SPEECH

The effectiveness and transmission of
monetary policy in the euro area

Contribution by Philip R. Lane, Member of the Executive Board of
the ECB, to the panel on "Reassessing the effectiveness and
transmission of monetary policy" at the Federal Reserve Bank of
Kansas City Economic Symposium

Jackson Hole, 24 August 2024

Introduction
My aim in this contribution is to provide a euro area perspective on the effectiveness and transmission

of monetary policy." As expressed in the monetary policy statements of the ECB's Governing Council,
the aim of monetary policy tightening has been to deliver a timely return of inflation to the medium-term
two per cent target by dampening demand and guarding against the risk of a persistent upward shift in
inflation expectations. Even if sectoral shocks had played an important role in triggering the initial 2021-
2022 inflation surges, monetary policy tightening was necessary in order to contain domestic demand
and to signal clearly to price and wage-setters that monetary policymakers would not tolerate inflation

remaining above the target for an excessively-long period. 2]

In this contribution, I will report on the transmission of monetary policy, via financial markets and the
banking system, to domestic demand and inflation expectations during this tightening episode. My
interim conclusion is that monetary policy has been effective in underpinning the disinflation process,
with the transmission of monetary tightening operating to restrict demand and stabilise inflation
expectations.

The effectiveness and efficiency of monetary policy has required a data-dependent approach to the
calibration of the monetary stance. To this end, I will also discuss the importance for the calibration of
monetary policy of fully recognising the asymmetric sectoral nature of the pandemic and energy shocks
that triggered the initial inflation surges and the impact of sectoral balance sheets on macroeconomic
dynamics. These considerations have shaped the monetary policy reaction function of the ECB during
this episode, which has been guided by the incoming evidence on: (a) the unfolding inflation outlook;
(b) the evolution of underlying inflation; and (c) the strength of monetary transmission (which, inter alia,
depends on sectoral balance sheets).

Monetary transmission

Chart 1 shows the evolution of the euro short-term rate (ESTR) forward curve since December 2021. In
terms of the adjustment in policy rates, there were several distinct phases. Early in 2022, the yield
curve shifted up in anticipation of future rate hikes, with the markets anticipating that the ECB would
respond forcefully to the building inflation shock. In the second half of 2022, there was an accelerated

campaign of outsized hikes in order to move sharply away from an accommodative stance. In the first
nine months of 2023, further hikes brought the policy rate to a level that was assessed to be sufficiently
restrictive, if held for a sufficiently long duration, to underpin a timely disinflation process. The policy
rate was then held at its peak of 4 per cent from September 2023 to June 2024.

Chart 1
Policy rate path and risk-free curve over time

(percentages per annum)

Realised DFR wee Dec 2021 = Dec 2022 eee Sep 2023 === Latest

45
4.0
3.5
3.0
25
2.0
1.5
1.0
0.5
0.0 +

-0.5

-1.0
2022 2023 2024 2025 2026 2027

Sources: Bloomberg and ECB calculations.

Notes: "DFR" stands for "deposit facility rate'. The cut-off dates for the data used for the €STR forward curves are
17 December 2021, 16 December 2022, 15 September 2023, and 13 August 2024.

Astriking feature of Chart 1 is that the inflation shock triggered a repricing of not only the near-term
policy rate path but also the long-term policy rate path. At the end of 2021, the policy rate was expected
to remain negative even in 2027 according to market pricing (and expert surveys). The re-pricing
occurred in early 2022 and has persisted, with the 2027 (and longer-horizon) policy rate expected to
settle in the neighbourhood of two per cent, which is consistent with market views of a near-zero
equilibrium real rate and the successful delivery of the inflation target in the medium term.

This has meant the inflation shock triggered a fundamental re-setting of the interest rate path, with no
expectation of a return to the extraordinarily accommodative monetary stance that had been in place
since 2014/2015. At the same time, Chart 2 shows the longer-term yields rose by much less than short-
term yields. The negative slope of the yield curve reflects the market assessment that inflation would
normalise relatively quickly, such that the cumulative increase in policy rates also had a significant
cyclical component that would be unwound. At the same time, this inversion of the yield curve also
masked a marked increase in the term premium, including due to the significant decline in the bond
market footprint of the Eurosystem (Chart 3): since December 2021, quantitative tightening is estimated

to have raised the term premium in the overnight index swap (OIS) curve by about 55 basis points.)

