue net asset purchases under the
PEPP at the end of March 2022, given that the gap with the pre-pandemic medium-term
inflation trajectory had been closed. Also, we confirmed that the special conditions
applicable under our TLTROs would end in June 2022.
Next, in March we announced the monthly net purchases under the APP would gradually
reduce, to conclude in the third quarter conditional on the medium-term inflation outlook. In
April, we judged that the evolution of economic indicators reinforced the expectation that
net purchases under the APP should be concluded in the third quarter.
Once net asset purchases come to an end, the next step in the normalisation process will
be the increase - or "lift-off" - in our interest rates. In this regard, in March we established
that any adjustments to our policy rates will take place "some time" after the end of net
asset purchases under the APP and will be gradual, a pledge we reaffirmed in April.
In my opinion, given that the inflation outlook is consistent with fulfilling our forward
guidance conditions, net purchases under the APP should conclude in early July so that the
first interest rate rise can be made during that month and we can exit the current negative
rates at the end of Q3.
The first interest rate rise could be followed by further increases. One benchmark that could
inform that path is the long-run level of the so-called "natural rate of interest", defined as
the interest rate that maintains inflation stable at its target level.1 According to the estimates
available, which are subject to much uncertainty, the natural interest rate is relatively low in
the euro area, hovering around or slightly above 1%. This would suggest that, until these
levels are reached, the monetary policy stance will continue to be expansionary, at least
from a long-term perspective.
In any case, and as we stressed in April, interest rate increases should be gradual. The aim
is to avoid abrupt movements, which could be particularly harmful in a setting as uncertain
as the current one. This gradualism is also justified by the relatively short distance between
the current level of policy rates and the estimates for the long-run natural interest rate that I
mentioned before.
However, in order for us to adopt this gradual normalisation approach, it is essential that
inflation expectations remain anchored at the 2% target and that no second-round effects
arise on a scale that could jeopardise such anchoring.
Nevertheless, we do not have pre-established guidelines for the normalisation. As I have
just said, after the first interest rate movements, in principle further rises could be made over
the following quarters until reaching, for example, levels in line with the natural rate of
interest, assuming the medium-term inflation outlook remains around our target. But it
should be borne in mind that the current uncertainty relates to aspects of such importance
for future inflation as the course of the war, the clearing of the global transport and
production bottlenecks, the extent to which second-round effects materialise, globalisation
dynamics and energy and climate change policies. We will therefore have to fine-tune the
normalisation process based on the incoming data. It is not optimal to pre-commit to any
specific interest rate path, much less so in the current uncertain context.
We will act with total flexibility and adopt the measures needed to fulfil our mandate and
contribute to safeguarding financial stability. Along the path to a more neutral interest rate
configuration, flexibility is particularly important to preventing the emergence of threats to
the smooth transmission of monetary policy throughout the euro area. As I mentioned
earlier, the pandemic has shown that, under stressed conditions, flexibility in asset
purchases effectively helps to counter these threats. Within our mandate, this flexibility will
remain a cornerstone of our monetary policy.
One example of this commitment to flexibility is our pledge to adjust PEPP reinvestments
flexibly across time, asset classes and jurisdictions in the event of renewed market
fragmentation related to the pandemic. In addition, we have shown in the past that we are
able to quickly design and deploy new instruments to secure monetary policy transmission.
In step with the communication of this process of monetary policy normalisation, market
expectations of policy rate hikes have been brought forward since December. The prospect
of a normalisation of the monetary policy stance has also been reflected in an upturn in short
and long-term interest rates in the euro area. Specifically, the 10-year OIS rate, which
proxies the euro area long-term risk-free interest rate, has risen by about 135 bp since the
beginning of the year, while the 12-month EURIBOR has increased by 86 bp. The risk
premium on Spanish government debt increased by 30 bp in this period.
Conclusions
In sum, since mid-2021, euro area inflation has maintained a clear upward trend. This has
intensified in recent months and spread, albeit to a lesser extent, to underlying inflation.
The analysts' consensus expects inflation to remain high in the coming months, but to slow
gradually as from the final stretch of the year, assuming there are no new inflationary shocks,
towards levels compatible with the ECB's target of 2%. This outlook is supported by the
medium and long-term inflation expectation indicators drawing on financial markets and
surveys of experts.
However, the upside risks surrounding the inflation outlook have increased. The greater
persistence and intensification of inflationary pressures have driven up the likelihood of the
indirect and second-round effects becoming more acute. Although these effects have not
materialised sharply for the time being, there are signs, which will need to be monitored
closely, that medium-term inflation expectations are being revised up above the target level.
Against this backdrop, the ECB has embarked on a process of normalisation of its monetary
policy, which has been extraordinarily expansionary following the forceful measures
adopted during the pandemic. The calibration of this process will be data-dependent and
reflect our evolving assessment of the inflation outlook at any given moment. The process
will be gradual, provided the inflation expectations remain anchored at 2% and no
significant second-round or indirect effects arise. We stand ready to adjust all of our
instruments within our mandate, incorporating flexibility if warranted, to ensure that inflation
stabilises at its 2% target over the medium term.