22.05.2023
The European Central Bank's monetary policy in response to the
price stability challenge
Círculo Financiero La Caixa
Barcelona
Pablo Hernández de Cos
Governor
Ladies and gentlemen,
It is my pleasure to be able to participate in this event and I would like to take the opportunity
to share with you my thoughts on euro area monetary policy at what remains a complex
juncture. The first part of my address will describe the decisions we took at the meeting of
the Governing Council of the European Central Bank (ECB) held in early May. I will then
break down the main determinants of our future decisions.
The May decisions
Amid persistently very high inflation, our May decisions were a further step in the monetary
tightening process we launched at the end of 2021 to bring inflation down to our 2%
medium-term target. Specifically, we decided to raise interest rates by 25 basis points (bp),
in line with market expectations, increasing the deposit facility rate to 3.25%. This
represents a cumulative increase of 375 bp since July 2022.
This decision was based on the overall assessment of the three factors currently informing
our interest rate policy: the inflation outlook in light of incoming economic and financial data,
the dynamics of underlying inflation and the strength of monetary policy transmission.
With regard to the inflation outlook, our assessment largely rests on the Eurosystem staff
quarterly projections, which paint a coherent picture of different macroeconomic
developments - including the risk factors - and their likely future path.
The latest projections, published in March,1 forecast that euro area real GDP growth will
slow to 1% in 2023 (down 2.6 percentage points (pp) on 2022), albeit gradually recovering
in the second part of the year, with growth of 1.6% expected for 2024 and 2025.
The outlook for 2023 is somewhat brighter than projected in December, as the European
economy has proven more resilient, with energy costs falling further and global production
chains easing more than initially expected and households and firms receiving significant
fiscal policy support.
The data show that headline inflation peaked in November 2022. It has fallen by 3 pp since
then, to 7% in April, underpinned by lower energy prices and, since early 2023, negative
base effects.2 April also saw food inflation fall for the first time since September 2021 (13.6%
versus 14.7% in March).
Inflation is projected to gradually fall from 8.4% on average in 2022 to 5.3% in 2023 (2.8%
in Q4), then drop to 2.9% in 2024, before drawing close to our medium-term target in 2025,
when it will stand at 2.1% (2% in Q3 and Q4 of that year).
The downward trend in inflation will be driven by easing global supply chain bottlenecks,
the reversal of the energy price shock's indirect effects on underlying inflation, the
dissipation of the upward pressures from the reopening of the economy after the pandemic
and the stronger euro exchange rate. In the more medium term, the moderation of domestic
demand - as a result, among other factors, of our monetary policy - will help contain
inflationary pressures.
Nevertheless, as I will detail later, these projections are subject to a high level of uncertainty.
From a monetary policy perspective, it must be borne in mind that this inflation forecast -
which, I stress, is compatible with our medium-term price stability target - is based, among
other assumptions, on market expectations for our interest rates that envisage the deposit
facility rate peaking at around 3.75% in the coming months, holding at that level over the
following quarters and only gradually falling from 2024 Q2.
Although no new projections were available in May, the latest data published since the
March projections were prepared show, firstly, that economic activity has performed in line
with the forecast. Thus, euro area GDP grew 0.1% in Q1 and the partial and essentially
qualitative information available for Q2 suggests a slight acceleration. By component,
private consumption remained weak, but the labour market continued to prove robust: the
unemployment rate stood at historically low levels (6.9% in March, almost 1 pp below the
February 2020 rate), although hours worked were still 1.6% below the pre-pandemic level.
Inflation of 7% in April was slightly higher than expected, while financial conditions tightened
further - as a result, above all, of an even stronger euro exchange rate - and energy prices
were at somewhat lower levels than those incorporated into the March projections.
All this information led us to consider that the medium-term inflation outlook in the March
projections essentially remained valid. In this respect, the International Monetary Fund
projections published on 18 April forecast a similar GDP and inflation outlook to that of the
Eurosystem.
Underlying inflation (i.e. excluding energy and food) fell slightly in April, to 5.6%, but was
higher than expected, after reaching a record high of 5.7% in March. Other indicators
confirm that underlying price pressures remain strong. First, inflation rates for the
underlying inflation components most exposed to higher energy prices,3 which increased
by 4.5 pp over the course of 2022 (to 7.2% in December), have continued to rise and stood
at 7.7% in April. Second, the price growth of those items most affected by the recovery in
demand after the pandemic restrictions were lifted, such as those related to transport and
household equipment and maintenance, shows signs of stabilising, albeit at levels that
remain high (above 7%).4 In addition, inflation rates for the components related to recreation,
food service activities and tourism reached an all-time high of 7.5% in March (7.4% in April).