Chart 2
Slope of the risk-free yield curve

(percentage points)
1
08

2019 2020 2021 2022 2023 2024 13-Aug-24

Sources: Bloomberg and ECB calculations.

Notes: The slope of the risk-free yield curve is calculated as the difference between the ten-year and two-year OIS
rates. The latest observation is for 13 August 2024.

Chart 3
Eurosystem balance sheet

(EUR trillions)

mAPP
=PEPP
= TLTROs

2020 2021 2022 2023 2024 2-Aug-24

Sources: ECB calculations.

Notes: "APP" stands for "asset purchase programme", "PEPP" for "pandemic emergency purchase programme"
and "TLTROs" for "targeted longer-term refinancing operations". Purchase programmes are based on book value
at amortised cost.The latest observations are for 2 August 2024.

In the bank-based European financial system, the transmission of the restrictive monetary policy stance

to bank lending conditions plays a central role.4] As shown in Chart 4, banks have faced higher funding
costs (due to the combination of a rapid increase in bank bond yields and an increase (even if slower)

in bank deposit rates) and bank lending rates to firms and households for new loans increased
significantly (the prevalence of fixed-rate mortgages has meant that the lending rates facing existing

household customers have increased far more slowly). Banks have also tightened their credit
standards applied to the approval of loans, as shown in Chart 5.5 Credit volumes moderated rapidly

and nominal credit growth has been very low since 2022, as shown in Chart 64

Chart 4
Bank lending rates to firms and households, plus bank funding costs

(percentages per annum)

New business volumes - firms

New business volumes - households
Outstanding amounts - firms
Outstanding amounts - households
== --_ Bank funding cost

Jan-22 Jul-22 Jan-23 Jul-23 Jan-24 Jun-24

Sources: ECB (BSI, MIR, MMSR) and ECB calculations.

Notes: The indicators for the total cost of borrowing for firms and households are calculated by aggregating short-
term and long-term rates using a 24-month moving average of new business volumes. The bank funding cost
series is a weighted average of new business costs for overnight deposits, deposits redeemable at notice, time
deposits, bonds, and interbank borrowing, weighted by outstanding amounts. The latest observations are for June
2024.

Chart 5
Evolution of bank credit standards

(cumulated net percentages of banks reporting a tightening of credit standards)

---= Loans to firms ees Loans to households for house purchase

150
100

50

-50

-100
2014 2015 2017 2018 2020 2021 2023 2024Q2

Sources: ECB (BLS) and ECB calculations.

Notes: Net percentages for credit standards are defined as the difference between the sum of the percentages of
banks responding "tightened considerably" and "tightened somewhat" and the sum of the percentages of banks
responding "eased somewhat" and "eased considerably". Cumulation starts in the first quarter of 2014.

The latest observations are for the second quarter of 2024.

Chart 6
Credit volumes to firms and households

(annual percentage changes)

== Bank loans to households
= Bank loans to firms

Q4 2021 Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Q2 2024

Source: ECB (BSI).

Notes: Bank loans to firms are adjusted for sales, securitisation and cash pooling. Bank loans to households are
adjusted for sales and securitisation. The latest observations are for the second quarter of 2024.

The decline in credit observed so far in the current cycle has been stronger than historical regularities,
based on linear models, would have suggested. The particularly large and rapid increase in policy rates
may have amplified the tightening impulse. Moreover, the perceived and abrupt end of the "low for long"

era reduced the incentives to search for yield, further contributing to a pullback in risk taking by banks

and customers. 2] Large policy rate hikes (including a persistent component) increased the riskiness of
borrowers, reducing the willingness to lend. The combination of the war impact and rapid rate hikes
also signalled a less positive economic future, reducing the expected revenues and increasing the
expected future funding costs of potential borrowers, leading them to reduce their demand for credit.

