Philip R Lane: The macroeconomics of price and wage-setting
Panel remarks by Mr Philip R Lane, Governor of the Central Bank of Ireland, at the ECB Forum
on Central Banking, Sintra, 19 June 2018.
* * *
In my remarks, I will focus on three questions: (i) how should central banks respond to low
inflation?; (ii) how should central banks react to headwind shocks to inflation; and (iii) how
effective have been unconventional monetary policy measures in lifting inflation towards the
target level?
I will discuss these questions in the context of the euro area and the monetary strategy of the
ECB that has included non-standard elements (negative interest rate, forward guidance, asset
purchase programme, targeted long-term liquidity refinancing operations) since the middle of
2014.
The policy package that was initially launched in Summer 2014 was a response to the
belowtarget outlook for the inflation rate and the subdued level of aggregate demand in the euro area. If
the ECB had not taken decisive action, it is possible to entertain alternative scenarios in which
expectations of ultra-low inflation or even deflation took hold. An excessively-tight monetary
stance could also have contributed to further recessionary impulses, especially given the
vulnerability of highly-indebted groups to adverse feedback dynamics between high lending rates,
low aggregate demand and high bank funding conditions in some member countries.
Accordingly, the experience of the last several years is that a phase of persistently-low inflation
requires a vigorous central bank response. Praet (2018) estimates that the ECB's package of
unconventional measures will add a cumulative 1.9 percentage points to both inflation and output
over 2016-2020, which has been achieved through an easing of financial conditions and the
anchoring of inflation expectations. Furthermore, the probability distribution of inflation has shifted
to the right, with very little weight now attached to deflation scenarios. In the absence of these
non-standard measures, the inflation and output outlook for the euro area would be substantially
worse.
Let me emphasise that such measures take time to operate, such that the gap between current
inflation and the inflation target can only be closed gradually. During an extended period in which
inflation is below its target, it is vital that a central bank is energetic and consistent in
communicating its commitment to meeting its medium-term inflation target, while also being
transparent about the need for patience during the convergence process. A successful
communications strategy also involves publishing as much as possible in terms of the central
bank's analysis of the impact of non-standard measures, especially in view of the limited
historical track record for such policies.
In addition to the role played by the considerable economic slack that remained after the 2008-
2012 crisis years, temporary factors such as a phase of declining oil prices during 2014-2016
and some sectoral relative price movements (such as declines in the price of
telecommunications bundles) have also contributed to below-target inflation. Considerable effort
is devoted to unpicking pricing dynamics between less-volatile and more-volatile components
and between more-cyclical and less-cyclical sectors, even while the target rate is appropriately
measured in relation to headline inflation. As temporary and one-off factors fade away, the
headline path should align with the underlying persistent component of inflation.
At one level, the distinction between the current headline inflation rate (affected by one-off
factors) and the target medium-term inflation rate is well understood, since the practical reality of
transmission lags means that central banks must necessarily set policy in relation to the medium
term. However, if headline inflation is persistently below the target rate, this runs the risk of de-
anchoring inflation expectations and can also lead to slower adjustment towards the target to the
extent that there are backward-looking elements in price- and wage-setting. This reinforces the
essential role played by a clear and consistent communication strategy that the central bank is
intent on achieving its inflation target in the medium term and is acting through its full set of
monetary policy instruments to ensure that inflation is on a path that will sustainably converge
towards the target.
Returning to the 2014 debate on whether unconventional monetary instruments would prove
helpful in tackling low inflation in the euro area, the accumulated evidence since then has proven
the value of these measures. In a situation in which there was room for an easing in financial
conditions and there was considerable economic slack, the combined impact of the different
measures delivered a level shift downwards in the yield curve and a considerable reduction in
lending rates. In turn, the easing in financial conditions and the commitment to the inflation target
have facilitated a positive but measured pace of credit growth in recent years and a broad-based
recovery in domestic activity levels across the euro area, together with a positive contribution
from external demand that was especially important during 2014-2015. As noted earlier, the
probability distribution for inflation has shifted rightwards and projections for inflation and output
are more positive than would have been the case in the absence of these measures.
At the same time, inflation remains below target: as re-confirmed by the Governing Council at
last week's meeting, an accommodative monetary strategy will remain in place in order to
underpin the ongoing adjustment path for inflation towards its medium-term target.
Acknowledgements: I thank Robert Goodhead and Shayan Zakipour-Saber for their assistance in
preparing these remarks.
Reference: Peter Praet (2018), "Assessment of Quantitative Easing and Challenges of Policy
Normalisation," Speech at The ECB and Its Watchers XIX Conference, Frankfurt, 14th March.