Christine Lagarde: Monetary policy in the euro area
Speech by Ms Christine Lagarde, President of the European Central Bank, at the Bank
of Lithuania's Annual Economics Conference on "Pillars of Resilience Amid Global
Geopolitical Shifts", on the occasion of the 10th anniversary of euro introduction,
Vilnius, 16 December 2024.
* * *
It is an honour to be here today to mark 10 years of Lithuania in the euro.
" Laisv , Vienyb , Gerov" - freedom, unity and well-being. These are core national values
in Lithuania - and accordingly, they are engraved in the edge-lettering on Lithuania's €2
coin.
Freedom, because of the liberation from Soviet occupation. Unity, because of the need
for national solidarity. And well-being, expressing hope for economic and social
prosperity.
These three words capture the spirit of the Lithuanian people. And I believe that being
part of the euro has strengthened each of them.
The country is now an equal partner in setting monetary policy by one of the world's
most important central banks in the third largest economy, the euro area. That gives
Lithuania freedom in charting its own macroeconomic destiny that smaller economies
cannot typically claim, who often have to import the monetary policy of their larger
neighbours.
Lithuania now also issues the world's second most important reserve and invoicing
currency. That provides unity in the face of a more volatile world, as foreign shocks do
not penetrate the domestic economy as much, owing to domestic currency invoicing.
Lithuania is especially resilient on this front, invoicing 78% of its exports to non-member
countries in euros last year, the fourth highest share across the EU.
well-being
And being part of the euro has increased the of the Lithuanian people. When
Lithuania joined the euro area in 2015, GDP per capita in purchasing power standard
terms was around 70% of the euro area average. By 2023, it exceeded 83%.
But more recently, the country has dealt with very high inflation, peaking at 22.5% in
September 2022 - more than double the peak seen in the euro area as a whole.
This high-inflation episode has led to a pronounced monetary policy cycle, with the ECB
raising rates by 450 basis points, holding them steady for 9 months, and then cutting
rates by 100 basis points since June as we entered the "dialling back" phase of our
policy.
However, even in this "dialling back" phase, until recently we retained a restrictive bias
in our future policy orientation. At our last meeting, we dropped that bias.
Today, I would like to explain what motivated this change and what it implies for the
future.
In a nutshell, we have seen the environment change in three important ways that
increase our confidence that inflation is returning to our target. These changes concern
path of inflation shocks driving inflation risks to inflation
the , the and the .
The path of inflation
The first important change relates to the path of inflation .
In the earlier part of our monetary policy cycle, the path of inflation was characterised
by high uncertainty. We consistently saw the return of inflation to target in our
projections being pushed back. At the same time, the incoming inflation data were
surprising on the upside, casting further doubt on the accuracy of those projections.
1
ECB staff models using machine learning indicate that in 2022 and 2023 uncertainty
around inflation forecasts was around four to five times higher than in the long-term
average.
This uncertainty about the inflation path had implications for the policy horizon - that is,
the period within which we want to see inflation converging to our target.
Normally, the medium-term policy horizon is flexible and can be extended depending on
the nature, size and persistence of the shocks. But if there is a risk of inflation
expectations becoming de-anchored, the horizon must be shortened to the nearest
possible date that monetary policy can take effect to prevent that risk materialising -
which given normal transmission lags is around two years.
With inflation rising and its return to target continually being pushed back, at a certain
point we considered that the risk of de-anchoring had become too high. So, in
September 2022 we introduced the notion that the return of inflation to our target had to
be "timely". Our aim was to fix the policy horizon and thereby build confidence among
the public that there would be no more delays.
Now, after a lengthy period of restrictive policy, our confidence that we are seeing a
"timely" return to target has increased.
Since September last year, we have had six consecutive forecast rounds showing
inflation returning to target in the course of 2025. And this arrival date has stayed
constant even as we have drawn closer to it.
The uncertainty around these projections has decreased significantly. Our machine
learning models now put the uncertainty bands at close to pre-pandemic levels.
The incoming data have, over time, validated the path laid out in the forecasts. Since
early 2023, the accuracy of staff projections has returned to the levels seen pre-COVID,
especially for headline inflation. While errors for core inflation have taken longer to
normalise, this year they have also returned to historical standards.
And this confidence is confirmed in inflation expectations. Among households, median
expectations for inflation three years ahead are close to 2%, and market-based
indicators of longer-term inflation expectations have also fallen in recent months.