The dampening of demand

Through the tightening of market-based and bank-based financing conditions, the restrictive policy
stance has fed through to economic activity. Chart 7 shows that, the recovery in output over the period
2022-2024 has been much weaker than expected. Despite the impact of the war-related energy shock,
the post-pandemic reopening did allow GDP to grow during the first nine months of 2022 (when

monetary policy was not yet restrictive). Subsequently, economic activity stagnated between late 2022

and late 2023, with only a limited recovery during the first half of 2024. In terms of demand
components, public consumption has been the main consistent driver of growth, while private
consumption and external demand have remained subdued in recent quarters (Chart 8). Investment
has also been weak: a decline in housing investment has been a persistent drag on growth; while
business investment was also hit, the impact was mitigated during 2022-2023 by past order backlogs

that somewhat supported the production of capital goods.44

Chart 7
Real GDP growth and projections

(annual percentage changes)

@ December 2021 projections
m December 2022 projections
tm® December 2023 projections
@ June 2024 projections
5 @ GDP outcome
4
3
I i;
I Lo i
; a _ 7

2022 2023 2024

Sources: Eurostat; June 2024, December 2023, December 2022 and December 2021 Eurosystem staff
projections; and ECB calculations.

Notes: The latest observations are for 2023 for GDP and 2024 for projections.

Chart 8
GDP growth contributions

(quarter-on-quarter percentage changes and contributions)

GDP at market prices
Private consumption
Government consumption
Total investment
Changes in inventories
Net exports

BEEBE

Q1 2021 Q3 2021 Q1 2022 Q3 2022 Q1 2023 Q3 2023 Q1 2024 Q2 2024

Sources: Eurostat and ECB calculations.

Notes: The latest observations are for the second quarter of 2024 for GDP and the first quarter of 2024 for the
contributions.

The subdued economic performance is also clearly connected to the uncertainty shock and the energy
price and terms of trade shocks triggered by the unjustified invasion of Ukraine by Russia. For instance,
Chart 9 shows that, despite the post-pandemic output recovery and strong increase in employment,
real disposable income stagnated during 2022 as inflation rose far more quickly than wages. The
decline in real incomes would have been more severe in the absence of the countervailing fiscal
measures that were widely introduced during 2022 and that boosted transfers to households and
suppressed the most intense impact of rising energy prices on households. Indicators of consumer
confidence fell at the onset of the war and, despite some gradual improvement, still remain below the
pre-war level. Together with the contribution of the restrictive monetary stance, this helps to explain the
still-limited response of consumption to the improvement in real disposable income that has been in
train since the middle of 2023, due to the recovery in wages, the decline in inflation and the

improvement in the terms of trade.

Chart 9
Private consumption, real disposable income and consumer confidence

(left scale: index Q4 2019 = 100, right scale: net percentage balance)

tm Private consumption
tm Real disposable income
== Consumer confidence (rhs)

106 0
105 5
104
-10
103
-15
102
-20
104
100 2
99 -30
98
Dec-21 Jun-22 Dec-22 Jun-23 Dec-23 Aug-24

Sources: Eurostat and European Commission.

Notes: The latest observations are for the first quarter of 2024 for private consumption and disposable income, and
August 2024 for consumer confidence.

Put differently, the adverse war-related 2022 shocks to household incomes, the terms of trade and
confidence indicators for both households and firms served as countervailing influences on demand
conditions and thereby reduced the extent of demand dampening that needed to be generated by
monetary tightening.

While employment growth also decelerated, it remained above the rate of output growth.
Unemployment has remained broadly stable at a historically-low level, with employment growth
accommodated by an increase in the labour force through a mix of rising participation and a recovery in
immigration. This robust labour market performance (which has also mitigated the impact of rising
interest rates on consumption) reflects the composition of activity, with services (including public
services) more robust than manufacturing. It also reflects labour hoarding, with the anticipation of future
recovery motivating firms to retain workers. In turn, labour hoarding was supported in 2022-2023 by
strong profitability levels, the decline in real wages and the rise in interest rates (such that the relative
price of labour versus capital declined). The moderation in the labour market in 2024 is consistent with
a weakening of these forces, with profitability declining, real wages rising and a turn in the interest rate
cycle.

