Monetary policy and inflation: recent developments*
Ignazio Visco
Governor of the Bank of Italy
September 2022
In the last year or so, inflation has been sparked almost everywhere by the exceptional
increases in the prices of energy commodities. However, the ways in which these increases
have taken place and their relative weight with respect to other factors differ widely
across countries, in particular when comparing the United States and the euro area.
- The most important difference between the two economies probably concerns
the fiscal response to the pandemic crisis in 2020-21. Although many countries
took budgetary measures on a massive scale to strengthen their health systems
and support households and businesses, the measures introduced by the US
Administration were exceptionally strong. Over those two years, the debt-to-GDP
ratio rose by almost 25 percentage points, to over 130 per cent, against an average
increase of less than 15 points in euro-area countries, to around 95 per cent.
The support given in the United States had an astonishing effect on households'
disposable income, which, in 2020, recorded its highest rate of growth since the
mid-1980s, with a 6.2 per cent increase in real terms, against a drop in GDP of 3.4
per cent. In the euro area, instead, household disposable income fell, by 0.6 per
cent, though to a much lesser extent than the decline in GDP (6.4 per cent). The
inflationary effects of the ensuing overheating of the US economy were amplified
by the still partial recovery of global supply due to the recurring pandemic waves,
contributing to the creation of bottlenecks in the international supply chains of
intermediate goods, with adverse effects on production in many countries.
- A related striking difference concerns the state of the labour market. In the United
States, the unemployment rate was just 3.7 per cent last month, almost 3 percentage
points less than in the euro area in July. The job openings rate (the number of job
openings divided by the sum of employment and job openings) was as high as 7 per
cent in the United States (in July), twice the level recorded in the euro area (in the
second quarter).1 As it turns out, in the United States there are two job openings for
each unemployed person, while in the euro area two unemployed persons compete
for less than one opening. As a result, all the main indicators (employment cost
index, average hourly earnings and the Atlanta Fed's wage growth tracker) suggest
a wage growth close to or above 5 per cent (on a yearly basis) in the United States,
a level that is difficult to reconcile with a 2 per cent inflation target. In the euro area,
on the other hand, contractual earnings have so far continued to increase at a pace
of around 2 per cent.
- In the United States, the greater impact of these demand factors has been
accompanied by a lower contribution of supply factors. As in the euro area, oil
prices are 20 per cent higher than a year ago. Over the same period, however, gas
prices have increased by an astonishing 150 per cent in the euro area to around
€200 per megawatt hour, a level at which they have been hovering, with very wide
oscillations, since mid-June, against 50 per cent in the United States, to less than $30
per megawatt hour (Figure 1). This is particularly worrying because gas plays a key
role not only in heating and other domestic uses but also in producing electricity.
These differences notwithstanding, headline inflation recorded similar dynamics in the
two economies and progressively increased to above 8 per cent both in the United States
and in the euro area. However, the trend of core inflation (which excludes food and
energy products) was different. In the United States it went above 6 per cent at the
beginning of this year and was still 6.3 per cent in August, while in the euro area it was
only slightly above 2 per cent at the start of the year and, in August, its level was still 2
percentage points lower than in the United States (Figure 2).
The differences in the relative weight of demand factors and in the dynamics of core
inflation explain why, in the face of headline inflation reaching similar values, monetary
policy normalisation has proceeded with different timing and speed in the two economies.
These differences also suggest that assuming that the ECB will follow the Fed blindly in
the coming months could be a serious misjudgement.
In emphasising the supposed mistake made by the ECB in delaying the change in its
monetary policy stance, many commentators have pointed to some errors in inflation
projections. While in mid-2021 headline inflation was still below 2 per cent and core
inflation was less than 1 per cent, since late last year, inflation has been unexpectedly
high in the euro area. In particular, the forecast errors in consumer price growth made by
the ECB and Eurosystem staff during the first two quarters of 2022 (Figure 3) have been
much larger than those observed in the past (more recently mostly of the opposite sign).2
Some have even argued that these very large errors call into question the credibility of
central banks,3 even though other international institutions and private forecasters have
made similarly large mistakes.
