Remarks by Governor Gabriel Makhlouf at The Economist 18th Annual
Cyprus Summit
18 October 2022 Speech
Good morning from the other end of the European Union. Let me say a few words on monetary policy and NPLs.
Monetary policy
First, monetary policy.
In the lifetime of the euro, ination has reached record highs. Headline ination was 10% in the euro area and 8.6% in
Ireland in September. This marks a rapid shift from the low ination we experienced for much of the decade before the
pandemic: in Ireland, ination averaged just 0.5% per year in the ten years to 2019.
The initial impulse for higher ination was the pandemic, in particular the lifting of restrictions, and the global supply
bottlenecks that resulted from it. Russia's war in Ukraine was a further shock impacting commodity prices, and
especially gas prices. In August, food and energy price increases accounted for two-thirds of headline ination in the
euro area.
The persistent and overlapping nature of these shocks has had signicant indirect effects.
The prices of many services and goods that rely on energy as an input have also risen sharply. We see this in the core
ination measure - stripping out energy and food price changes - which has risen steadily over the year to stand at 4.8%
in September.
The number of items in the euro area HICP basket with price increases of greater than 2% has been rising. Now, more
than six out ten items in the basket are seeing price increases greater than 5% year-on-year.
As price pressures broaden across the basket, the case for tighter monetary policy becomes stronger.
It is sometimes said that, as it operates primarily through aggregate demand, that monetary policy should 'look through'
supply shocks. To an extent, this is correct, and it is a view that underpins the medium-term orientation of our monetary
policy strategy. This is not, however, an argument to do nothing in the current climate. We need to pay close attention to
supply-demand imbalances, and decide how signicant these are, and what monetary policy needs to do to bring things
back into balance.
While the initial impulse for ination was a sequence of supply shocks, it is quite clear that demand coming out of the
pandemic has also been exceptionally strong. In the labour market, for example, labour supply shortages are still being
reported by rms, even in the face of a deteriorating outlook. The Beveridge curve shows a historically tight labour
market (Chart 1.1), with high job vacancy and low unemployment rates.
Chart 1.1 | Beveridge curve
Source: Eurostat for underlying data
We pay close attention to labour market developments, both as indicator of the economic outlook, but also for wage
developments that could indicate persistently high ination becoming embedded.
Wage growth estimates data show an acceleration of wage growth during 2022 (to 3% in Q2), but still lagging ination
(Chart 1.2). At the Central Bank of Ireland, we also track trends in posted wages, drawing on data from millions of job ads
across the euro area. This data also points to an acceleration of wage growth, especially during the rst half of 2022 as
economies reopened after the pandemic.
Some degree of so-called 'second round' effects is to be expected as real wages catch-up. In fact, the current trends in
both the ofcial wage growth data and our posted wages tracker are broadly in-line with the ECB's current projections
for wages in 2023 to grow at around double the rate we saw before the pandemic. What we wish to avoid are third or
fourth round effects, whereby expectations of higher ination above target become embedded in wage demands,
contributing to self-fullling inationary dynamics.
Chart 10 | Wage growth & ination, 2022
Source: National statistics bodies. EA, UK and Ireland is Q2 data, wages adjusted for job retention schemes; US
wage/ination data is September/August 2022.
Faced with the risk of persistently high ination, the Governing Council increased rates by 50 and 75 basis points in July
and September of this year. As we have signalled in our communications, further increases are expected.
The scale and pace of future interest rate changes needed to achieve our 2% ination target will be based on the
incoming data and the evolving outlook, what we describe as a 'meeting-by-meeting' approach.
A pivot to tighten monetary policy has been necessary. History teaches us that these issues will only be exacerbated if
we delay action. Raising interest rates is absolutely necessary as persistent ination is damaging to macroeconomic
stability and longer term living standards.
NPLs
Turning to non-performing loans (NPLs), which, to some extent, were "the dog that never barked" during the pandemic.
Thanks to the widespread deployment of payment moratoria, loan guarantees, and direct scal transfers and wage
subsidies, the increase in NPL ratios experienced in Europe during 2020 was almost non-existent, and in most cases has
been followed by subsequent declines into mid-2020 (Chart 2.1).
Given the labour market shock and GDP falls experienced, this is quite striking and shows the full force of the policy
support deployed from March 2020.
Chart 2.1. NPL ratios across Europe
Source: EBA risk dashboard
We must however remain vigilant. Roughly one in ten loans across Europe are classied as Stage 2, at high risk but not
yet default (Chart 2.2).
Chart 2.2. Stage 2 loans across Europe
Source: EBA risk dashboard
These loans take higher provisions to account for their higher risk, and the prudent recognition by banks of these higher
risks should ultimately make them more resilient to future adverse events. Households and businesses are now
transitioning almost without a break from the pandemic-related shock to an energy-driven inationary shock.
Resilience has been eroded, undoubtedly, and it is difcult to measure precisely how much latent distress is lurking
under the surface, ready to be exposed by the interlocking nature of these shocks.
Fiscal support will again provide some absorption of this shock for many with bank debts, but there may be a limit to the
role scal support can play in cushioning exposed businesses in particular from the protability effects of this episode.
We in Ireland are acutely aware of how difcult it can be to repair bank balance sheets after a surge in NPLs. The post-
2008 experience taught us that early engagement between borrower and lender is absolutely essential, as are strong
frameworks for protection of consumers during that engagement, and a streamlined data collection and assessment
process for distressed borrowers.
In recent years, banks beneted from global nancial conditions by selling and securitising portfolios of NPLs to
specialist market entities, as well as from economic recovery to support successful loan restructures. However, in a
higher rate environment, we must not be complacent: it is not obvious that such a ready portfolio sales market, at an
appropriate price, will remain available to banks, nor that loan restructures will prove as successful.
There are reasons to believe loan impairment dynamics, and the risk of potential balance sheet amplication by banks,
are not as severe as during the post-2008 crisis. Nominal ination in incomes and house prices may improve defaults and
losses relative to previous shocks.
Finally, the level of capital headroom remains strong, and, as such, a negative credit supply response which could amplify
economic stress is less likely than before.
On all of these fronts, we will remain vigilant, and ready to use releasable macroprudential tools if we deem it
appropriate the counter-cyclical policy requires an easing of capital requirements in order to support the economy, in
line with our nancial stability mandate.
Conclusion
The euro area economy is facing a difcult combination of high ination and low economic growth, including the
possibility of a technical recession. It is an uncertain and challenging environment which is perhaps inevitable when a
war is taking place on the continent and when the supply of energy has become an instrument of that war. The role of
central banks has to be to focus resolutely on their core price stability mandate and governments need to think carefully
about their scal policy choices and avoid those that would further fuel ination.
©2022 Central Bank of Ireland