Monetary policy affects demand and prices through multiple channels: someare more direct (via
intertemporal substitution) and others are more indirect (via growth and employment). This means that
the full impact of changes in monetary policy on aggregate inflation occurs only with long and variable
lags. As consumers rein in their spending in response to monetary policy tightening, they start by
consuming fewer goods with a high intertemporal elasticity of substitution, such as durables and non-

essential items. They also reduce spending on goods that are more interest-rate sensitive, such as
durable goods purchased using credit, including housing. Analysis by ECB staff suggests that the peak
price response of items most sensitive to monetary policy shocks, which tend to include durables and

non-essential items, is around three times larger than for less sensitive items." The price reaction to
monetary policy shocks of these more sensitive consumer items has been stronger in the recent
tightening cycle than in past episodes of monetary restraint, reflecting the effectiveness of the steep
and decisive hiking policy in dampening demand.

In summary, monetary tightening has restricted domestic demand, especially since late 2022. A
dampened-demand environment directly reduces the capacity of firms to raise prices and workers to
obtain wage increases. It also contributes to the stabilisation of inflation expectations, to which we now
turn.

The anchoring of inflation expectations

A primary task for monetary policy in the disinflation process has been to ensure that the large
pandemic and sectoral shocks did not translate into an increase in the medium-term inflation trend by
fostering an upward de-anchoring of inflation expectations that could persist even after the unwinding of
the sectoral shocks. In particular, the very sharp rise in actual and projected inflation in the course of
2022 put a premium on guarding against the de-anchoring of inflation expectations and motivated an
accelerated approach to monetary tightening between July 2022 and March 2023, with the policy rate
hiked by 350 basis points over six meetings.

In the post-crisis years before the pandemic, expectations had become de-anchored to the downside.
The pre-pandemic distribution of long-term inflation expectations in the Survey of Professional
Forecasters (SPF) was skewed to the left, as shown in Chart 10, and had a median expectation of 1.7
per cent. A similar pattern was evident in market-based indicators."2] Between the middle of 2021 and
early 2022, there was a remarkable shift in long-term inflation expectations, with survey respondents
moving away from the long-held views that inflation would remain below two per cent indefinitely.3] In
essence, the majority of respondents assessed that the inflation shock opportunistically served to re-
anchor long-term inflation expectations at the target by demonstrating that target risks were two-sided.
[14] This is in line with the behaviour of market interest rates shown in Chart 1: the re-anchoring of

medium-term inflation expectations has removed the need for an open-ended accommodative
underlying monetary stance.

Chart 10
Survey of Professional Forecasters: distribution of longer-term inflation expectations

(percentages of respondents)

@ 242019
® 42022
@ 32024

60

£15 16 17 18 19 20 24 22 23 24 225

Sources: SPF and ECB calculations.

Notes: The vertical axis shows the percentages of respondents; the horizontal axis shows the HICP inflation rate.
Longer-term inflation expectations refer to four to five years ahead. The latest observations are for the third quarter
of 2024.

Reinforced by the target-consistent monetary policy decisions during this period, the stabilisation of

medium-term inflation expectations has provided an important anchor in the disinflation process. 15]
The sheer magnitude of the inflation surge, the successive upward price shocks and the shifts in the
short-term inflation outlook clearly could have generated upside de-anchoring risks. Instead, as shown
in Chart 11, throughout this period the high-inflation phase has been expected to be relatively short-
lived, supporting the timely return of inflation to the target. As shown in Charts 12 and 13, there has
also been a decline in the medium-term inflation expectations reported by firms in the survey on the
access to finance of enterprises (SAFE) and by households in the Consumer Expectations Survey
(CES).

Chart 11
Term structure of inflation expectations from professional forecasters

(annual percentage changes)
Term structure inflation expectations (Q3 2021 to Q3 2024)

-HicP
12

10

2

0
2
2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Sources: Eurostat, SPF and ECB calculations.