The observed size of the errors may cast doubt on the reliability of the models used
for the projections, resulting in a calling for the use of less formal frameworks and
more judgmental assessments (although all forecasting models include judgmental
factors). We must not forget that econometric models are nothing more than simplified
approximations of reality. They cannot mechanically take into account all specific
non-linearities in financial or commodity markets or regime changes in behaviours
resulting from health or geopolitical shocks. When defining economic policy measures,
they should therefore be used carefully, integrating them with external information and
qualitative assessments. However, while they can be subject to continuous checks and
improvements as well as better used, we cannot dispose of them, as they are especially
useful for a disciplined organisation of the evaluations on which policy measures are
based.4 This said, our analyses indicate that the effects of energy prices - the most
important exogenous variables, whose changes are inferred from the quotes of futures
contracts - explain, directly and indirectly (i.e. via their effects on production costs), 65
per cent of the overall error made in forecasting inflation. This share rises to 80 per cent
when the effects of food prices, the other volatile component of the harmonised index of
consumer prices, are also taken into account.5
These results suggest that the functioning of the economy has not changed dramatically
in the last year or so and that the framework used for projections remains valid overall.
They do draw our attention, however, to the quality of the forecasts used as inputs. A
key problem has been a generalised underestimation of geopolitical tensions, with the
sharp drop in gas supplies from Russia observed since early last year, attributed first (and
probably mistakenly) to the effects of a particularly cold winter and then to pressures by
the Russian Government in connection with the Nord Stream 2 pipeline. But the most
important factor has, of course, been the Russian invasion of Ukraine: while the quotes
of futures had continued to factor in descending oil and gas prices up to the end of last
year, the conflict has pushed not only current but also expected prices to extremely high
levels.
Gas prices provide a significant example. At the end of September 2021, when the spot
price of gas had risen to €100 per megawatt hour, the quotes of futures had predicted a
decline to well below €50 by June 2022. As it turned out, instead of declining by more than
50 per cent, gas prices increased by almost 100 per cent, averaging, as already pointed
out, at about €200 since the second half of June. In general, while the repercussions
of rising energy prices on inflation were considered as temporary before the outbreak
of war, owing to the expectations of base effects soon turning negative, they instead
became persistent. These considerations are emblematic of the difficulties in predicting
macroeconomic variables, particularly when driven by non-economic phenomena, like
mounting geopolitical tensions. We will have to take this into account if and when,
symmetrically, a tendency to make forecast errors of the opposite sign emerges due to
the attenuation of these tensions, hopefully in a short time but unfortunately still very
uncertain today.
Given the information available, the claims that the Governing Council of the ECB
has wrongly delayed the re-balancing of its monetary policy appear unjustified. The
normalisation of the monetary stance has been under way since last December when,
against the background of an improvement in the economic outlook and the rise of
medium-term inflation expectations towards the price stability target, the Governing
Council announced the start of the reduction of net purchases under its quantitative
easing programmes. In the early part of this year, the process gained speed, avoiding,
however, potentially dangerous cliff-effects of too sharp a drop, and was completed on
the 1st of July. A few weeks later, we started raising the key official rates by a significant
size (50 basis points in July and 75 in September), aimed at frontloading the exit from
their highly accommodative levels.
This radical change in monetary stance mirrors a corresponding sharp change in the
economic and inflationary outlook. First, the pandemic fears that drove the economy
into recession - not only in Europe - and reduced inflation temporarily to below zero
have been overcome. Thanks to the non-conventional monetary policies adopted by the
Governing Council, especially its quantitative easing programmes, the risks of deflation
have thus dissipated. Moreover, the euro area has been hit by an energy shock of
extraordinary magnitude, far greater than the oil price shocks that hit the world economy
in the 1970s. The ensuing marked rise in actual inflation cannot be ignored by the central
bank: the risk that it could cause an increase in inflation expectations and in turn lead to
a futile and damaging spiral between prices and wages should be countered decisively.
It is therefore crucial, at this stage, to carefully monitor inflation expectations and the
dynamics of wages and profits. Indicators of future inflation measured on the basis of
inflation-linked swaps continue to suggest that price dynamics will remain elevated in the
near future, at around 5 per cent in mid-2023, and then decline rapidly and persistently
to levels just above the 2 per cent target (Figure 4).6 As inflation risk premia are currently
estimated to be slightly above zero, the actual medium-term inflation expectations implicit
in swap rates could, substantially, be in line to our target. Survey-based expectations
provide a broadly similar picture. According to the median respondent in the ECB Survey
of Monetary Analysts conducted in late August, inflation is expected to stand at 4.4 per
cent, on average, in 2023 and at 2.1 per cent in 2024.