Lastly, inflation rates for the rest of the items, which account for more than 30% of the
consumption basket, held at 3.6%5 in April, with the prices of more than half of the items
growing at rates of over 4%.
Nonetheless, various short-term underlying inflation indicators - measured in
month-onmonth or quarter-on-quarter terms - have started to ease somewhat. In this respect,
nonenergy industrial goods inflation fell from 6.6% in March to 6.2% in April.
At the same time, wage pressures have continued to increase, with compensation per
employee and per hour growing by 5% and 4.3%, respectively, in 2022 Q4 (3.9% and 2.9%
in Q3). In any event, this is in line with the March projections. However, the recent agreement
for the German public sector, which includes very substantial wage settlements for 2023
and 2024, augurs further pressures, and it must be borne in mind that the empirical evidence
shows that private-sector wages in Germany tend to respond to changes in public-sector
wages.6 An indicator of underlying inflation for the most labour input-intensive components
and, therefore, those most sensitive to wage growth, has remained high over the last three
months, at around 4.3%.7
On Quarterly National Accounts data for Q1, firms in some sectors have continued to widen
their profit margins. However, other indicators, based on firm-level data, suggest a
somewhat more moderate performance.
Lastly, April 2023 saw the longer-term inflation expectations of professional forecasters
(relating to 2027) and those in the Consensus Forecasts (referring to the average for
20282032) revised down slightly, to 2.1% and 2%, respectively. Conversely, the latest Consumer
Expectations Survey, conducted in March, saw inflation expectations three years ahead
increase to 2.9%, up from 2.4% in February. This requires ongoing monitoring over the
coming months. After factoring in the inflation premium, the financial markets' medium and
long-term inflation expectations stand at around 2%.
The latest data confirm that our monetary policy is being transmitted forcefully to
financing and monetary conditions, while the speed and strength of transmission to the
real economy remain highly uncertain.
In particular, lending has lost considerable momentum, with bank loans to non-financial
corporations (NFCs) and households growing by 5.2% and 2.9%, respectively, in March,
significantly lower than their 2021 peaks. Bank interest rates for NFCs and households
reached 3.9% and 3.2%, respectively (1.6% and 1.8% in May 2022).
The latest ECB Bank Lending Survey (BLS) shows that credit standards tightened further
across the board in 2023 Q1 and more than expected a quarter earlier. The fall in demand
has also contributed to weak financing flows. In addition, banks expect loan supply to
tighten further and a fresh decrease in loan demand in Q2.
In sum, the data available to us in May pointed to medium-term inflation expectations
similar to those of March and strong underlying inflationary pressures, and confirmed
that our interest rate increases are being transmitted forcefully to financing
conditions.
In light of this information, we established that achieving our medium-term inflation target
would require a further interest rate increase. In this case, we decided to raise rates by
25 bp, a smaller increase than previous rises, given that the monetary policy tightening
process is well under way, with interest rates clearly in restrictive territory.
At the May meeting we also took further steps towards reducing the size of the Eurosystem's
balance sheet. This also contributes to tightening financing conditions, especially medium
and long-term interest rates, and therefore complements interest rate increases, which are
our primary tool for setting the monetary policy stance.
In early March we launched the process to reduce the size of the asset purchase programme
(APP) portfolio at a measured and predictable pace. Specifically, by not reinvesting all of the
principal payments from maturing securities, we agreed to reduce the APP portfolio at an
average pace of €15 billion per month up to June. In May we decided to accelerate the pace
of the run-off from July, by discontinuing reinvestments, also in line with the market
expectations.
Future interest rate decisions
Looking ahead, we will continue to take our decisions based on the incoming data and,
in particular, on our assessment of the three factors I referred to earlier. Allow me a few
observations on these factors.
In terms of the inflation outlook, a new projection exercise is due in June. In any event,
macroeconomic developments will be shaped by various sources of uncertainty in the
coming quarters. I will now single out some of these.
First, the euro area economy proved resilient in a context marked by the significant
reversal of earlier supply shocks, in which, moreover, households had ample savings to
draw on, the post-COVID-19 pick-up in demand continued to generate positive effects and
the transmission of monetary policy remained incomplete.
There is, however, much uncertainty over the persistence of these factors.
First, the sharp fall in gas prices in Europe in recent months reflects the unusually mild
weather and the energy savings measures. Nonetheless, the potential duration of the war in
Ukraine remains a significant source of uncertainty in terms of how such prices might
develop. Moreover, euro area GDP growth in 2023 Q1 appears to have been underpinned,
in particular, by non-residential investment and the positive contribution of net trade.
