Olli Rehn: Dialling back monetary restraint
Speech by Mr Olli Rehn, Governor of the Bank of Finland, at the Citi Macro Forum,
Washington DC, 18 April 2024.
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Slides accompanying the speech
Ladies and Gentlemen, Dear Friends,
Let me start by thanking the organisers for the invitation to share some thoughts with
you here at the Citi Macro Forum today. In my introductory remarks, I will discuss the
euro area economic and policy outlook following our ECB Governing Council monetary
policy meeting last week.
As you know, we at the Governing Council started discussing the dialling back of our
restrictive monetary policy stance in March, and we continued that discussion in our
meeting last week.
Slide 2. Economic activity in the euro area, 2007-2026
What makes this discussion particularly interesting is the fact that this time we are
considering easing our monetary policy stance simultaneously with a projected start of
recovery in domestic demand and a record low unemployment rate. Growth is projected
to pick up in the course of the second half of this year and to strengthen in the
20252026.
This interesting policy situation reflects the unconventional path that has led us to this
point over the past one and a half decades.
Slide 3. Three periods of inflation in the euro era, 1999-2024
Let me illustrate this trajectory with a graph that neatly divides the last quarter century
of the euro era into three periods of inflation: approx. 2% in 1999-2009; 1.2% in
200921; and 6.6 % since 2021.
It is worth remembering that only three years ago, in 2021, we had had 13 years of too
low inflation behind us, although we had resorted to a negative policy rate for seven
years, and to significant asset purchases and credit operations as well, which took our
balance sheet from 2 trillion to almost 9 trillion euros. This stubbornly low inflation,
together with a structurally low natural rate of interest and very limited remaining policy
space, led us to launch the review of our monetary policy strategy in January 2020. It
was concluded in July 2021.
Slide 4. The ECB strategy review and symmetric inflation target
The key outcome of the strategy review was that we decided to change our inflation
target to a symmetric one, meaning that both negative and positive deviations from the
2% target are regarded as equally undesirable. Prior to the review, our price stability
definition ('below but close to 2%') was perceived as asymmetric, effectively setting a
2% ceiling for inflation. This asymmetry very likely contributed to lowering inflation
expectations and thereby inflation itself. The new symmetric inflation target is expected
to influence long-term inflation expectations and to anchor them more solidly to the 2%
inflation target.
When we published our new symmetric inflation target in July 2021, the operating
environment for monetary policy was changing dramatically.
Slide 5. Inflation is converging towards the ECB's 2% target
The supply shocks, caused first by the pandemic and then by Russia's unjustified and
brutal war in Ukraine, pushed the euro area inflation rate above 2.5% for the first time in
nine years by the fall of 2021, and then all the way up to 10.6% in October 2022.
Thanks to the normalisation of energy prices and the determined but very consistent
monetary tightening, euro area HICP inflation is now at 2.4%. It is expected to decline
further, reaching our inflation target next year.
When I addressed this forum a year and a half ago, in October 2022, the uncertainty
related to energy supply in Europe was extreme. Rationing of energy supplies was
widely discussed. So were the various risk scenarios, some containing severe
stagflationary tendencies. At the time, energy was the key driver of euro area inflation,
while moderate wage inflation was acting as an anchor.
Subsequently, Europe reacted decisively and cut the energy crisis short. Today, wages
have replaced energy as the main inflation driver - but wage growth is now moderating
and inflation declining.
Due to the energy price assumptions, our inflation forecasts overestimated actual
inflation in the fourth quarter last year. For this year, our assumptions and inflation
forecasts have been more accurate, although in March we did revise down our inflation
forecast for this year to 2.3%. In September last year, our 2024 inflation forecast was at
3.2%, so we have in fact been approaching our target faster than we had expected at
the time we raised the policy rate to the current level.
However, disinflation is more than just a story of the reversal in energy price
movements. Monetary policy has played an important role in dampening demand since
the rate hiking cycle started in July 2022. Monetary restraint is continuing to reduce
inflation and impact the real economy strongly, affecting the growth outlook, particularly
for this year. In March, we also revised down our growth forecast for this year to 0.6%.