Notes: The term structure of inflation expectations shows expectations for different horizons in past rounds of the
SPF.

Chart 12
Consumer Expectations Survey

(annual percentage changes)

=== Perception of past inflation === Inflation expectations three years ahead
=== Inflation expectations one year ahead =-= HICP

10

0
Jan-23 Apr-23 Jul-23 Oct-23 Jan-24 Apr-24 Jul-24

Sources: Eurostat and CES.

Notes: The series refer to the median value. The latest observations are for July 2024.

Chart 13
Firms' expectations for euro area inflation at different horizons

(annual percentages)

@ Median
@ Mode
© Interquartile range

Jun-23 Dec-23 Mar-24 Jun-24 Jun-23 Dec-23 Mar-24 Jun-24 Jun-23 Dec-23 Mar-24 Jun-24

re Ce

1 year 3 year 5 year

Sources: SAFE and ECB calculations.

Notes: Survey-weighted median, mode and interquartile ranges of firms' expectations for euro area inflation in one
year, three years and five years. Quantiles are computed by linear interpolation of the mid-distribution function. The
statistics are computed after trimming the data at the country-specific 1st and 99th percentiles. Base: all
enterprises.

In turn, the anticipation of the monetary policy response helped to reduce the scale and duration of the
inflation response to the large shocks. This anticipation effect was plausibly stronger during this
episode, since the large shocks in 2021 and especially 2022 triggered an increase in the frequency of

price adjustment.) A monetary policy stance that is clearly committed to the timely return of inflation

to the target is especially powerful under state-dependent pricing."41 An increase in the frequency of
price changes represents both an extra cost from high inflation (since there are economic costs -
including management costs - from adjusting prices more frequently) but also an opportunity: if price
setters understand that the central bank is committed to returning inflation to the target in a timely
manner through an aggressive interest rate response to the large shock, the phase of intense inflation
will be shorter and the sacrifice ratio in terms of lost output will be lower since price setters only have to
focus on adjusting prices to the cost shock rather than also having to incorporate an excessively-
prolonged aftershock phase of second round effects.

In summary, the risk of an upside de-anchoring of inflation expectations has been contained. This has
certainly been facilitated by the nature of the initial inflation shocks, with the relative price shifts
triggered by the pandemic and the war-related energy shock reversing fairly quickly and disinflation
being further supported by the innate demand-dampening characteristics of the war and the terms of
trade deterioration. The historical evidence and model-based counterfactual analyses clearly indicate
that an insufficiently -vigorous monetary policy response could have resulted in a persistent increase in
the inflation trend. At the same time, the calibration of the monetary policy response also needed to
contain the risk of returning to the downside-deanchored equilibrium that had prevailed in the euro area
before the pandemic.

Sectoral shocks and disinflation dynamics

During the disinflation process, the calibration of monetary policy needed to take into account the
reversal in energy inflation, the easing of pipeline pressures and the relaxation of supply bottlenecks.
The pandemic and the subsequent energy shock triggered by Russia's unjustified invasion of Ukraine
had asymmetric and time-varying effects on different sectors. During 2020 and 2021, the impact of the
pandemic on activity was most severe for contact-intensive services, while the goods sector was
overwhelmed by the mismatch between a positive global demand shift and a decline in global supply
capacity due to pandemic-related shutdowns and supply-chain interruptions. During 2022, the
dislocations in the oil and gas sectors due to the Russia-Ukraine war were associated with an
extraordinary surge in energy prices, which also constituted a severe terms of trade shock for the euro
area as a net energy importer. In Europe, the full relaxation of pandemic-related lockdown measures
also occurred only in spring 2022, after the subsidence of the Omicron variant. Accordingly, in 2022, the
mis-match in the goods sector was succeeded by a mis-match in the services sector, with demand for
contact-intensive services rising more quickly than supply capacity in the immediate aftermath of the
full post-pandemic reopening that spring.

