Monetary policy and the return of inflation*
Ignazio Visco
Governor of the Bank of Italy
The Warwick Economics Summit 2023
Bishnodat Persaud Lecture
Coventry, United Kingdom, 11 February 2023
Introduction and some history
Inflation is back. After at least three decades of moderate-to-very moderate consumer price
changes in advanced economies, inflation has returned to levels that are severely affecting
the lives of households and firms, their decisions to consume and to save, to work and
to invest. Last year, average inflation for the world economy was almost 9 per cent, more
than 7 per cent in advanced countries and almost 10 per cent in emerging and developing
economies. During the year it peaked at between 9 and 11 per cent in the United States,
the euro area and the United Kingdom, well above the targets of central banks (fig. 1).
In this lecture, I will mainly consider the recent developments of inflation in the euro area
and the monetary policy response that has been taking place since the autumn of 2021.
The high inflation that we are observing is by no means a new phenomenon, although
perhaps one that had been increasingly considered a phenomenon of the past. Indeed,
even higher inflation peaks were recorded in many advanced economies in the 1970s
and the early 1980s. A close look at the dynamics of inflation since 1970 suggests a
possible periodisation for the last 50 years.
The years of high inflation. The 1970s and 1980s were characterised by two oil shocks,
which pushed consumer price inflation above 20 per cent in countries like the United
Kingdom and Italy, and to 15 per cent in the United States. To make things worse,
following the spikes due to higher oil prices (initially linked to the Yom Kippur war in
1973 and subsequently as a result of the Iranian revolution in 1979), and notwithstanding
some key differences in its manifestation across countries, inflation turned out to be very
persistent. In Italy and the United Kingdom, for example, high inflation lasted until the
counter-shock of 1986;1 in the United States, consumer price growth remained above
5 per cent until what became to be known as the "Volcker disinflation" brought it back
under control, by means of a very restrictive monetary policy that caused a double-dip
recession in 1981-83 and a large surge in unemployment. Where inflation lasted longest,
multiple factors caused it to persist, including high wage growth, often spurred by
explicit or implicit indexation mechanisms, which gave rise to wage-price spirals; strongly
expansionary fiscal policies, in many cases already taking place before the two shocks
had occurred; the scarce attention paid to (the anchoring of) inflation expectations; and
the lack of independence of central banks.2
The Great Moderation. In the 1990s and until the Global Financial Crisis of 2007-08 the
picture changed substantially. In advanced countries, the lessons learned in previous
years led to an increased autonomy granted to central banks and to closer attention paid
to inflation expectations and wage dynamics within the framework of (flexible) inflation
targeting.3 Even more importantly, globalisation and the strong progress in information
and communication technologies (the "ICT revolution") favoured a solid economic
expansion in a low inflation environment. Economic growth was, of course, not always
high,4 not all countries managed to take full advantage of these changes,5 and, most
importantly, benefits were not equally shared among households, with many left behind
without adequate safety nets; yet, inflation overall was moderate (hence the label of
"Great Moderation" usually given to these years).
The Great Recession and its legacy. From 2008 to 2019, first the global financial crisis
and then the euro area sovereign debt crisis triggered strong financial and economic
turbulence and intense disinflationary pressures. Negative inflation rates were observed,
for the first time in many years, both in the United States and in the euro area. The decline
in real interest rates seemed unstoppable and many observers put forward the possibility
of a new phase of secular stagnation.6 Central banks responded by implementing a series
of non-standard monetary measures, the most well-known being quantitative easing
(QE), that is the massive purchase of securities in the open market to maintain favourable
financing conditions across the whole term structure of nominal interest rates and spur
economic activity, countering the risks of deflation.
The return of inflation. The last three years have seen the arrival of a new shock and the
return of an older one. In early 2020, the outbreak and spread of the Covid-19 pandemic
shook the world economy. Many countries recorded a sharp and sudden collapse of
GDP and employment, as a consequence of both the unprecedented implementation
of "lockdown measures" to contain infections and the deep surge in uncertainty that
affected households' and businesses' saving and investment decisions. The response of
economic policies was equally swift and extraordinary, aimed at strengthening health
systems and supporting households and businesses. When the pandemic waves seemed
to become less critical, in part thanks to the success of vaccination campaigns, during 2021
energy prices started to increase. They began accelerating mid-year, reaching extremely
high levels for natural gas in Europe, where it was mostly imported from Russia. This
phenomenon gained in intensity and persistence with Russia's invasion of Ukraine, and
called for an acceleration in the process of monetary policy normalisation.