Slide 6. Wage growth is moderating in the euro area
The euro area unemployment rate has remained at a record low and employment has
increased, even though growth has been at a standstill since the end of 2022. This said,
there are indications that labour demand is now adjusting downwards. Recent euro
area wage growth has been developing broadly in line with our expectations, slowing
from 5% to 4%. Importantly, a key driver of wage growth has been past inflation
surprises rather than higher inflation expectations.
Slide 7. Inflation expectations remain well anchored to the target
Inflation expectations have in fact been well anchored at around our 2% target, as can
be seen from this slide.
Referring to the ongoing weak demand conditions in the euro area, and in the spirit of
the multilateral IMF and World Bank spring meetings this week, I would like to draw
your attention to the developments in the euro area current account. In the March
projections, the forecast for the current account surplus was revised significantly
upwards, from 1% to 3.2% of GDP for the current year and similarly for the two
following years.
As we know, the current account can be defined as the difference between investment
and savings. This definition provides a useful viewpoint when assessing the effects of
recent monetary policy tightening and its strong transmission. An increase in the current
account surplus may reflect a lower level of investment or higher level of savings - or
both, which seems to be the case in the euro area currently.
An important factor contributing to a higher euro area current account is the low level of
business and housing investment, which are expected to be very weak this year. This is
reflected in the weak credit demand due to higher interest rates and also somewhat
tighter credit supply. As bank profitability is not expected to remain as strong as before
and credit risks are increasing somewhat, the supply factors may start to play a bigger
role in credit extension, while credit demand is expected to start recovering.
If weaker investments are contributing to a stronger current account, so too are higher
savings. The savings rate increased to 14.6%, which is clearly above the pre-pandemic
13%.
Of course, tighter monetary policy and higher interest rates play a major role in
explaining the higher savings rate. However, uncertainty and low confidence also
incentivise higher savings. The continuation of the Russian war has probably had more
complex and wide-ranging effects on confidence and savings than we can currently
estimate.
The ECB, major forecasters like the IMF, central bank watchers and the current pricing
in the financial markets all seem to agree that the euro area inflation rate will return to
our 2% target in a sustained manner in the course of next year. Since prolonged high
inflation could put the well-anchored inflation expectations at risk, any further delay in
achieving the target cannot, of course, be accepted.
Slide 8. The ECB decisions in April
The key message from our policy meeting last week was that although the key ECB
interest rates are at levels that are making a substantial contribution to the ongoing
disinflation process, we no longer see the need to maintain them at the current levels
for a long duration.
It is also worth noting that with the extent of disinflation already seen, real short-term
rates are now higher than we expected them to be when the policy rate was raised to
the current level last September.
With declining inflation and delayed economic growth, we are continuously assessing
how restrictive our policy stance is and should be. Without prejudging our primary
objective of price stability we need to avoid a stance that unduly delays the closing of
the negative output gap.
The risks to the growth outlook remain tilted to the downside. Russia's unjustified war
against Ukraine and the intensified conflict in the Middle East are major sources of
geopolitical risk, feeding uncertainty and potentially increasing energy prices again.
Clearly, geopolitics is the risk factor that could derail the improving outlook for the euro
area economy.
As headline inflation and underlying inflation have continued to slow down and inflation
expectations have remained well anchored, we can start dialling back monetary
restraint as summer approaches. Provided that we are confident that inflation will
continue converging to our 2% target in a sustained way, the time will be ripe in June to
start easing the monetary policy stance and to cut rates. This obviously assumes that
there will be no further setbacks in the geopolitical situation and thus in energy prices.
We in the ECB Governing Council will continue to follow a data-dependent and
meetingby-meeting approach when determining the pertinent policy stance. We will set our
rates based on our updated assessment of the inflation outlook, the dynamics of
underlying inflation and the strength of monetary transmission. And we are not
precommitting to any rate path.
Thank you very much for your attention, and I look forward to your questions.