Subsequently, the improvement in supply capacity and the unwinding of the adverse terms of trade
shock has both supported economic activity and contributed to disinflation. In particular, the
normalisation of demand and the expansion in supply capacity reduced these sectoral mismatches.
After peaking in 2021, supply chain bottlenecks gradually eased during the course of 2022 and 2023,
contributing to a decline in the relative price of goods. The decline in energy demand and the increase
in energy supply capacity, together with the contribution from the various subsidy schemes that limited
the impact of the shocks on retail energy prices, meant that energy prices fell by 14 per cent between
their peak in October 2022 and July 2023.

The easing of bottlenecks and the decline in the relative price of energy also helped to calm food

inflation and, via lower cost pressures, services inflation.42] In addition, the reversal of the adverse
supply shocks also boosted activity and employment, with the fading of the pandemic in particular
supporting activity in 2021 and 2022, and falling energy prices and the receding impact of past
bottlenecks boosting activity in 2023 and 2024. Compared to a purely demand-driven inflation episode,
the nature of this inflation shock limited the extent to which disinflation would necessarily be
accompanied by a severe economic contraction: rather, the aim of monetary policy was to make sure
that demand grew more slowly than supply capacity during the disinflation phase.

The euro area implementation of the Bernanke-Blanchard model provides a useful organising device to

represent the contribution of sectoral shocks." The left panel of Chart 14 shows that shocks to energy
and food prices, together with pandemic-related shortages, accounted for the largest part of the 2021-
2022 inflation surges and the subsequent disinflation can largely be attributed to the fading of these
shocks. In contrast, labour market tightness has played a comparatively minor role in inflation
dynamics.

The right panel of Chart 14 shows that the phase of above-target inflation has primarily been prolonged
by the lagged adjustment of wages (and prices) to the initial inflation shocks. The aim of monetary
tightening has been to contain this adjustment phase by making sure that the post-shock rounds of

wage and price adjustments were limited by dampened demand and underpinned by stable longer-term
inflation expectations.

Chart 14
Sectoral shocks

HICP inflation Negotiated wage growth
(year-on-year growth rate, pp contributions) (year-on-year growth rate, pp contributions)

@ Initial conditions tm Food @ Lockdown @ Initialconditions tm Food @ Lockdown
@ Labour market tm@ Shortages @ Residuals © Labour market @ Shortages @ Residuals
Hm Energy I Productivity HICP inflation Energy tm@ Productivity = Wage growth

11 6

10

9 5

8

7 4

6 3

5

4 2

3

2 1

1

0 0

A 4

2

3 2
2020 2021 2022 2023 2024 2025 2026 2020 2021 2022 2023 2024 2025 2026

Source: ECB calculations based on Arce, O., Ciccarelli, M., Kornprobst, A. and Montes-Galdon, C. (2024), "What
caused the euro area post-pandemic inflation?", Occasional Paper Series, No 343, ECB.

Notes: The figures show decompositions of the sources of seasonally adjusted annual wage growth and HICP
inflation based on the solution of the full model and the implied impulse response functions. The out-sample
projection is constructed by performing a conditional forecast starting in Q1 2020, conditional on realised variables
between Q1 2020 and Q1 2024 and technical assumptions and inverted residuals between Q2 2024 and Q4 2026
such that HICP in the conditional projection is equal to the seasonally adjusted June 2024 Eurosystem staff
projections. Assumptions from the June 2024 projections baseline correspond to energy and food price inflation
and productivity growth. Labour market tightness is assumed to remain constant. The "shortages" (measured by
the Global Supply Chain Pressure Index) are known up to Q2 2024 and projected according to an AR(3) process
thereafter. The historical decomposition treats the projection as data and is carried out from Q1 2020 onwards to
compute the contributions of the initial conditions and of the exogenous variables.

According to this analytical framework, the bulk of disinflation could be expected to take place relatively
quickly with the fading of the sectoral shocks, but full convergence back to the target would be slower
due to the lagged nature of wage adjustments and the staggered pattern of economy-wide price
adjustments to cost increases. In turn, these characteristics of the disinflation process (an initial rapid
phase, followed by a slower convergence phase) have informed the calibration of monetary tightening.

