The interaction between monetary and fiscal policies
in the pandemic crisis and beyond
Remarks by Ignazio Visco
Governor of the Bank of Italy
The ECB and Its Watchers XXII
Hybrid event, 17 March 2022
Coordination between fiscal and monetary policy has been a key factor at a global level
over the last two years, to contrast the consequences of the pandemic crisis and to
support the recovery as the state of emergency began to subside. In these brief remarks,
I will first focus on the similarities and, more specifically, the differences between the
policy mixes implemented in the United States and in the euro area, and then on how
I see the situation evolving in light of the Russian invasion of Ukraine.
In essentially all countries, following the outbreak of the pandemic, governments stepped
in to strengthen health systems and support household income and credit to firms; fiscal
policies everywhere were strongly facilitated by the accommodative stance of monetary
policy. In the US, however, fiscal measures were especially bold: the public debt-to-GDP
ratio rose by 25 p.p. in 2020-21, to over 130 per cent. In the euro area, instead, the debt
ratio increased by 15 p.p., to slightly less than 100 per cent, despite a much deeper
decline of nominal GDP in 2020 (by 4.8 per cent, against 2.2 in the US) and a slower
recovery last year (7.5 versus 10.1 per cent in the US); it was, until the outbreak of the
Russia-Ukraine war, on a steady downward trend. At the same time, concerns over the
impact of structural changes to growth potential led to the launch of the recovery and
resilience programmes associated with the Next Generation EU initiative.
The extraordinary support to households provided by the US fiscal policy is particularly
evident when comparing the dynamics of GDP to household disposable income (Figure 1):
in 2020, just as the former recorded its sharpest collapse in real terms in the entire
postWorld War II period (-3.4 per cent), real household disposable income grew by over 6 per
cent, its largest rise since the mid-1980s. In the euro area, on the other hand, it declined,
even though by a much smaller extent than GDP (-0.6 versus -6.4 per cent).
The different dynamics of household disposable income across the two economies
translated into very diverse effects on consumer and aggregate demand and consumer
price inflation. In the US, GDP returned to its pre-crisis trend at the end of last year,
but aggregate data hid a somewhat elevated degree of heterogeneity between sectors:
while demand in the service sector was (and still is) restrained by pandemic-related
factors, the goods sector increasingly showed signs of overheating (Figure 2). In the
spring of 2021, for example, personal consumption expenditure in the durable goods
sector was already more than 30 per cent higher than its pre-crisis level.
Even in the euro area, goods purchases were less affected by lockdowns and fears
of contagion, but their growth rates remained relatively contained and, at end-2021,
consumption expenditure in this sector was still lower than its modest pre-pandemic trend.
Pressures on consumer prices have been intensifying in the US since the spring of
last year, with headline inflation peaking at 7.9 per cent last February (Figure 3); core
inflation played a key role throughout this process: in April 2021 it had already risen to
3 per cent and, last month, it had reached 6.4 per cent, the highest in 40 years (the picture
remains essentially the same if we look at the personal consumption expenditure price
index, which rose to above 6 per cent in January, with its core component increasing to
5.2 per cent). Headline inflation also rose in the euro area, to 5.8 per cent in February,
but energy and food took the lion's share, as the growth of the "core" component was
more than 3 percentage points lower (2.7 per cent).
* * *
Before the Russian invasion of Ukraine, to understand the economic outlook on both
sides of the Atlantic and how the policy mix should have evolved accordingly, three key
factors were especially important.
The first factor is related to the developments in the energy market. Oil prices rose,
gradually but steadily, at the global level from the lows of the most acute phase of the
health emergency: on the eve of the war, they were 60 per cent higher than in January
2020 (for both the US and Europe). Gas prices in the US recorded similar dynamics, almost
doubling with respect to January 2020 (Figure 4). But it was the cost of European gas,
strongly dependent on supply from Russia, that really skyrocketed: between September
2021 and February 2022 it averaged at over 8 times the value of January 2020; after the
outbreak of the war it was even higher, with a peak of 20 times the level of January 2020,
before returning somewhat closer to the previous average in the last few days. This is
particularly worrying due to the special role of gas in determining retail prices not only
for heating and industrial uses, but also for electricity at large.