Conversely, private consumption remained weak. Furthermore, households have used
some of the savings built up to invest in assets less liquid than bank deposits, suggesting
less is available for consumption.8 By sector, growth continues to be concentrated
exclusively in services, while industry is showing signs of further weakness.
Second, there is also considerable uncertainty over the future path of the world
economy, against a backdrop of tighter monetary policy globally and significant geopolitical
risks. In the first part of the year, global economic activity has surprised on the upside, albeit
with an increasing divergence between services, with the Services Purchasing Managers'
Index (PMI) hitting its highest level for eight months in March, and manufacturing, with the
Manufacturing PMI falling further into negative territory in the advanced economies.
Meanwhile, global trade also remained in negative territory in February.
Economic activity in the United States slowed to 0.3% in Q1 (half that of the previous
quarter), owing in particular to declining inventories and weaker non-residential investment.
In any event, the labour market continues to be very resilient and underlying wage pressures
remain high. In this setting, doubts remain over the level of monetary tightening needed to
bring inflation down to the Federal Reserve's target and its impact on economic activity,
particularly given the stress in the US banking sector in recent months.
Elsewhere, uncertainty persists as to how the reopening of the Chinese economy will impact
inflation. On the one hand, a more buoyant Chinese economy is likely to boost global
demand, especially for commodities, which would tend to drive inflation rates up. On the
other, it could quicken the disappearance of global production chain bottlenecks and
strengthen the capacity of global supply to meet demand, which would ease inflationary
pressures. Which of the two channels will dominate and by what margin will depend, among
other factors, on the breakdown of the country's recovery.9 Although China recorded strong
growth in Q1, inflation eased and supply chains continued to improve.
Third, fresh outbreaks of financial instability such as those seen in March could
amplify recessionary forces. The fallout from this episode has been limited, with euro area
financing conditions tightening somewhat, primarily via corporate risk premia. As I
mentioned earlier, data from the April BLS point to credit standards having tightened
substantially in 2023 Q1. This tightening reflects banks' higher risk perceptions, essentially
linked to the deterioration in the macroeconomic outlook and in borrowers' creditworthiness
and, to a lesser degree, to banks' lower risk tolerance, the higher cost of funds and balance
sheet constraints. It does not therefore appear to be related to the episode of stress.
Nonetheless, a return of financial instability could trigger a further tightening of credit terms
and dent confidence, while also giving rise to a scenario of slower economic growth and
faster falling inflation.
A fourth factor, which clouds the inflation outlook somewhat, has to do with fiscal
policy. The authorities have rolled out numerous anti-inflation measures, some of them
exerting direct downward pressure on consumer prices, in both 2022 and 2023. In addition
to the uncertainty stemming from their design and implementation and the impact they
ultimately have, some of these measures include energy price caps and, therefore, whether
or not they are activated will depend on energy market developments. Moreover, the
withdrawal of such measures drive consumer prices up in the coming years, especially in
2024. The scale of these effects will depend on the pace of their withdrawal.10
It is important to stress here that, in the current high inflation environment, in order to get
the right policy mix, the fiscal policy stance must be compatible with the tightening of
monetary policy. This means that any public support measures must be temporary, targeted
on the most vulnerable agents and tailored to preserving incentives to consume less energy,
and should be withdrawn as and when energy prices fall. Otherwise, we run the risk of
amplifying the inflationary pressures in the medium term, thus necessitating a more forceful
monetary policy response.
As regards the dynamics of underlying inflation, following an initial stage in which
external pressures held sway, these have gradually abated, while domestic pressures
remain high and are increasingly relevant.11 Nonetheless, as I noted earlier, falling energy
prices, improvements in supply chains and slowing demand, as a result of tighter financing
conditions, are expected to begin gradually bringing inflation down.
However, the strength of these effects is uncertain, as they may not be symmetrical to the
upside effects. The economic literature is inconclusive as regards the existence of these
possible asymmetries, and this aspect should therefore be closely monitored.12
Our attention is now also turning to how wages and profit margins respond and, by
extension, to the possible emergence of second-round effects.
The March inflation projections assume a gradual recovery in real wages, which are
expected to stand at levels similar to their 2022 Q1 levels by the end of 2025. This would be
compatible with a decline in unit labour costs, since productivity is expected to rise slightly.
However, wage negotiations are taking place against a backdrop of tight labour markets
and new collective bargaining agreements point to growing wage pressures.
Meanwhile, the projections anticipate that margins will be squeezed somewhat by
weakening demand. However, stronger demand or the emergence of financial vulnerabilities
at firms could give rise to more buoyant margins.
