Klaas Knot: Inflation strikes back - drivers and policy reactions
Speech by Mr Klaas Knot, President of the Netherlands Bank, at the 25th Annual DNB
Research Conference "Inflation strikes back: drivers and policy reactions", Amsterdam,
10 November 2022.
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Welcome everyone!
This is a sight for sore eyes: a whole room full of real-life delegates!
A posse of bankers, a pride of economists, a pack of scientists. Or whatever the proper
collective noun would be for a gathering like this-I only know we are a collective.
Because we share an interest, a passion, a purpose: we are interested in economic
developments.
My interest in economics was triggered by the great inflation of the 1970s. I remember
my parents' distress about exploding mortgage costs, the fuel coupons, the empty
roads on Sundays, our concerned prime minister on television warning us that nothing
would ever be the same again-
And I wondered: how on earth could this happen? And, what could be done?
How can we prevent this from happening again? So I studied economics, I worked in
public policy, I became a central banker. And I learned that economics is not a
selfcontained science, there is never one right answer that stays right forever, like in a hard
science such as mathematics.
As John Maynard Keynes one said: "The master-economist must possess a rare
combination of gifts. He must reach a high standard in several different directions and
must combine talents not often found together. He must be mathematician, historian,
statesman, philosopher - in some degree. He must contemplate the particular in terms
of the general, and touch abstract and concrete in the same flight of thought. "
That is our challenge: to come up with different ideas, combining different talents and
different perspectives, in response to the problems of our times. With a big advantage
of our time: economists are not only 'he' anymore-
Coming up with ideas, that is what we, what you, will do during this conference.
In answer to the problem of today, because inflation is back. With a vengeance.
Last October HICP inflation reached 10.7 percent, with some heterogeneity among euro
area countries. Here in the Netherlands we are experiencing a 16.8 annual percentage
change in the overall level of prices. Like in the 1970s, the current high inflation is
rooted in energy price shocks, this time as a result of the war in Ukraine. However,
recent analyses show that supply factors alone cannot explain the very high figures we
are observing today. Core inflation is also on the rise, having reached 5.0 percent in
October.
Intuitively, both the slow recovery from supply chain bottlenecks and the extraordinary
increases in energy prices have a negative impact on the real economy. So if they were
the only drivers of the current high inflation, we would have seen a drop in production in
the first half of the year. But we do not find this drop in the data, suggesting that
demand factors must also play a role. The question is: which factors in particular?
Let me suggest a couple of candidates: the relaxation of COVID restrictions and the
fiscal policy of our governments. A fiscal policy that boosted demand in the aftermath of
the pandemic, designed to counteract the negative effects of the lockdowns.
A fiscal policy that is now being called upon to compensate our energy bills. That
question - how much of the current inflation can be attributed to fiscal measures - is a
topic of this morning's discussion.
This interaction between monetary and fiscal policy is just one aspect of the complexity
of the policy reaction to the current situation. Because that's what it is: very complex. As
I said: in economics, in monetary policy, there is never one answer. Conducting
monetary policy requires a deep understanding of the drivers of inflation.
And that understanding is constantly tested by reality. By events.
According to British Prime Minister Harold McMillan, this is the greatest challenge for a
statesman. And the greatest challenge for an economist and a central banker.
After the 1970s we enjoyed a long period of stable prices: inflation was under control
and we thought we had that deep understanding of its drivers and dynamics. Then the
financial crisis challenged our confidence, followed by a period of persistently low
inflation, and now we have been surprised again. By the persistence of inflation
dynamics, and skyrocketing prices. Price dynamics are more complex than we thought:
events are wreaking havoc on our numbers, our models, our data.
We see that the models we use in our analyses very often struggle to capture the
persistence of inflation dynamics in a satisfactory way. Is it possible that the economy is
becoming more vulnerable to systemic shocks? Are the after-effects of these shocks
more persistent than we expected? Do we underestimate the longer term impact of
supply-driven shocks? It is obvious that the structure of the economy today is different
than it was fifteen, let alone fifty, years ago, so it is possible that the transmission
mechanism of inflation shocks might be different. The question is: does this uncertainty
imply that policy-makers should react strongly to these kind of shocks? Act faster,
intervene earlier to avoid the dangerous fall-out of inflation?
Of course there is one big difference between inflation now and in the 1970s: we now
have the euro, a crucial pillar of financial stability that stands between us and a
currency crisis.
The challenge is clear: if we want to understand the recent developments of price
changes, if we want to understand and fight inflation, we need to understand and
pinpoint the transmission mechanisms of inflation shocks. During this conference, the
discussion will touch on essential topics like the role of heterogeneity in sectors, the
implication of firms dynamics, the amplification effects that derive from uncertainty.
The following questions are also on our research agenda at DNB: how can we enhance
our understanding of inflation expectations, of how they are formed, and how they
evolve over time? The answers to these questions are crucial. As Keynes also said
when he described the tasks of the economist: "He must study the present in the light of
the past for the purposes of the future ."
Also on our agenda, and also crucial for 'the purpose of the future' is the role of long-run
trends and the normative implications that arise from low or even negative natural rates.
Yes, there is work to be done. We must 'study the present' to understand the normative
implications and to guide the practical implementation of monetary policy.
And although fighting inflation - in Europe and the US - is our common goal, let's not
forget that there are differences in the economic developments in our countries and on
our continents. Differences that justify some diversity in the policy reaction of the
different authorities: a very interesting topic to be discussed in the policy panel later
today.
You may have heard the saying: Ask five economist a question, and you get five
different answers - six if one went to Harvard...
The fact that we do not always agree is often used against us. It is also used as a
reason to doubt that economics is a real science. But what some people see as our
weakness, I consider a strength of social sciences. Yes, we have different opinions, we
have debates and discussions, but that is part of the challenge. As Keynes concluded
his description of the tasks of economists: "No part of man's nature or his institutions
must lie entirely outside his regard. He must be purposeful and disinterested in a
simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the
earth as a politician.
"
Yes, economics is not only a science, but an art. The art of thinking outside the box, the
art of finding solutions. Of finding new ideas to face up to today's economic problems,
to fight inflation. I wish you two very artistic days!