At the same time, the median household participating in the ECB Consumers Expectations
Surveys foresees inflation at 5 per cent in the next 12 months and at 3 per cent at 3-year
horizon. This latter level stands somewhat above those of market participants and
economic experts, possibly reflecting a greater relevance of backward-looking elements
in the expectation formation mechanism of households. A more granular analysis shows
that the upward revision of inflation expectation (over all horizons) has been more intense
for less affluent households. The share of the most volatile inflation components, namely
energy and food items, in these households' consumption basket is, however, much
higher and may lead them to revise their expectations more frequently and significantly.
In other words, the observed rise in expectation from household surveys may simply
mirror what is happening in the energy and food sectors, and may therefore be reversed
as soon as pressures on the price of these items diminish.
Moving on to wages, even though requests have been made in some countries for
increases greater than those recorded in recent years, their growth in the euro area
remains, as already mentioned, around 2 per cent (net of one-off components). In
addition, the ECB forward-looking wage tracker points to a very gradual acceleration of
wages in the last part of 2022 and in 2023 (Figure 5), although some tension may arise in
countries where wages (especially minimum wages) react almost mechanically to actual
inflation.
My reading of these data makes me confident that, at the moment, there is no evidence
that medium-term expectations are drifting away from the price stability objective, nor
are there signs of pernicious spirals between prices and wages. Indeed, the high level
of inflation expectations in the coming quarters, reflecting the standard price growth
inertia and the persistence of energy prices at very high levels, rapidly declines in the
subsequent years, in line with the Eurosystem/ECB's projections as well as most others.7
Should energy prices prove to be higher than what is currently projected, their negative
demand effects via purchasing-power and wealth losses would probably contribute to
curbing actual and expected inflation and, in turn, wage requests.
In any case, we pay close attention not only to the current levels of price and wage
expectations, but also to their prospective dynamics. An assessment of the risk of a
de-anchoring of expectations from the inflation target based merely on their current
level could, in fact, be dangerous.8 Since a de-anchoring could occur abruptly and
non-linearly, expectations must be assessed both in terms of their convergence towards
the price stability objective as well as their responsiveness to shocks and their dispersion.
From this perspective, the evidence is less clear. On one hand, expectations from market
data and surveys continue to show a relatively low sensitivity to inflation surprises. On
the other hand, in many surveys the distributions of expected inflation tend to be skewed
towards high inflation and show an increase in uncertainty, suggesting a greater, though
still moderate today, risk of a sharp upward shift of the entire distribution.9 Although
these features of expected inflation could be a mere consequence of the repeated
upward surprises in actual inflation related to the unforeseen persistence of the energy
shock, these developments need to be monitored carefully. However, the fact that the
"expectations curve" is downward sloping is reassuring for anchoring, as medium to
long-term inflation expectations remain well below current inflation levels.
While the normalisation of monetary policy should continue with the aim of gradually
reabsorbing the ample accommodation created since 2014, the Governing Council is
currently faced with a difficult dilemma. Rising inflation is now being accompanied by a
sudden deterioration in the economic growth outlook, reflecting the loss of purchasing
power of incomes (Figure 6). In this context, excessively rapid and pronounced rate hikes
would end up increasing the risk of a recession. Moreover, should the deterioration of the
economic outlook turn out to be worse than expected, an excessive front-loading in the
normalisation of key rates could ex post result disproportionate, something that could
seriously undermine public confidence in our ability to make well-considered decisions
and that would paradoxically make it more difficult to maintain price stability over the
medium term. This is a risk that deserves to be considered carefully, along with that of
letting inflation remain excessively high for too long.
A further concern is related to risks to financial stability. In the current context, these risks
are amplified by the rapidly deteriorating economic environment, both in the euro area
and beyond. Moreover, the marked rises in official rates being announced by all major
central banks may create spillover effects that are difficult to quantify but are likely not
to be negligible.10 The risk of financial instability is particularly relevant in the Economic
and Monetary Union, whose incomplete architecture - especially its decentralised fiscal
policy and the delays in completing the banking and the capital markets unions - exposes
it to a possible fragmentation of financial markets along national borders. If this risk were
to materialise, we would see severe repercussions in all euro area countries, leading to a
tightening of financing conditions well beyond what is deemed appropriate for curbing
high inflation. For this reason, the Governing Council is ready to continue to exploit the
flexibility in its asset purchase programme related to the pandemic emergency and to
resort to its new Transmission Protection Instrument, to prevent financial markets tensions
from counteracting any progress made in price stability and hindering economic growth.