It should continue to be stressed that much of the high inflation in the euro area stems from
the surge in commodity import prices, which has led to a significant worsening of the real
terms of trade. This brings with it an inevitable short and medium-term loss of real income
for the euro area economy as a whole. An equitable distribution of this loss between workers
and firms could prevent the inflationary spiral that would emerge were both groups to
attempt to avoid this loss unilaterally, by maintaining, respectively, the same level of real
wages and profit margins.
In short, protracted inflation increases the risk of significant second-round effects. This, in
turn, makes the deanchoring of inflation expectations a more likely prospect. Nonetheless,
for the time being, such expectations remain anchored at levels compatible with the price
stability target, and the second-round effects have been moderate.
As far as monetary policy transmission is concerned, the current episode has certain
notable idiosyncrasies when compared with other historical episodes.
First, the last cycle of significant and sustained tightening took place almost two decades
ago. Since then, the euro area and global economies have undergone transformations that
may have affected the transmission mechanism.
Second, the current cycle was preceded by a long period of expansionary monetary policy,
including new unconventional measures, such as the purchase of financial assets, which
have now begun to be reversed. The reversal of these measures will trigger a tightening of
financing conditions beyond that associated with policy interest rate hikes, for which there
are no precedents that might allow for an accurate ex ante estimation.
Third, the scale and pace of the ECB's interest rate hikes are unprecedented, which could
generate non-linear effects in the economy.
Lastly, unlike in previous cycles, in which demand shocks took centre stage, this time round
negative supply shocks have predominated. This means that the economy has to cope with
a tightening of financing conditions against a background of weak economic growth.
In this setting, we have already identified several differences in the way financing conditions
have responded to monetary policy compared with historical patterns.
Some aspects point to a slower transmission than in the past.
The first is the lower sensitivity of the non-financial private sector's debt burden to interest
rate rises, owing to the reduction in the proportion of households' bank debt with a fixed
interest rate period of one year or less (from 35% of the total in 2012 to 25% in 2021) and
of NFCs' bank debt with a maturity or a fixed interest rate period of one year or less (from
70% to 58% of the total in the same period).13
The second is the slower pass-through of market interest rates to the remuneration of
retail deposits, which may be at least partly explained by the fact that deposit rates were
higher than market rates during the period of negative interest rates and by the ample
liquidity currently available. Indeed, there is evidence that banks have raised deposit rates
more moderately in jurisdictions with a lower reliance on deposit funding to underpin
lending.14
However, other developments point to a sharper tightening of financing conditions than
would be expected based on historical patterns.
First, the current cycle has seen a higher increase in some risk premia and, therefore, a
higher increase in the cost of funding than would result from the rise in policy interest rates.
This has affected, in particular, the term premia implicit in long-term yields that compensate
investors for the risk that interest rates will change and, to a lesser extent, corporate and
sovereign premia. These movements can be explained, among other reasons, by the high
uncertainty about the future course of inflation and monetary policy, the expected decline
in the Eurosystem's asset portfolio, other regions' monetary policy externalities (mainly the
United States) and the initially low levels of some of these premia due to the long period of
expansionary monetary conditions that preceded the current cycle.
Second, market-based debt financing has increased from 16% to 24% of total NFC
debt.15 This type of financing tends to reflect movements in policy interest rates more
rapidly.
Third, the pass-through to the cost of new bank lending to firms is occurring somewhat
faster than in the past and may have been spurred by the rise in credit risk premia in an
adverse macroeconomic context.
Fourth, there are signs that the tightening of financing conditions for firms and households
is not only materialising in the form of higher interest rates, but also via the greater
difficulties they now face in accessing credit. Based on the responses of the banks
participating in the BLS, from end-2021 to 2023 Q1 euro area banks tightened credit
standards and credit conditions across all credit market segments. This tightening is the
sharpest since the euro area sovereign debt crisis and appears to be linked to greater risk
perception, consistent with the negative supply shocks prevailing in this cycle.
Credit flows have in fact slowed significantly. In the case of mortgage loans, the slowdown
is faster in the countries showing signs of greater house price overvaluation.16
These credit developments can be expected to eventually be reflected in real activity.
Indeed, the credit standards observed in the BLS in a given quarter are closely correlated
with GDP growth a few quarters later.17
In addition, close attention will need to be paid to incoming data on credit conditions to
assess the potential impact of the recent financial market tensions. In particular, the latest
BLS information will be very useful for understanding recent credit supply developments.
But a more restrictive monetary policy is not only transmitted through the capital markets
and the bank channel: other channels, such as the exchange rate channel, are also
relevant.
