SPEECH
Regaining control

'We have made important progress in regaining control over inflation, but we are
not quite there, yet. To continue this progress, and reach our target, restrictive
policies will likely remain needed for some time to come. All in all, current policy is
in the right place. If, nevertheless, the disinflation process were to Stall, central
banks will stand ready to, once again, adjust their interest rates.' This is how Klaas
Knot concluded his talk at the Euro50 Group Marrakech Roundtable on 13 October
2023.

Published: 13 October 2023

© DNB

Date: 13 oktober 2023

Speaker: Klaas Knot

Location: EuroSO Marrakech Roundtable on 'Inflation, Deflation: Looking for price stability
in various parts of the world'

Hello everyone.

Over the past decade, central banks around the world have been particularly challenged in
their quest for price stability.

After the Great Recession, inflation rates were low. In response, central banks around the
world turned to ultra loose conventional and unconventional monetary policy measures.

This approach succeeded in staving off deflation risks. And once inflation was about to
return to target, central banks could start thinking about policy normalization.

But then the pandemic hit us.

And soon enough, central banks, all over the world, had to deal with a roller coaster of
lockdowns, fear of deflation, followed by a steep rise of inflation and, most recently, some
encouraging signs of disinflation.

But the impact of that roller coaster, and the way central banks dealt with it, differed
significantly between countries or regions. Like the euro area and the US - which is today's
topic.

When the pandemic hit, the economic starting positions of the US and the euro area were
different.

The US recovered earlier from the Great Recession than the euro area. This allowed the Fed
to implement its first rate hike as early as December 2015. According to its statement, the
FOMC was 'reasonably confident that inflation will rise, over the medium term, to its two
percent objective.' By contrast, by the time the pandemic hit the euro area in February
2020, core inflation was still only a little higher than one percent. This is illustrated on slide
2 Ihs.

Looking back

Core inflationin US and euro area Contribution of supply, energy and demand
Annual percent changes shocks to euro area HICP-inflation
Annual percent changes

ty)
11 12 13 14 15 16 17 18 19 20 21 22 23 Oct 2021 Jan 2022 Apr2022 0 Jul2022 Oct. 2022
euro area core HICP --US core PCE SB Supply GBB Energy GB Demand
== Source: Eurostat, US BLS Source: The Euro Area Great Inflation Surge, DNB (2023)
2

As I already mentioned, another difference lies in the responses. In both the US and the
euro area, governments were quick to react to the economic fallout of the pandemic. The
design and impact of the rescue packages, however, were different. The US government
provided direct income support to households by sending stimulus cheques. In the euro
area, employment and household income were protected by wage subsidies.

While the various support measures stimulated demand, containment measures kept
constraining supply. Eventually, this fuelled inflation. In early 2021, US inflation rose above
two percent. And by the second quarter of 2021, GDP exceeded pre-pandemic levels. In the
euro area, core inflation had climbed to almost two percent, by the end of 2021, while GDP
reached pre-pandemic levels. In sum, compared to the US, the recovery in the euro area
was lagging two to three quarters, as reflected in core inflation (slide 2 Ihs).

In the final stages of the recovery, different negative shocks hit the supply side of the euro
area economy. After a period of acceleration in global commodity prices, aggregate supply
was hit by a sharp increase in energy prices in late 2021. Soon after, from February 2022
onwards, the Russian invasion of Ukraine led to a further acceleration of energy prices. In
order to sustain the economy and offset the energy shock, government consumption in the
euro area remained elevated and several governments announced fiscal measures to
address private energy bills. This combination of positive demand and negative supply
shocks strongly hit the euro area and was an important driver of the surge in headline
inflation and of the rise in core inflation (slide 2 rhs).

In response, the ECB started tightening its monetary policy stance. This happened in
several steps.

In December 2021, we took the first step: we reduced the pace of our asset purchases, and
shortly thereafter, we entirely stopped the net purchases under the PEPP and the APP

(slide 3 Ihs). This led to an immediate increase in long rates (slide 3 rhs). By now, as we by
and large discontinued our TLTRO operations and stopped reinvesting the principal
payments from maturing securities under the APP, the Eurosystem's balance sheet is
shrinking at a measurable pace.