Different sources of inflation
Even though inflation is currently affecting many economies in an apparently similar
manner, its underlying sources are different across countries, especially so if we compare
the euro area and the United States.
First, while fiscal policies were expansionary everywhere during the acute phase of the
pandemic, measures in the United States were especially bold: the public debt-to-GDP
ratio rose by 25 percentage points in 2020-21, to over 130 per cent. In the euro area,
instead, the increase was limited to 15 percentage points, to slightly less than 100 per
cent, despite a much deeper decline of nominal GDP in 2020 (by 4.8 per cent, against
2.2) and a slower recovery in 2021 (7.5 versus 10.1 per cent). The exceptional support
provided to US households is particularly evident when comparing the dynamics of GDP
and disposable income (fig. 2): in 2020, just as the former recorded its sharpest collapse in
real terms in the entire post-World War II period (-3.4 per cent), real disposable personal
income grew by over 6 per cent, its largest rise since the mid-1980s. In the euro area,
instead, household real disposable income declined, even though by a smaller extent
than GDP (-0.6 versus -6.4 per cent).
Second, the different dynamics of household disposable income across the two
economic areas translated into very diverse effects on demand. In the US, GDP returned
to its pre-crisis trend at the end of 2021, but aggregate data hid an elevated degree of
heterogeneity between sectors: while demand in the service sector was restrained by
pandemic-related factors, the goods sector increasingly showed signs of overheating
(fig. 3). In the spring of 2021, for example, personal consumption expenditure in the
durable goods sector was already more than 30 per cent higher than its pre-crisis level.
The fast recovery in US demand, in a phase in which supply elsewhere was still constrained
due to the pandemic waves, caused bottlenecks in the global value chains to drove up
the prices of intermediate goods everywhere. In the euro area, demand for both goods
and services remained below pre-pandemic trends up until the end of 2021.
Third, the labour market appears to be much tighter in the United States than in the
euro area. The US unemployment rate still stands at just 3.4 per cent, a value last seen
only in the late 1960s and about half the level of the euro area (6.6 per cent). More
importantly, the difference between the number of vacancies in the US non-farm sector
and the number of people who are unemployed is, today, over 5 million, i.e. there are
many more jobs available than there are people looking for them, while in the euro
area the opposite is true, with the number of unemployed exceeding the number of job
vacancies by about 6 million. Unsurprisingly, the annual change of US nominal wages
(measured by the employment cost index) surpassed 4 per cent as early as in the third
quarter of 2021, approached 6 per cent in 2022, and today still stands above 5 per cent, a
level that is difficult to reconcile with an inflation target of 2 per cent (fig. 4). In the euro
area, on the other hand, in spite of current requests for sizeable wage increases in some
countries, wage growth has so far remained moderate, around 3 per cent, and there are
no clear signs of a wage-price spiral as a whole.
Fourth, the energy shock had a very different role on both sides of the Atlantic. Since the
second half of 2020, oil prices rose gradually in both the United States and the euro area.7
The price of the natural gas delivered in the United States increased much more sharply,
rising from around $10 per megawatt hour before the pandemic to a peak of over $30
last summer, before sliding back below $10 (fig. 5). However, it was the price of the
natural gas delivered in Europe that recorded the most extraordinary dynamics, dwarfing
even the 1973 oil price increase (which itself had increased four-fold): from slightly above
€10 per megawatt hour in early 2020, it rocketed to €180 before the war, soaring to a
peak of €350 last summer and then stabilising at around €60 over the past few weeks.
A further major problem then emerged, i.e. the extreme volatility of gas prices, the result
of a "bullwhip effect", which is the response of demand to uncertain supply, consisting of
ordering more, ordering earlier and replenishing gas stocks.
As a result of these dynamics, US consumer price inflation increased from below 2 per
cent in February 2021 to a peak of over 9 per cent last June (fig. 6). Core inflation (i.e. net
of energy and food products) took the lion's share of this increase, peaking at almost 7
per cent last year. In the euro area, on the other hand, the increase in the price of food
(another consequence of the war in Ukraine) and energy was responsible for the largest
share of the rise in headline inflation, with energy costs increasing by about 40 per cent
since last spring. Considering the combination of direct and indirect effects, in 2022
about 60 per cent of headline inflation was attributable to higher energy prices.