The uncertainty surrounding the economic and inflation outlook makes it very difficult
to predetermine the possible terminal point of official rates. One shortcut that is often
considered is based on the so-called natural rate of interest (usually referred to as r
star).11 This is, in the Wicksellian definition, the level of the real interest rate at which
investment equals savings, and the economy's resources are fully employed; if prices
were fully flexible, at this rate inflation would be equal to its target.12
This is therefore an equilibrium concept that provides an extremely simplified description
of the functioning of the economy and of monetary policy. For example, the credibility
of the central bank is irrelevant in this framework, as are the level of uncertainty and
inflation expectations, as well as the stance of fiscal policy or the debt-to-GDP ratio.
Furthermore, taking into account the dynamics of the process that leads to the longer-term
equilibrium is a crucial challenge. Finally, to further complicate matters, the natural rate
is unobservable and a wide variety of methods to estimate it provides a large range of
different results.13
In some speeches delivered earlier this year, for example, members of the Governing
Council of the ECB estimated r star in a range between below -2 per cent and slightly
above 0 per cent.14 An update of those estimates would now place its level in a range
between -1.3 and -0.2 per cent.15 By adding to those values the inflation target of 2
per cent, it follows that the "neutral" policy rate (the one at which, in the medium-term
equilibrium, monetary policy is supposed to be neither accommodative nor restrictive)
would be in a range between 0.7 and 1.8 per cent and could already have been achieved
(or be close to being achieved) by the ECB with its latest rate hike (or the ones that will
soon be taking place). But it is clear that there is no close relationship between this rate
and the level to be achieved to ensure inflation expectations consistent with maintaining
the target of an average inflation around 2 percent over the medium term.
How much, then, should we further raise official rates? Two further problems affect this
decision.
- First, a high level of uncertainty also surrounds the extent to which current inflation
can be curbed by the central bank. Rate hikes, in particular, would not affect the part
determined, directly and indirectly, by the energy shock, which is overwhelming.
In addition, it is difficult to say ex ante what terminal level of official rates would
reassure households and businesses about the determination of the central bank to
reducing inflation, thus minimising the risks of a de-anchoring of expectations and
preventing the emergence of spirals between prices and wages.
- Second, high uncertainty also influences the distribution over time of the effects of
rate hikes on inflation and growth. Putting together the econometric evidence we
have, in the euro area a rate hike exerts its largest effect on inflation after one or two
years; however, it also has its largest impact on GDP growth after about a year and
a half. In the current juncture, this suggests that any rate hikes we implement now
are likely to have their largest effect on inflation when the economy has already
slowed down significantly, running the risk of triggering or exacerbating a recession
and, assuming that energy prices continue to be the main driver of consumer price
growth, without having had a previous visible effect on inflation.
Even if long-term inflation expectations are still anchored and wage growth remains
moderate, the high level of inflation and the need to increase the extremely low values
achieved by short-term interest rates in real terms require policy rates to continue to rise.
The high uncertainty surrounding the economic prospects, however, suggests prudence
in setting the "pace" of the rate hikes and strongly advises against committing to a
pre-determined terminal point for official rates.
Our future decisions will therefore continue to follow a meeting-by-meeting approach
and will be data-dependent - meaning, however, that they will not simply be dependent
on current data, but will instead continue to assume a forward-looking orientation,
based on the economic perspectives of the euro area as a whole, over the medium-term.
As in other tightening cycles, we will have to discover the terminal rate by proceeding
gradually. This does not mean that quantitative assessments cannot be made, based on
the experience accumulated to date; on the contrary, they would be certainly useful for
estimating the effects of rate increases on aggregate demand and changes in the costs
and prices of goods and services.16 However, we will have to take these assessments into
account together with the information that will gradually become available on inflation
expectations and on the evolution of labour income and profits. In any case, today I do
not see any obvious reason to tie our hands with hypotheses of extraordinarily high
increases, such as those that can be sometimes read, in some cases extrapolating the
more recent decisions or the experience of other countries.
* * *
To conclude, since the introduction of the euro, we have always shown our willingness
to invest greatly in the analytical capacity of the ECB and the national central banks of
the euro area, as well as the readiness to adjust our tools to account for all the factors
affecting the pursuit of price stability preservation. Today, the main threat to this objective
comes from the energy shock, mostly a consequence of the conflict in Ukraine, which has
sparked an exceptional rise in inflation, not only within the euro area.
It has recently been argued that high inflation and repeated errors in our projection
exercises have called into question our credibility. However, public confidence in our
determination to maintain price stability is not measured by the level of current inflation,
which is mainly caused in the euro area by the unprecedented energy shock. Nor is
it determined by the forecasting errors, which do not signal a major failure of the
quantitative models used in the Eurosystem, but instead are the result of the intrinsic
unpredictability of geopolitical tensions lying outside the economic realm. Our credibility
is measured, rather, by the anchoring of medium-term inflation expectations,17 a key
factor that also helps to prevent the triggering of dangerous price-wage spirals.