It is consequently important to assess the effects of Europe's energy crisis on consumer
prices, also beyond their direct effects on headline inflation. A significant share of the rise
in core and food inflation, in fact, is due to higher energy prices; in particular, we may
estimate that, absent the energy shock, headline inflation in February this year would
have been 3.5 percentage points lower, at a level, therefore, only slightly above the ECB's
2 per cent target. The failure of inflation forecasts in 2021 has been repeatedly highlighted:
however, indirect effects stemming from the increase in the costs of production - mostly
due to unpredictable geopolitical factors that are outside the realm of economics -
explain almost entirely the upward surprises recorded on core inflation in the euro area
in the second half of the year.
The energy shock has also relevant consequences for aggregate demand in energy
importing economies, where it translates into a drag on domestic resources. In the euro
area, the deterioration of the terms of trade, mostly due to the rise of energy prices, has
reduced the purchasing power of domestic incomes (which includes all sectors of the
economy) by about 1 percentage point in 2021, and is expected to have an even larger
impact in 2022.
The repercussions of the energy shock are likely to be especially severe for households. In
the euro area, should gas and oil prices remain at the exceptionally high levels currently
implied by future contracts, the increase in consumer prices would cumulatively curtail
their disposable income by around 4 percentage points in 2021 and 2022. These losses
are asymmetrically distributed across families, hitting more heavily the less well-off who
typically devote a larger portion of their incomes to energy purchases.
The second key factor is related to the labour market. In the US the growth of nominal
wages (measured as average hourly earnings) amounted to more than 4 per cent last
summer, nearing 6 per cent in January 2022 (Figure 5). In the euro area, instead, the
increase in wages (as measured by negotiated wages, which tend to grow broadly in
line with actual earnings, but are much less volatile) still remains below 2 per cent.
The substantial slackening that we continue to observe in the intensive margin of labour
utilisation - in the third quarter of 2021 hours per worker were still almost 2 per cent
less than on the eve of the pandemic - and the low level of vacancy rates - which does
not suggest any potential signal of a mismatch between the supply and demand of
labour - have not pointed so far to the possibility of a worryingly persistent acceleration
of nominal wages. It goes without saying that this is a factor whose evolution will have
to be closely monitored.
The third factor concerns inflation expectations. In the US, longer-term expectations
(beyond five years) do not show clear signs of a de-anchoring, providing an encouraging
perspective on the possibility, for the Fed, of bringing actual inflation down without
implementing surprising and abrupt changes in the monetary stance, which could
trigger a recession (Figure 6). In the euro area, the process of the gradual re-anchoring
of longer-term expectations from the lows observed in the last few years is being
completed, even if a relatively large percentage of analysts continues to predict inflation
to be somewhat below our 2 per cent (symmetric) target in five years.
Given these developments - while in the US the Federal Open Market Committee
decided it wise to quickly reduce asset purchases and implemented an effective line
of communication aimed at preparing the public for the lift-off of the target range for
the federal funds rate - in the euro area a gradual normalisation of monetary policy
was deemed to be the most appropriate stance. From the evidence that I have briefly
summarised, I strongly believe that monetary policy in the euro area has not been
behind the curve.
Indeed, I would venture to say that the re-anchoring of inflation expectations, after a
rather long period during which the ECB has successfully countered material deflationary
risks, also bears witness to the success of the new monetary policy strategy completed in
July of last year. And there is certainly good reason to believe that, given wage prospects
and the state of expectations, headline inflation will progressively converge to 2 per cent
as the serious disturbances generated by the dramatic evolution of the Russia-Ukraine
war fade away.