However, when discussing the high level of headline inflation reached within the euro
area, some commentators have paid less attention to the size and persistence of the
energy shock, instead pointing the finger at the supposed delays of the central bank in
exiting from QE and initiating monetary tightening.8 Critics of this hypothetical mistake
have also highlighted the errors in the inflation projections made by the ECB/Eurosystem
staff in 2022 (fig. 7). The forecast errors in predicting consumer price changes during
last year were indeed sizeable and much larger than those observed in the past.9 Some
have even argued that these large errors call into question the very credibility of the
ECB, although other international institutions and private forecasters have made similarly
large mistakes.
While the observed size of the errors may understandably cast doubt on the reliability
of the models used for the projections, our analyses for Italy indicate that the effects of
energy prices - the most important exogenous variables in the forecasting model, whose
changes are usually inferred from the market price of futures contracts - explain, directly
and indirectly (i.e. via their effects on production costs), 70 per cent of the overall error
made in forecasting inflation in 2022.10 This share rises to 80 per cent when the effects
of food prices, the other volatile component of the consumer price index, are also taken
into account. Critics also forget that, in June 2021, the euro area headline inflation was
still below 2 per cent and the core inflation below 1 per cent: therefore, at the time, the
ECB Governing Council was still concentrating on how to increase inflation durably, in the
wake of its successful battle against deflation.
These results suggest that, although all models should be (and are) subject to continuous
checks and improvements, the functioning of the economy has not changed dramatically
over the last year. They do draw our attention, however, to the quality of the forecasts used
as inputs. Undoubtedly the effects of supply bottlenecks, although much less significant
than in the United States, were underestimated. The key problem, however, has been
the generalised underestimation of the recent geopolitical tensions. The sharp drop in
gas supplies from Russia observed since early 2021 was in fact (probably mistakenly)
attributed at first to the effects of a particularly cold winter in Russia and subsequently to
the political pressure from the Russian government to accelerate the opening of the Nord
Stream 2 gas pipeline. As a consequence, up until the end of 2021, futures quotations
had continued to factor in declining gas prices for the months following the 2021-22
winter. The Russian invasion of Ukraine a year ago has, instead, dramatically changed this
picture, triggering a sharp rise in volatility and pushing both current and expected gas
prices to the extremely high levels that I have just described.
Monetary policy in the euro area
As inflation had started to show worrying signals, at the end of 2021 the ECB Governing
Council began the process of monetary normalisation, announcing the reduction of net
purchases under its quantitative easing programmes. In the early part of last year, the
process gained speed, avoiding, however, the potentially dangerous cliff-effects of too
sharp a drop, not least in view of the major uncertainty caused by the Russian invasion of
Ukraine. It was completed on the 1st of July. A few weeks later, we started raising the key
official interest rates by a significant size, with the aim of frontloading the exit from their
highly accommodative, indeed still negative, levels.
Important steps forward have already been taken. Following last week's monetary policy
decision, the overall increase of official rates since July has reached 300 basis points and
has been fully transmitted to market interest rates. Since the start of the reduction of
monetary accommodation, one-year risk-free rates (measured by overnight index swaps)
have picked up from negative levels to 3.4 per cent, while ten-year rates have increased
from barely positive values to 2.7 per cent. In real terms, using the inflation-linked swap
(ILS) as a deflator, interest rates currently stand at about 0.9 and 0.3 per cent respectively,
from around -4 and -2 per cent at the end of 2021 (fig. 8).
Another look at the role of supply and demand factors and a first measure of the effects
of monetary tightening can be obtained through a quantification of the structural
drivers of euro area and US inflation expectations, as measured by ILSs, obtained by
breaking down their daily fluctuations into domestic and global shocks (fig. 9).11 Leaving
the technicalities aside, results show that, since the start of the war in Ukraine, inflation
expectations (5-year ILS) in the euro area increased mostly in response to supply shocks;
the much smaller contribution of demand shocks rose progressively over the course
of 2022, reflecting improved business cycle conditions. Results also document strong
spillover effects of US monetary policy on euro area inflation expectations since the
second half of 2022 and initial signs that the ECB's monetary policy tightening is having
the desired soothing effects on the economy. In the United States, on the other hand,
inflation expectations had been steadily sustained by domestic demand until the end of
last October, and have since been reined in by contractionary monetary policy effects.