High inflation warrants continuing the normalisation of monetary conditions, but at a
pace and to a level that will have to be determined meeting-by-meeting, based on the
flow of new data and on updated perspectives. Worrying signals, however, come from
the sharp deterioration in the economic growth outlook, whose ultimate cause is still the
energy shock and its consequences on the purchasing power of incomes and on firm
profits.
Ensuring the containment of the effects of this shock will require not only an incisive and
appropriate response from monetary policy, but also the shouldering of responsibility
on both sides of the labour market and the contribution of budgetary policy. It must be
understood that, as it was with the oil shocks of the 1970s, the current energy shock is an
unavoidable burden for the euro area as a whole, and especially for the countries most
affected, such as Italy undoubtedly is.
Any attempt to completely counteract its impact on the incomes of labour and capital
would be in vain and would inevitably end up having negative repercussions on inflation.
To prevent this outcome, budgetary policy can redistribute the effects of the shock
between consumers, production factors, present and future generations, with targeted
and temporary interventions in support of the households and businesses most affected.
The redistributive and allocative consequences of what happens on the energy front, in
fact, cannot be ignored. If, however, it were to be decided that the redistribution should
weigh most heavily on future generations by issuing public debt, we would run the risk
of loading them with unfair burdens and of further fuelling both current and expected
inflation. For Italy, this would also entail the risk of derailing public debt (as a share of
GDP) from its current descending path - a path that is necessary for preserving the
possibility of a swift return to strong and durable economic growth.
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FIGURES
Figure 1
Gas prices
350 350
300 300
250 250
Europe (euro)
200 200
150 150
100 100
50 50
0 0
United States (dollars)
2020 2020 2020 2021 2021 2022
Source: Refinitiv. Note: Title Transfer Facility (TTF) quotations for European gas and Henry Hub for US gas; latest
observations: 29 September 2022.
Figure 2
Headline and core inflation in the euro area and in the United States
10 10 10 10
euro area United States
8 8 8 8
headline
6 headline 6 6 6
4 4 4 4
core
2 2 2 2
core
0 0 0 0
-2 -2 -2 -2
Figure 3
ECB/Eurosystem projections errors for euro area headline inflation
(percentage points; 4 quarters ahead projection errors)
8 8
6 6
4 4
2 2
0 0
-2 -2
-4 -4
2003 2006 2009 2012 2015 2018 2021
Note: dashed lines denote an interval around zero of plus/minus two standard deviations of projection errors realized in
2003-2020; latest observation: 2022 Q2.
Figure 4
Market-based inflation expectations
(per cent; inflation swap rates)
5.5 5.5
5 5
4.5 4.5
4 4
3.5 3.5
3 3
2.5 2.5
2 2
1.5 1.5
spot 1 2 3 4 5 6 7 8 9
years ahead
Source: based on Refinitv. Note: spot and forward one-year rates implicit in inflation swaps, relative to the horizons
shown on the x-axis; based on the quotations of 29 September 2022.
Figure 5
Euro area forward-looking wage tracker
(annual percentage change)
Percentage share of workers covered by agreements that have not
Signed in 22Q1
expired (right side)
Percentage share of workers covered by new agreements signed
Signed in 22Q2
that have not expired (right side)
Forward-looking wage tracker
Signed in 22Q3
Wage tracker
Weighted average of
agreements
Weighted average of agreements signed in 2022
3.5
4 100
3.0
3 75
2.5
2.0
2 50
1.5
1.0
1 25
0.5
0 0 0.0
2020 2021 2022 2023
2022 2023
Source: P. Lane, Cantillon Lecture, 45th DEW Annual Economic Policy Conference, 17 September 2022. Note: euro area
aggregate based on Germany, Italy, the Netherlands and Spain. Calculations based on micro data on wage agreements
provided by Bundesbank, Bank of Italy, the Dutch employer association (AWVN) and Bank of Spain.
Figure 6
Recent evolution of expected GDP growth in 2023
(annual percentage growth)
2.5 2.5
2 2
United States
1.5 1.5
euro area
1 1
.5 .5
0 United Kingdom 0
-.5 -.5
Jan-22 Apr-22 Jul-22 Oct-22
Source: Consensus Economics. Note: expected GDP growth in the monthly issues of Consensus Forecasts since the
beginning of 2022; latest observation: September 2022.