Luis de Guindos: The inflation outlook and monetary policy in the
euro area
Keynote speech by Mr Luis de Guindos, Vice-President of the European Central
Bank, at the First Annual Conference, organised by the Central Bank of Cyprus,
Limassol, 4 October 2023.
* * *
Introduction
I will start by giving you an overview of the economic outlook for the euro area before
going on to look at how the ECB has adjusted its monetary policy to this outlook. I will
then discuss in more detail the transmission of our monetary policy in the current
environment and the sources of uncertainty that appear particularly relevant at this
stage.
The outlook for inflation and growth in the euro area
Economic activity broadly stagnated over the first half of the year and is likely to remain
subdued in the coming months. Weaker foreign demand and tight financing conditions
are dampening growth, especially in the manufacturing sector. The services sector,
which had been resilient so far, is now starting to "catch down" to manufacturing.
The labour market remains resilient despite the slowdown in activity, with the
unemployment rate standing at its historical low of 6.4 per cent in August. However,
there are signs that labour market momentum is slowing as the economy weakens. The
employment Purchasing Managers' Index declined significantly between the second
and the third quarters of 2023, despite a slight uptick in September. The services
sector, which has been a major driver of employment growth since mid-2022, is now
also creating fewer jobs.
In September ECB staff revised down projected GDP growth, particularly for this year
and next, due to a greater contractionary effect from tightening financing conditions and
the weakening international trade environment. Beyond the near term, ECB staff expect
growth to recover owing to higher real disposable income thanks to rising wages and
falling inflation, which is set to underpin spending. ECB staff now expect the euro area
economy to expand by 0.7% in 2023, 1.0% in 2024 and 1.5% in 2025.
Inflation fell markedly from its double-digit peak last October, with the headline rate
having declined to 4.3% in September (flash estimate). In the coming months, the sharp
increases recorded in the autumn of 2022 will drop out of the yearly rates, lending
further support to a deceleration in inflation. At the same time, underlying price
pressures remain strong, although most measures of inflation have started to ease
thanks to aggregate demand and supply becoming more aligned and lower energy
prices in recent months being passed on to other parts of the economy. Labour costs
are increasingly contributing to domestic inflation, while the latest data indicate that the
contribution of profits fell for the first time since early 2022. Most measures of
longerterm inflation expectations currently stand at around 2%, but the increase in some
indicators needs to be closely monitored.
The September ECB staff macroeconomic projections see average inflation at 5.6% in
2023, 3.2% in 2024 and 2.1% in 2025. Compared with the June Eurosystem staff
projections, this is an upward revision for 2023 and 2024 - which mainly reflects a
higher projected path for energy prices - and a downward revision for 2025. ECB staff
have revised down slightly the projected path for inflation excluding energy and food, to
an average of 5.1% in 2023, 2.9% in 2024 and 2.2% in 2025. This is on account of
tighter financing conditions - which also reflect the restrictive impact of our monetary
policy tightening - and a weaker economic outlook.
The ECB's monetary policy response
In summary, while inflation continues to decline, it is still expected to remain too high for
too long. The ECB is determined to ensure that inflation returns to our 2% medium-term
target in a timely manner. In order to reinforce progress towards this target, we decided
to raise the three key ECB interest rates by 25 basis points at the September meeting
of the Governing Council. This decision was informed by the three legs of our reaction
function: first, the inflation outlook in light of the incoming economic and financial data;
second, the dynamics of underlying inflation; and third, the strength of monetary policy
transmission. Having raised interest rates by a total of 450 basis points since July 2022,
we consider that the key ECB interest rates have now reached levels that, maintained
for a sufficiently long duration, will make a substantial contribution to the timely return of
inflation to our target. Our reaction function will continue to serve as the framework for
future decisions, and we will continue to follow a data-dependent approach to
determining the appropriate level and duration of a restrictive monetary policy stance.
Uncertainty regarding the transmission of monetary policy
As part of this data-dependent approach, we continually assess how monetary policy is
transmitted to financing conditions, the real economy and, ultimately, to inflation. In the
current hiking cycle, the first leg of monetary policy transmission - to financing
conditions - has been very strong. Compared with previous hiking cycles, firms' lending
rates have increased at a faster pace and credit volumes have weakened more
markedly. Transmission to the bank lending channel is likely to continue unfolding as
lenders may become more prudent in light of rising funding costs and a slowing
economy. Moreover, interest rates on outstanding debt will continue to increase as
loans are progressively repriced. All in all, in my view, the transmission of our policy
tightening to financing conditions seems to be well underway.