Other preliminary signs of the success of the ECB monetary strategy can be found by
looking at headline inflation, which came down from its peak of 10.6 per cent in October
2022 to 8.5 per cent in January 2023, although the core component has remained steady
at 5.2 per cent, owing to the usual lags in the pass-through of increased energy prices.
On a 3-month annualised basis, which offers the most faithful representation of the
impulses that have been predominantly driving inflation recently, the deceleration of
prices has been even more marked (fig. 10).
Given the previous historical excursus, and despite the current encouraging signs around
the inflation situation, we may wonder whether the euro area will experience the long
persistence of inflation observed in many countries during the 1970s. I believe that this is
very unlikely, not only because of substantial improvements in monetary policymaking,
but also and above all because of the numerous structural changes that have taken place
in our economies since then.
First, the euro area today is well integrated into a global economic system which certainly
has a greater capacity to absorb inflationary shocks through positive technological
spill-overs and improved import competition.
Second, in the 1970s, the oil shocks were preceded and followed by a substantial instability
of exchange rates that, for countries like Italy and the United Kingdom, caused large rises
in imported inflation. In the euro area today, however, this is much more limited by the
increased stability of the common currency.l
Key changes have also taken place in product and labour markets. In most countries,
such as Italy, following the negative experience of the wage-price spirals of the 1970s and
1980s, automatic indexation to previous price changes has been completely superseded.
For the euro area as a whole, the share of wages and salaries directly linked to inflation
is low, mitigating the risk of a sharp acceleration.
The framework within which monetary policy is conducted today has also changed
dramatically. Indeed, the ECB has a firm mandate to preserve price stability and acts
accordingly. Monetary policy is transparent in its objectives and is credible, as is also
shown by the resilience of inflation expectations. The context in which fiscal policies
operate has also changed and nowadays, it would be unthinkable to maintain excessive
and prolonged fiscal deficit as it occurred, for example, in Italy during the 1970s and
1980s.
Money and prices, wages, expectations and catching-up
After 25 years of low and stable inflation, many observers have questioned the connection
between money and prices as well as that between inflation and real economic activity.12
This includes attempts to protect labour incomes and accumulated savings from the
loss in purchasing power generated by the energy shock, giving rise to "second-round"
effects.
On the first issue, the persistence of low inflation during the 2010s, despite the extensive
liquidity created by central banks, may seem at odds with Milton Friedman's famous
quote that "inflation is always and everywhere a monetary phenomenon". Indeed, "too
much money chasing too few goods" did not result in too much inflation during those
years.13
Clearly, it must be acknowledged that Friedman's words, besides being a statement on
the long-run neutrality of money, can be interpreted either as an innocuous truism or as
a causal relation between money supply and the level of prices that may hold, albeit with
variable lags, on horizons that are not necessarily long. Some say that the breadth and
persistence of the inflationary consequences of the energy shock may have found fertile
ground in the abundant liquidity created before and after the pandemic. According to
this view, this may have resulted in a fully-fledged cumulative increase in the general level
of prices, spurring persistent inflation, rather than being limited to a change of relative
prices. In any case, the crucial point is what will happen next. I see no compelling reasons
for inflation not to return to target, notwithstanding the still abundant (and excessive)
liquidity present in the economic system. The latter will be gradually reduced through the
actions of monetary policy. At the same time, it will be crucial to consider how society at
large will react to the shocks that have materialised in the last two to three years.
With respect to the second issue, let us remember that the debate on the flattening of
the Phillips curve is in full swing. There is some evidence of a significant reduction in the
slope of the curve compared with estimates relating to the second half of the last century,
although not to levels that would result in a complete disconnect.14 The drop in the slope
might be linked to the structural changes discussed above, and especially to the wage
bargaining process and to the pricing behaviour of firms in globally integrated markets.15
Whatever the underlying reason, if the unemployment and the output gaps have a smaller
effect on inflation, preserving price stability may have to hinge strongly on maintaining
well-anchored inflation expectations. Following a supply shock, in particular, expectations
that remain firmly anchored to the inflation target may succeed in containing wage
growth, helping to bring inflation back to the central bank target, with a limited impact
on economic activity.