The shocks driving inflation
The second change in the environment relates to the shocks driving inflation .
The major challenge for monetary policy during this cycle is that we have faced a
sequence of very large shocks which - given staggered wage- and price-setting in the
euro area - have transmitted through the economy in persistent and hard-to-forecast
ways.
So, even as our confidence in our projections increased, we had to be careful in making
our policy stance less restrictive too quickly. We needed a policy framework that would
allow us to better understand this complex inflation process. That is why we built our
reaction function around our well-known three criteria: the inflation outlook, the
dynamics of underlying inflation and the strength of monetary transmission.
Focusing on the dynamics of underlying inflation allowed us to extract more robustly the
trend in inflation based on the data we could see in front of us, complementing the
information provided by our forecasts.
And for a given inflation path, assessing the strength of monetary transmission allowed
us to judge whether our tightening impulse was being passed on through the
transmission chain and was thus effective in steering inflation back towards 2%.
This forward-looking framework has provided a way of broadening our information set
to capture the pace at which a very large past shock - 10.6% inflation at its peak - was
running its course, and how our monetary policy stance was transmitting through the
economy and affecting medium-term inflation.
For some time, the signals from underlying inflation were still flagging the risk that
inflation might not decline as quickly as indicated in our forecasts. But recently this risk
has declined and there is now greater alignment between our forecasts and underlying
inflation.
The width of the range of measures of underlying inflation that we monitor has
narrowed towards its historical average, with most indicators hovering between 2% and
2.8%, which we take as an indicator of receding uncertainty on future inflation
dynamics. The Persistent and Common Component of Inflation (PCCI), which has the
best predictive power for future inflation, has remained at around 2% since the end of
last year.
There is one measure that is still above this range, which is domestic inflation, capturing
items with a low import content. But this is a year-on-year measures that is made up
97% of services items, and so it is still registering repricing events that took place
earlier this year that are keeping services inflation around 4%.
However, if we look at the PCCI for services, which strips out base effects, the measure
currently stands at 2.5%. Inflation momentum for services has also dropped steeply
recently. These data suggest that there is scope for a downward adjustment in services
inflation, and thereby domestic inflation, in the coming months.
Confirming this picture, wage growth - which is the main cost factor driving services - is
on a downward trajectory and continues to be buffered by negative growth in unit
profits, buffering the pass-through of rising wages to prices.
The ECB wage tracker - which captures wage agreements in seven euro area
countries representing around 85% of total wages in the euro area - sees wage growth
slowing from 4.8% this year to around 3% in 2025, the level we generally consider to be
consistent with our target.
The risks to inflation
The third change in the environment relates to the risks to inflation .
The fact that past shocks were expected to travel slowly along the pricing chain meant
that, in recent years, the risks to inflation were mostly to the upside. And despite the
progress we have seen in underlying inflation, these risks have not disappeared entirely.
The composition of inflation remains unbalanced, with the recent slowdown being
driven mostly by energy inflation, which is particularly volatile, and industrial goods. The
adjustment process for slower-moving services inflation is still unfinished. So, we will
have to remain watchful until the downward adjustment in services inflation that we
expect is confirmed by the data.
However, as past shocks fade, the risks to the inflation outlook have changed. And
crucially, these risks are now related more to potential future shocks than to the
transmission of past ones.
The main downside risks relate to the weaker-than-expected growth outlook and the
increased uncertainty surrounding growth triggered by geopolitical events.
For some time now, we have been seeing small sequential downward revisions to the
growth outlook which have cumulatively amounted to a quite significant downgrade over
time. For example, if we go back to our June 2023 projections, we expected average
growth of 1.5% in 2024. Now, we expect 0.7%.
One driver of this delayed recovery has been sluggish export growth, driven by the
competitive challenges facing euro area companies. But the most important driver of
our growth forecast misses has been the domestic economy. In fact, around half of the
misses since end-2021 relate to investment and a quarter relate to consumption.
The behaviour of investment can be attributed to a combination of factors, including the
stronger-than-expected impact of higher interest rates, higher energy prices and
structural deterrents. The inertia in consumption has been striking given that the
conditions for a recovery are in place. Employment is historically high and real incomes
are rising. But households continue to save an unusually high share of their income and
take a cautious approach to spending.