The rise in energy prices (which has also been accompanied by price increases of other
commodities, most prominently food) is, in fact, a clear and unexpected supply-side
shock, one that may admittedly last for some time. In addition, as I have observed,
it is likely to have important negative effects on aggregate demand and, in turn, on the
medium-term inflation outlook. While both monetary and fiscal policy may, in principle,
counter the inflationary effects of energy costs, only the latter is able to directly influence
these costs, also offsetting the loss in disposable income - at least in part and to the extent
that it does not jeopardise debt sustainability - and limiting their impact on the economy.
That said, the main response to what is essentially a tax cannot come from monetary
policy, especially in the absence of a wage-price loop and with inflation expectations
re-anchoring to the central bank's objective.
However, these issues emphasise the importance of swiftly designing a strategy,
particularly at the European level, that, while in the short run helps to curb the unjustified
spike in energy prices, on a more structural basis takes into consideration the issue of
energy source diversification, energy storage and the identification of common resources
for managing energy crises. It is a challenge that, today, goes hand in hand with the one
posed by climate change and its resolution is essential also for avoiding uncontrolled
and dangerous increases in the relative prices of fossil fuels.
* * *
The Russian invasion of Ukraine implies some very important changes in the economic
outlook of the euro area and in the assessment of risks. Further increases of energy
prices will not only affect the short-term inflation outlook, but will also determine
significant headwinds to domestic demand, while the announced sanctions and the
sharp deterioration of Russia's economic conditions will weaken external demand and
cause potential risks to financial stability. Household and business confidence may be
strongly shaken. This would result in a worsening of the prospects for GDP growth
and, in turn, greater downside pressures to inflation in the medium-term, which could
follow the large price increases observed so far and, perhaps, still to come over the rest
of the year.
The ECB staff has made some new baseline projections available - which were discussed
by the Governing Council last week - built on the assumptions that disruptions to energy
supplies and impacts on confidence are only temporary, while global supply chains are
not significantly affected. Overall, GDP growth is projected to 3.7 per cent in 2022 and
2.8 per cent in 2023, a downward revision of, respectively, 0.5 and 0.1 percentage points
compared to December 2021. On the other hand, inflation is set to average 5.1 per cent
in 2022, increasing markedly since December, and 2.1 per cent in 2023.
The outlook has severely worsened since the cut-off date used in the projections. Looking
beyond the short-term volatility of oil and gas prices, whose fluctuations follow the unfolding
of the conflict and of diplomatic efforts, there are grounds to believe that these projections
are already outdated. It is clear that households will be hard hit by the energy (and food)
price shock, particularly those in the lower income brackets, with higher propensity to
consume and lower savings buffers. The situation of elevated uncertainty will affect the
less liquidity-constrained households, whose precautionary savings are likely to rise, in
line with historical regularities, negatively affecting consumption. The dramatic increase in
uncertainty also suggests that, in the current circumstances, focusing on scenarios analysis
is a more useful and wiser approach than relying on point projections.
The war also considerably increases the tail risks. Here I am primarily referring to the
worrying possibility of gas shortages pushing energy prices further up or forcing for
some time gas and electricity rationing, disrupting production. But market integration
and multilateral cooperation also risk being very much affected. What we are living
through is a profound, as well as dramatic, watershed, which may lead to economic
patterns that are now difficult to define.
In this respect, I believe that the public discussion that has followed the ECB Governing
Council's latest decision about the perceived prevalence of a hawkish tone lacks focus.
By acknowledging the situation of high Knightian uncertainty that we are facing we
decided that we could not commit our actions beyond the very short term. Even
proceeding along the path of gradual monetary policy normalisation, we chose to keep
all our options open, as it is clear that we are not yet in a position to fully assess the
economic implications of this unprecedented situation. On one hand, second-round
effects on nominal wages and longer-term inflation expectations have to be closely
monitored; on the other, the effects on real activity and incomes, and through them on
aggregate demand and price developments, obviously have to be taken into account.