However, we may observe that, after a substantial hit to their purchasing power, such as
the one generated by the extreme hike in energy prices, wage earners may first attempt
to catch up with the increase in the overall consumer price level. This would reflect
both the direct and the indirect effects of the energy shock, the former on the cost of
energy-related goods and services purchased by households, the second resulting from
the pass-through of higher energy costs, first to the producer and then to the retail
prices of other goods and services in the consumer price basket.
In such a situation, the organisation and results of the bargaining process between labour
and firms will clearly be crucial. In several countries in the 1970s and 1980s, formal and
de facto mechanisms of price indexation were at work. This helped to propagate inflation
shocks over time, calling for very restrictive monetary policy measures.
As I was, at the time, involved in econometric modelling at the Bank of Italy, paying
special attention to the effects of price indexation and inflation expectations, I would just
like to recall the main results of our investigations. Basically, changes in unemployment
appeared to have a significant, even if not exceptional, impact on nominal wages,
though a permanent trade-off between unemployment and wage inflation was ruled
out by the data. Expected inflation only influenced wage changes in the short term, but
wages caught up quite rapidly with respect to previous errors in anticipating inflation.
Eventually, all that mattered were past actual price changes. As this took place with rather
short lags and with producer prices marking up on unit labour costs - while reflecting the
pass-through of the increase in the prices of imported production inputs due to negative
supply shocks and exchange rate depreciations - a prolonged wage-price spiral was a
rather obvious consequence, calling for a strong and, at times intricate, monetary policy
reaction.16
The many changes that took place after those years of high inflation included a general
withdrawal of formal indexation mechanisms. In the bargaining process, more attention
was possibly paid to the links between real wages and productivity, while nominal wages,
rather than looking at past inflation, tended to be evaluated in terms of new, much more
moderate, inflation trends. This led to the consideration that, in order to maintain this
moderation, it would be crucial to keep short-to-medium term inflation expectations
under check. The firm anchoring of longer-term expectations was a clear indicator of the
credibility of monetary policy in achieving this goal.
The situation that we are currently in is consistent with this picture. In the euro area,
short-term inflation expectations derived from financial market prices are falling sharply.
Inflation-linked swap rates indicate that the expected inflation rate twelve months
ahead is 2.4 per cent (fig. 11). At the same time, the initial signs of a decline in inflation
expectations are confirmed overall by the surveys among firms and households.
On the other hand, longer-term expectations, net of risk premia, remain at levels consistent
with our 2 per cent price stability target, and tail-risks of excessive inflation are gradually
dissipating (fig. 12).17 The anchoring of inflation expectations is also supported by the
results of the January ECB surveys of analysts. The credibility that the ECB has gained over
time has not been lost and is currently paying off. However, we may ask whether this will
be enough in light of the substantial losses of purchasing power due to the energy shock,
which, as I have said, has been extremely violent in Europe, especially so for the price of
the natural gas imported from Russia. In short, the question now is what can be done to
avoid a return to the old model of catching up with those losses and propagating them
through second round effects and wage-price spirals (though certainly mitigated today
by the very limited presence of automatic indexation mechanisms).
Monetary tightening in the current environment
There is no question that the restriction of the euro area monetary stance must continue
to ensure that a temporary increase in inflation caused by a supply shock does not
become a more persistent phenomenon sustained by demand factors. There is also high
uncertainty, not only over the global economic picture, but especially over geopolitical
developments. These have highly significant consequences for the evolution of energy
prices, currently back at considerably lower levels than the peaks observed last year
(and also much lower than the cap on natural gas prices unilaterally established by the
European Union in December). These levels are reflected in the current mood of financial
markets and the substantial lowering of short-term inflation expectations. Yet we have
seen how volatile gas prices have been and it is still extremely difficult to assess to what
extent the dramatic conflict in Ukraine will bear on the euro area economy. Following
the ECB Governing Council's latest decision, the pace of any further rate hike will then
continue to be decided on the basis of incoming data and their impact on the inflation
outlook.