The nature of the disinflation process has been recognised in the Eurosystem staff projections. For
instance, the December 2022 projections foresaw that inflation would decline from the quarterly peak of
10 per cent in Q4 2022 to 3.6 per cent in Q4 2023, 3.3 per cent in Q4 2024 and 2.0 per cent in Q4

2025. Disinflation turned out to be even more rapid during 2023, with Q4 inflation at 2.7 per cent. The
June 2024 projections foresee inflation at 2.5 per cent in Q4 2024 and 2.0 per cent in Q4 2025.

In summary, diagnosing the nature of inflation dynamics has been essential in calibrating monetary
tightening. Conditional on inflation expectations remaining anchored, the fading out of the initial shocks
that triggered the steep rise in inflation could be expected to deliver a two-phase disinflation process,
with an initial steep decline followed by a slower convergence phase as wage-price and price-price

staggered adjustment dynamics played out.25 The role of a demand-dampening monetary stance has
been to make sure that inflation did not remain too far above the target for too long and to reinforce the
commitment to a timely return to the inflation target, such that price and wage-setters could focus on
"backward" adjustment dynamics - aimed at recovering lost purchasing power and re-establishing
optimal relative prices - without worrying about the "forward" adjustment dynamics that would be
generated by any de-anchoring of inflation expectations.

Sectoral balance sheets

In calibrating the monetary stance, it is also essential to take into account that the impact of monetary
policy depends on the condition of sectoral balance sheets. These encompass the balance sheets of

firms, households, banks, the public sector and the rest of the world.24)

Chart 15
Euro area net lending / net borrowing

(as a percent of nominal GDP - four quarter sums)

Households

®@ Non-financial corporations
Financial corporations

@ General government

= Euro area

Ss

ora kK HON FD @

Ss

2019 2020 2021 2022 2023 2024

Sources: Eurostat and ECB.

Note: The latest observations are for the first quarter of 2024.

Chart 16
Sectoral leverage

(percentages of nominal GDP - four-quarter sums)

= Government
tm Households (rhs)
tm Non-financial corporations

180 80
160 75
140 70
120 65
100 60
80 55
60 50
2000 2003 2006 2009 2012 2015 2018 2021 2024

Sources: Eurostat, ECB and ECB calculations.
Note: Leverage is defined as total non-equity liabilities divided by the four-quarter sum of nominal GDP.

The latest observations are for the first quarter of 2024.

Chart 17
Non-financial corporations' margins and saving ratio

(percentages - four quarter moving averages)

tm Net operating surplus to value added
tm Net retained earnings to value added

30 8
28 6
26 4
24 2
8 ss  -__ 0
2017 2018 2019 2020 2021 2022 2023 2024

Sources: ECB and ECB calculations.

Note: The latest observations are for the first quarter of 2024.

Chart 18
Net worth of households

(annual changes as percentages of nominal disposable income)

Change due to holding gains and losses on financial assets
Change due to holding gains and losses on non-financial assets

50

Q1 2022 Q2 2022 Q3 2022 Q4 2022 Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024

Sources: Eurostat, ECB and ECB calculations.

Note: Changes are mainly due to movements in real estate and share prices. The latest observations are for the
first quarter of 2024.

Chart 15 shows that households had exceptionally high savings rates in 2020 and 2021. While firms
were net borrowers during the initial months of the pandemic in 2020, corporate debt was contained by
significant fiscal transfers and de-risked through extensive public loan guarantees. Taking a longer-term
perspective, Chart 16 shows that household leverage before the pandemic had declined relative to the
2010 peak but was still elevated compared to the initial years of the euro; although there had been
some decline since 2016, the pre-pandemic level of corporate leverage was much higher than at the
start of the euro.

While the collapse of GDP meant that these leverage ratios jumped during 2020, both now stand well
below their pre-pandemic levels, also due to the significant rise in nominal GDP. These balance sheet
improvements have helped to cushion the financial impact of monetary policy tightening on