In 2022 the euro depreciated by a cumulative 4% in nominal terms against its main trade
partners and by 17% against the US dollar.18 The depreciation against the US dollar owed
mainly to earlier and stronger monetary policy tightening in the United States, greater global
risk aversion and the fact that the energy shock led to a terms-of-trade deterioration in the
euro area but not in the United States.19
However, since October 2022, the euro has appreciated by around 12%, on the back of a
better than initially expected macroeconomic outlook in the euro area, a less restrictive US
monetary policy than anticipated and lower global risk aversion.
The available evidence20 suggests that the sharp fluctuations in the euro exchange rate
during this tightening cycle may have led to these movements (particularly those caused by
monetary policy or energy shocks)21 being passed through to consumer prices more quickly
than in the past.22 This evidence also shows that the pass-through is roughly symmetric
(with no meaningful differences between depreciations and appreciations). The recent
appreciation is therefore likely to have a significant impact on prices in the coming
quarters.23
On balance, it is safe to say that monetary policy is already beginning to pass through to
real activity and inflation, though the bulk of the impact will be felt from this year onwards.
17Franziska Huennekes and Petra Köhler-Ulbrich. (2022). "Box 7. What information does the euro area bank lending
survey provide on future loan developments?". Economic Bulletin, 8, European Central Bank.
18
This depreciation drove up costs for euro area producers, as most imported inputs were denominated in US dollars,
leading to a certain loss of export market share (an estimated 2.5% in 2022).
19
See section 4.2.4 of Chapter 3 of the Annual Report 2022 of the Banco de España, "The current episode of price
pressures in the euro area, the monetary policy response and its effects", May 2023.
20
See, for instance, Roberta Colavecchio and Ieva Rubene. (2020). "Non-linear exchange rate pass-through to euro area
inflation: a local projection approach". Working Paper Series, 2362, European Central Bank.
21
Danilo Leiva-Leon, Jaime Martínez-Martín and Eva Ortega. (2022). "Exchange Rate Shocks and Inflation Co-movement
in the Euro Area". International Journal of Central Banking, 18(1), pp. 239-275.
22
For a review of the literature on the pass-through of exchange rate fluctuations to prices in Europe, see Eva Ortega
and Chiara Osbat. (2020). "Exchange rate pass-through in the euro area and EU countries". Occasional Paper Series,
241, European Central Bank.
23
Philip R. Lane and Livio Stracca. (2018). "Can appreciation be expansionary? Evidence from the euro area". Economic
Policy, 33(94), pp. 225-264.
Take Spain, for example. According to the Quarterly Macroeconometric Model of the Banco
de España, in a counterfactual scenario where the different channels operate in line with
historical patterns, the tightening of monetary policy in recent quarters would have reduced
inflation in Spain by around 0.2 pp. However, given the considerable lags with which
monetary policy operates, this tightening would reduce inflation by 0.5 pp in 2023, while the
impact would be 0.6 pp in both 2024 and 2025. In the case of GDP, it would have reduced
the pace of output growth by 0.6 pp in 2022, although its maximum impact, of around
1.1 pp, is expected in 2024. The exchange rate effect and intertemporal substitution effect
are the two main channels of transmission to inflation.
The available estimates using different models24 show similar results for the euro area
overall. Specifically, monetary policy would have had the effect of reducing inflation by
50 bp in 2022, and would drive up inflation by 2 pp on average in the period 2023-2025,
albeit with significant differences depending on the model used. The pass-through to
economic activity is faster, with an average impact of around 2 pp in the period 2022-2025
and a maximum negative impact on GDP in 2023.
In any event, as I noted earlier, these estimated effects could underestimate the
macroeconomic impact associated with the rapid and sharp interest rate rise.
Conclusion
To conclude, the ECB is clearly acting decisively to bring inflation back to the 2% target in
the medium term. Given the lags with which monetary policy operates, the bulk of the impact
of monetary policy tightening on inflation is expected to be felt this year and over the coming
years, with a peak in 2024.
Looking ahead, the process of tightening our monetary policy is already well under way,
although, based on the information currently available, we still have some way to go. We
also expect that interest rates will have to remain in restrictive territory for an extended
period of time to achieve our target in a sustained manner.
In any event, in a context as uncertain as the current one, we must again emphasise that
future decisions will continue to be data-dependent.
Allow me to conclude by pointing out that there clearly are and will be short-term costs to
this monetary policy tightening in terms of weaker economic activity, but maintaining price
stability is the main contribution that a central bank can make to ensure sound economic
growth in the long term.