It will also remain essential to continue balancing the risk of a too gradual recalibration,
which could cause inflation to become entrenched in expectations and in wage-setting
processes, with that of an excessive tightening, which would result in significant
repercussions for economic activity, financial stability and, ultimately, medium-term price
developments. In line with our symmetrical price stability objective, equal weight should
be given to both risks. In particular, I am concerned about statements that seem to give
a (much) higher weight to the risk of doing too little.
It is true that inflation is still currently above our target, and especially so if we look at
various measures of core or underlying inflation, and I do understand that it would come
at a cost for the economy if this led to the need for a stronger and more prolonged
restriction of monetary policy. However, the costs linked to the risk of doing too much
must not be considered less important, as we have learned from the experience in the
aftermath of the great financial crisis.18 Nor must we ignore the fact that, if the consequence
of doing too much were to be an overshooting below our target, nonlinear amplifications
stemming from firms' balance sheets could start to bite. Today, disinflation is obviously
needed, but given the levels of private and public debts that prevail in the euro area, we
must be careful to avoid engineering an unnecessary and excessive rise in real interest
rates. Indeed, I am convinced that the credibility of our actions is preserved not by flexing
our muscles in the face of inflation, but by continually showing wisdom and balance. To
this end, careful quantitative evaluations of the risks I just mentioned and their effects is
crucially needed.
On the same note, I do not believe that a recession is inevitable for reducing inflation.
Recent developments in the euro area and in the United States as well as surveys and
market expectations are comforting in this perspective, as inflation is predicted to decline
rapidly to 2 per cent in the context of a temporary slowdown. Communicating a strong
commitment to bringing inflation down to target in a speedy manner is fundamental, but
doing so by minimising the costs for the real economy is not any less important. In fact,
not only is the ECB required by the Maastricht Treaty to contribute, without prejudice to
price stability, to the achievement of the wider objectives of the European Union, but also
the social consequences of our actions, and the political reactions, including those on the
fiscal front that could result in further pressures on public debts, should not be ignored.
All this, of course, without any concession to instances of "fiscal dominance", in the spirit
of working independently but maintaining a dialogue with euro-area governments.
A cautious approach is also advisable due to a series of considerations. The first is
related to the high level of economic uncertainty and the Brainard principle, which states
that when the central bank is uncertain about the effects of its actions, it should move
conservatively.19 An exception to this principle is in the case of substantial uncertainty
around the persistence of inflation. More recent studies, in fact, suggest that when
persistence is high, a strong monetary reaction may be required,20 so as to avoid high
price growth becoming entrenched in agents' mind-sets. While this possibility should
be carefully monitored, the most recent data on market- and survey-based inflation
expectations - including their fall at short horizons and their further declining profile -
may call into question, at least temporarily, the persistence of inflation in the euro area
at the current high levels, reinforcing the arguments in favour of gradual monetary
normalisation.
The second concerns the "long and variable lags" of the monetary transmission process.
Credit dynamics are especially relevant in this respect. On a 3-month (annualised) basis,
the growth of loans to firms in the euro area was virtually nil in December (0.3 per cent)
from an almost double-digit expansion in October (9.8 per cent and 4.5 in November).
Although this deceleration is the natural (and desired) consequence of monetary
normalisation, both its size and speed require us to be cautious in our decisions on the
magnitude and time distribution of interest rate hikes. This observation is all the more
relevant when taking into account the fact that credit growth is negative in real terms and
that the additional tightening in credit conditions signalled by the Bank Lending Survey
may point to a further slowdown in lending dynamics.
The potential risks to financial stability also require a good dose of caution. The
unprecedented coordinated rises in official rates around the world may create spillover
effects that are difficult to quantify but may not be negligible, as I have previously
suggested. Financial instability risks are particularly relevant in the Economic and
Monetary Union, whose incomplete architecture - especially its decentralised fiscal policy
and the delays in completing the banking and the capital markets unions - exposes it to
a possible fragmentation of financial markets along national borders. For this reason, the
Governing Council will continue to exploit the flexibility in its asset purchase programme
related to the pandemic emergency and stands ready to resort to its new Transmission
Protection Instrument, to prevent financial markets tensions from counteracting any
progress made in price stability and hindering economic growth.
Finally, as I have mentioned, in the current uncertain environment, models and forecasts
should necessarily be taken cum grano salis, in particular when determining the
"terminal" level of key interest rates.