The second leg of transmission relates to the way in which changes in financing
conditions will affect economic activity, as firms and households adjust their plans for
consumption, investment and savings accordingly. The transmission of monetary policy
tightening to the real economy is proceeding at a slower pace, with a substantial share
of the transmission still in the pipeline. For example, real estate activity has slowed
down amid the weakening of property valuations. For the economy as a whole,
modelbased estimates continue to suggest that, owing to the typical lags in monetary
transmission, the bulk of the impact of our tightening is expected to materialise only in
the course of this year and thereafter. The downward impact of our tightening so far on
GDP and inflation is estimated to average around 2 percentage points over the 2023-25
period, with the strongest effect expected on GDP growth this year and on inflation over
the next two years.
It is also worth noting that the speed of transmission varies across the euro area. In
particular, the transmission to households is likely to be faster in countries where
variable rate mortgages predominate over mortgages at fixed rate.
At the same time, uncertainties regarding transmission remain, mainly in relation to two
sources. First, the current hiking cycle is unprecedented in speed. Moreover, it follows a
long period of accommodative monetary policy and was accompanied by the
recalibration of balance sheet policies, all of which limits comparability with historical
regularities. Second, the tightening of our policy stance occurred in reaction to an
unprecedented constellation of shocks hitting the euro area over the last three years,
which had a disruptive effect on economic conditions and the inflation environment. The
fact that we are still confronted with the overlapping legacy effects of these shocks may
imply that monetary policy transmission is proceeding differently this time around
compared with what historical regularities might suggest.
The euro area and the world economy are also exposed to a variety of risks that
accompany this monetary policy tightening. Based on our latest assessment, risks to
economic growth in the euro area are tilted to the downside. Growth could be slower if
the effects of monetary policy are more forceful than expected or if the world economy
weakens at a faster pace than currently projected, owing, for example, to a continued
slowdown in China. This may, in turn, dampen domestic economic activity and
encourage firms, banks and households to be more cautious, thereby putting a strain
on bank credit supply, investment and consumer spending. The tightening impulse may
be transmitted more forcefully to the real economy in an environment of this kind owing
to acceleration effects that often operate during periods of subdued growth and high
2
uncertainty. Conversely, growth could be higher than projected if the strong labour
market, rising real incomes and receding uncertainty mean that people and businesses
become more confident and spend more.
On the inflation side, weaker demand owing to the stronger transmission of monetary
policy or the worsening of the international economic environment could put stronger
downward pressure on prices than currently expected. Conversely, renewed upward
pressures on the costs of energy and food - with oil prices having already increased in
recent months - and the unfolding climate crisis could push commodity prices up by
more than expected. The role of wage dynamics and fiscal policy are of great
importance in determining the future path of inflation. Wages have been catching up;
elevated wage growth is therefore embedded in our projections, albeit at a decelerating
pace. But a lasting increase in inflation expectations above our target owing, for
instance, to higher-than-anticipated increases in wages or profit margins, could drive
inflation higher, including over the medium term. Similarly, as the energy crisis fades,
governments are rolling back the fiscal support measures implemented during the
crisis. But a slower rollback of this fiscal support or an expansionary fiscal policy stance
in the coming years would pose significant challenges to taming inflation and bringing it
back to our target. The challenging macroeconomic environment requires a consistent
mix of monetary and fiscal policies, with greater risks to price stability if these policies
pull in opposite directions.
Conclusion
To conclude, while we can be sure that our monetary policy tightening is transmitted
forcefully to financial markets and is increasingly leaving a footprint in the real economy,
the speed and scope of the transmission remain uncertain. This is partly due to the
stillfluid economic environment in which we are navigating, with the outlook for inflation and
economic activity being rendered particularly uncertain owing to both the legacy effects
of previous shocks and renewed risks. In addition, the current hiking cycle is unique,
with the sequence of rate hikes being unprecedented in speed.
Taking a longer-term view, structural changes in economic interactions may also exert
upward pressure on inflation in a more fundamental way. At the global level, changes in
trade patterns and energy markets, rising climate-related risks and the commitment to
decarbonise the economy, as well as geopolitical risks, may have longer-lasting
implications, which could pose greater challenges to price stability.
For these reasons, any assessment based on comparisons with historical regularities
and model-based estimates must be complemented by real-time monitoring of the
transmission to financial and economic conditions. While there are signs of the strength
of the first leg of the transmission, a substantial share of the transmission from financing
conditions to the real economy is expected to still be in the pipeline, subject to longer
lags. This reinforces the need for a data-dependent approach to determining the
appropriate level and duration of a restrictive monetary policy stance.
1
Darracq-Pariès, M., Motto, R., Montes-Galdón, C., Ristiniemi, A., Saint Guilhem, A.
and Zimic, S. (2023), "A model-based assessment of the macroeconomic impact of the
ECB's monetary policy tightening since December 2021 ", Economic Bulletin, Issue 3,
ECB.
2
See, for example, Aastveit, K.A., Natvik, G.J. and Sola, S. (2017), "Economic
uncertainty and the influence of monetary policy", Journal of International Money and
Finance, Vol. 76, pp. 50-67.