One reason for this caution is that many households have a perception of their real
income growth that is well below measured data. Just 37% of households in our
consumer survey believe that their real income has risen or stayed the same, even
though 50% of all households have experienced actual increases. And these
households have significantly lower consumption growth than those with correct
perceptions.
This pessimism about real incomes is largely driven by past inflation, and so in principle
it should dissipate as the high-inflation episode moves further into the rearview mirror.2
But increasing geopolitical uncertainty could create new dents in household sentiment.
In particular, if the United States - our largest export market - takes a protectionist turn,
growth in the euro area is likely to take a hit. Our exporters also specialise in capital
goods that other countries use for export production, which makes them particularly
sensitive to shifts in confidence about world trade.
The main upside risks we see in the future also relate to external shocks. A rise in
geopolitical tensions could push energy prices and freight costs higher in the near term,
while extreme weather events could drive up food prices. The net effect of trade
fragmentation and tariffs on inflation remains uncertain, as it involves assumptions that
are impossible to anticipate with precision. These include potential retaliatory actions as
well as exchange rate and commodity price movements.
Implications for monetary policy
So what does this changing environment mean for our monetary policy? There are
three main implications.
The first concerns our current policy stance and its future orientation .
The current policy stance is restrictive. But if the incoming data continue to confirm our
baseline, the direction of travel is clear and we expect to lower interest rates further.
In terms of the future orientation, we previously said that "we will keep policy rates
sufficiently restrictive for as long as necessary". This bias was necessary in an
environment of high realised inflation and high uncertainty about future inflation. But it
no longer reflects the evolving macroeconomic landscape, our outlook for inflation or
the balance of risks around it.
With the disinflation process well on track, and downside risks to growth, this bias in our
communication is no longer warranted. These considerations are reflected in the
monetary policy statement adopted by the Governing Council last week. We no longer
aim for "sufficiently restrictive" policy, but rather intend to deliver an "appropriate" policy
stance.
The second implication for monetary policy concerns our reaction function.
The high-inflation period has proven the value of the three criteria we have been using
to take decisions, which is why the Governing Council confirmed this policy framework
at last week's meeting. And these criteria will be invaluable in the period ahead, even
as the risks to inflation move from past shocks to future ones.
In an uncertain environment, we will need to continue complementing our baseline
outlook with a rich distribution of possible risks derived from current data. But our
framework is flexible, in the sense that we can change the weight we put on the
different legs of our reaction function depending on the nature of the shocks we are
facing.
For example, if we face large geopolitical shocks that significantly increase uncertainty
about the inflation projections, we will need to draw on other sources of data to make
the risk assessment surrounding our baseline outlook more robust.
At the same time, the purpose of monitoring underlying inflation is to help us
differentiate noise in the inflation data from underlying trends. So, if underlying trends
are not affected, it will help increase confidence in the baseline projection.
And assessing monetary transmission will continue to be important, as geopolitical
uncertainty may affect monetary transmission by altering the risk appetite of investors,
borrowers and financial intermediaries.
policy horizon
The third implication concerns the .
Even though we are not there yet, we are close to achieving our target. So, we are no
longer in a situation where we need to fix the policy horizon at the shortest possible
transmission lag. We can return to a situation where the policy horizon can adjust
depending on the nature, size and persistence of the shocks as needed.
This change explains why we have removed the notion of "timeliness" from our
monetary policy statement, focusing instead on achieving "sustainable" inflation
convergence. And it puts us in the best position to react to future shocks.
Conclusion
Let me conclude.
The Lithuanian poem "The Seasons" ( Metai ), written by Kristijonas Donelaitis, charts
the cyclical nature of the rural life of Lithuanians.
The ECB is also moving through its monetary policy cycle, and we are now at a stage
where the darkest days of winter look to be behind us, and we can start to look forward
instead.
We certainly hope that the days ahead will be better. But winds are blowing in different
directions and there is much uncertainty before us.
So, our monetary policy will be prepared for all scenarios to come.
[This speech was updated on 16 December 2024 at 11:25 CET to correct the ECB's
June 2023 average growth projections for 2024.]
1
Lenza, M., Moutachaker, I. and Paredes, J. (2023), "Density forecasts of inflation: a
quantile regression forest approach ", Working Paper Series, No 2830, ECB.
2
The ECB's consumer expectations survey shows that perceptions of past inflation
have declined by more than 5 percentage points from their peak of 8.4% in September
2023.