Monetary policy response

Net purchases and policy rate Yield curve euro area
EUR bn and percent Percent, GDP- weighted, spotrate government bonds
200 4.0 40
175 as 35 To
150 3.0 3.0
125 2. 25
100 2.0 2.0
7s Ls 1s
soi I I lh 1.0 1.0
2s Hl 0s os
= MLEURDTA EG OTV EN EE oo
"25 os OS ee
"50 "10 1.0
Jan 20 2420 Jan2i 2424 Jan22 Jul22 Jan23 dM 23 tm av ay or by 10¥
me APP mee PEPE - ECB DFR (rhs) -ortf23 - 21/22 -10/0e/21

Source: ECB SOW
senna :

To date, this 'quantitative tightening' has been smooth and well-absorbed by financial
markets. The same goes for our international peers, who - in fact - are reducing their
balance sheets at a relatively faster pace.

In July 2022, our focus shifted to our primary instrument: the policy rate. Since then, we
have increased the policy rate with every Governing Council meeting (slide 3). Today, these
increases add up to an unprecedented 450 basis points.

We did not get here on autopilot, however. While, up until this summer, upside risks around
an already too high projected path for inflation implied that the direction of travel was
clear, we relied on a meeting-by-meeting approach to calibrate the size of each step. In
every Governing Council meeting, we carefully assessed how inflation was developing and
how it was responding to our tightening measures. This, then, guided our decisions
towards the appropriately restrictive level at the right speed.

Whether rates are sufficiently restrictive, depends on how much traction our tightening
has on spending. Not only now, but also in the months ahead.

Luckily, more and more indicators show that the passthrough of our tightening campaign
is firmly taking hold. Financing conditions have tightened fast and smooth. Bank funding
costs have increased rapidly. And this translates into higher bank lending rates for
households and firms (slide 4), tighter credit standards, and contracting financing volumes

in the euro area. Sidenote: this is of course not only due to an increased policy rate, but also
to the phasing out of TLTRO.

Transmission strong, with more to come

Lending rates of NFCs Lending rates of household mortgages
Average cost of borrowing, MIR-data, new loans, percentages Average cost of borrowing, MIR-data, percentages per
per annum annum

6 6

5 s

4 a

3 3

2 2

i 1

° 0
is 6 v 8 i 20 2 22 2 as 16 7 18 19 2 21 22 23

<eolyr -- 1-Syr -- >Syr --Total outstanding = Total new credit

ey Source: ECB MIR-data Source: ECB MIR-data
4

Looking at banks: a prolonged rise in funding costs and higher credit risk might, eventually,
put downward pressure on their profitability and capitalization. But so far, banks are
benefiting from strong capital positions, solid net interest income and moderate
provisioning costs.

Looking at firms and households: many are currently holding fixed-rate or long-term loans
that will need to be refinanced. This means that a share of our tightening campaign will
probably still need to pass through (slide 4 rhs).

This expectation is reinforced by the typical lags in the transmission of financial conditions
to economic activity.

Nonetheless, the tighter financing conditions already have a clear, dampening impact on
demand. PMI indicators, having reached contractionary territory, confirm that business
activity has been weakening, and that manufacturing, in particular, was hit hard.

However, to fully understand how this will translate into actual growth, we will need to

marked decrease compared to the previous months. And I expect those numbers to fall
further in the months ahead, though it probably won't be a linear process.

Currently, the data confirm our projected inflation path. The longer it stays that way, the
more confident I become that the current monetary policy stance, with a key policy rate of

four percent, will be sufficiently restrictive to bring us back to our inflation target of two
percent in the medium term.

But we must remain cautious at all times. Today, it is still too early to declare victory over
inflation. For instance, wages in the euro area labour market are mostly set in collective
wage agreements. And an assumed gradual but steady easing of wage pressure crucially
underlies the downward path of core inflation in our inflation projection. Today, wage
growth is still at a high level. Partly, this is due to an understandable effort to recoup some
of the real wage losses suffered as a result of the high inflation. And one could even argue
that the recovering real wages that we are seeing are an important pillar under the soft
landing that we foresee in our projections. But now that inflation is coming down, wage
growth should align with this gradual downward path, back to a level that is consistent
with our aim of price stability.

We started the past decade mainly below our target. And in recent years, we found
ourselves above.

It has been a wild ride.

We have made important progress in regaining control over inflation, but we are not quite
there, yet. To continue this progress, and reach our target, restrictive policies will likely
remain needed for some time to come. All in all, current policy is in the right place. If,
nevertheless, the disinflation process were to Stall, central banks will stand ready to, once
again, adjust their interest rates.

Thank you.