Our contribution - and responsibility - in such difficult times is not to increase but
instead to reduce uncertainty. To this end, another aspect that plays a very important
role is the commitment that, within our mandate and under stressed conditions,
flexibility will remain an element of monetary policy whenever the emergence of threats
to the transmission mechanism of monetary policy jeopardises the attainment of price
stability. Indeed, guaranteeing a smooth functioning of financial markets and assessing
the implications of our decisions on financial conditions with great care are necessary
conditions for delivering on our medium-term price stability mandate.
Our decisions remain intertwined with those of the fiscal authorities. As I mentioned,
a supply-side shock should be tackled predominantly by fiscal policy which could
shield the economy by diminishing the transmission of price increases from energy to
consumer goods and limiting the loss in disposable income. The de facto coordination
between fiscal and monetary policy, which has worked well in the last two years to
counteract and contain the economic and financial consequences of the pandemic
crisis, is still necessary today. I believe that if fiscal policy is effective in attenuating the
impact on households and businesses of the incredible leap in energy prices and if
monetary policy proceeds with caution, absent the second-round effects that I already
mentioned, we will be able to successfully continue the gradual normalisation of our
monetary policy stance started at the end of last year.
This said, fiscal policies should remain focused on increasing growth potential, while
preserving the good health of public balances, two closely interconnected objectives.
The relevance of the former is magnified by the challenges that will characterise the next
decade, including the inevitable normalisation of the growth rate of the economy and of
short- and long-term interest rates as well as the ageing of the population. Regarding
the second objective, countries with high public debt will have to progressively improve
their primary balance.
Of course, an immediate end to the Russian aggression in Ukraine could quickly put an
end to the escalation of energy prices, bringing inflation down and helping us to put
the economy back on a growth path. In expressing solidarity with the Ukrainian people,
I believe I speak for everyone when I say that peace is the result we all hope for.
FIGURES

Figure 1
Real disposable income and GDP
(annual data; percentage changes)
United States Euro area
Source: US Bureau of Economic Analysis and Eurostat (real disposable income for the euro area in 2021 is estimated).
Figure 2
Demand in the goods and service sectors
a. United States
(monthly data; indices: Jan. 2020 = 100)
Goods sector Service sector
130 130 110 110
120 120
100 100
110 110
90 90
100 100
90 90
80 80
Jan-2019 Jan-2020 Jan-2021 Jan-2022 Jan-2019 Jan-2020 Jan-2021 Jan-2022
b. Euro area
(quarterly data; indices: 2019q4 = 100)
Goods sector Service sector
105 105 105 105
100 100
100 100
95 95
90 90
95 95
85 85
80 80
90 90
2019q1 2019q3 2020q1 2020q3 2021q1 2021q3 2019q1 2019q3 2020q1 2020q3 2021q1 2021q3
Source: US Bureau of Economic Analysis and estimates based on Eurostat data.
Note: dashed lines show pre-pandemic trends.
Figure 3
Contributions to consumer price index inflation
(monthly data; percentage changes and percentage points; year-on-year growth)
United States Euro area
Source: US Bureau of Labor Statistics and Eurostat.
Figure 4
Gas prices
(daily data)
250 250
200 200
150 150
100 100
50 50
0 0
01jan2020 01jul2020 01jan2021 01jul2021 01jan2022
Figure 5
Wages
(monthly data; percentage changes; year-on-year growth)
8 8
6 6
4 4
2 2
0 0
2015 2016 2017 2018 2019 2020 2021 2022
Euro area negotiated wages US average hourly earnings
Source: US Bureau of Labor Statistics and ECB.
Figure 6
Longer-term inflation expectations
(per cent of respondents)
United States Euro area
median
median
20 20
30 30
15 15
20 20
10 10
10 10
5 5
0 0
0 0
1 1.5 2 2.5 3
1 1.5 2 2.5 3
Source: Survey of Professional Forecasters, Federal Reserve Bank of Philadelphia, February 2022; Survey of Professional
Forecasters, ECB, February 2022; euro area data exclude one outlier.
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