Olli Rehn: Europe in search of growth and productivity in the shadow
of geopolitics
Speech by Mr Olli Rehn, Governor of the Bank of Finland, at the Peterson Institute for
International Economics, Washington DC, 22 October 2024.
* * *
Presentation accompanying the speech
Ladies and Gentlemen, Dear Friends,
Let me begin by thanking the Peterson Institute for inviting me to speak at this year's
Macro Week. It is a great honor to share my views with such a distinguished audience.
I have followed the Institute since nearly its inception, as Fred Bergsten's book was part
of our coursework when I was studying economics and international relations in
Minnesota. That was in the fall of 1982, a remarkable time in U.S. economic and
monetary history, as Paul Volcker's disinflationary measures were simultaneously
reducing both inflation and employment-a reality felt on the streets of St. Paul and
Minneapolis.
I must admit, Volcker was not especially popular among us students at the
liberalleaning Macalester College, though he was certainly respected for his consistency and
persistence, at least among the economics majors. In hindsight, his actions had historic
significance, not just for monetary policy, but also for great-power relations-they helped
restore the economic foundations of U.S. global strategic influence.
As for me, I could say-if it didn't show a serious lack of self-irony-that this was a
formative experience for a future central banker, though at the time, I had no inkling that
I would one day enter this field. In every central banker, there is a little Paul Volcker. - I
shall return to the lessons of Volcker's disinflation later, in the context of Europe's
recent experiences.
Slide 2. Roadmap of today's talk
You can see the roadmap of today's talk on this slide. I will first of present my thoughts
on the ongoing strategy review of the European Central Bank (ECB), which is due for
completion in 2025. Second, I will focus on the implications of the recent rise in both
geopolitical and geoeconomic fragmentation. Third and finally, I will discuss what in my
view is the Achilles heel of Europe: weak productivity growth.
Slide 3. Three periods of euro area inflation
To provide context for the ongoing ECB strategy review, let's take a look at the history
of inflation in the euro area over the last quarter of century, dividing it into three distinct
periods.
First, during the final years of the Great Moderation from 1999 to 2009, inflation
averaged around 2%. Then, in the post-financial crisis period until 2021, inflation was
exceptionally low, averaging just above 1%. After 2021, as we know, inflation surged
and has averaged over 5%. Each of these periods has been characterized by different
drivers of inflation (or deflation!).
When we at the ECB Governing Council last reviewed our monetary policy strategy, in
July 2021, we had witnessed nearly a decade of low inflation. But we were actually on
the brink of a period of dramatically accelerating inflation. The Federal Reserve faced a
similar situation, as the Federal Open Market Committee reviewed their monetary policy
strategy in August 2020. The Fed then adopted flexible average inflation targeting,
designed to address persistently low inflation.
Slide 4. The perceived de facto ceiling under the old target pushes inflation
expectations clearly below 2%
Before the ECB's 2021 review, the price stability definition ('below but close to 2%') was
perceived as a symmetric, as seen in this graph.
This perception is supported by several studies by the Bank of Finland and ECB staff.
The asymmetry set a virtual 2% ceiling for inflation, thus lowering the de facto inflation
target and leading to asymmetric policy responses and preferences.1
Slide 5. The ECB's current monetary policy strategy: a symmetric 2% inflation
target over the medium term
Hence, by far the most consequential decision in the ECB's 2021 strategy review was
to establish a symmetric inflation target of 2% over the medium term. The symmetry
implies that both negative and positive deviations from the target are equally
undesirable. Another key element of the strategy is the medium-term orientation for
reaching the target.
Empirical evidence shows that the ECB's revised symmetric inflation target has been
effective in anchoring long-term inflation expectations firmly to the 2% inflation target,
despite the turbulence of recent years.
In the 2021 strategy review, most of our work focused quite naturally on improving our
lowflation
policymaking in a ' ' environment. Now, over three years and three crises later,
we are re-assessing how well the revised strategy has performed in a high inflation
environment. Most importantly, we need to consider how to further develop our strategy
in the light of an emerging new - or perhaps old or recycled - normal.
Slide 6. Inflation is stabilizing to our symmetric 2% target - which has served us
well
Right after its introduction in 2021, the ECB's new monetary policy strategy was put to
the test in an environment it was not specifically designed for: a series of supply shocks
and rapidly accelerating inflation.
The supply shocks were caused first by the COVID-19 pandemic and then by Russia's
unjustified and brutal war in Ukraine that led to a sharp increase in energy prices.
These supply factors contributed to the surge of inflation to a peak of 10.6% in October
2022. Inflation averaged 8.4% in 2022 and 5.5% in 2023, as measured by the
Harmonized Index of Consumer Prices (HICP), shown on the left-hand graph. We've
come a long way from there: in September 2024, HICP inflation stood at 1.7%.
Besides driving the already high inflation rate, the energy crisis caused a rocketing rise
in the energy import bill for Europeans, increasing it by around 400 billion euros, equal
to 3%-4% of GDP. Stagflation, i.e. the combination of stagnation and high inflation,
became a serious threat scenario, presenting a major dilemma for monetary policy.
After a period of deliberation in 2022 from March until June, the ECB began raising
interest rates. We discontinued quantitative easing (QE) and increased policy rates
rapidly by a total of 450 basis points between July 2022 and September 2023, bringing
the deposit rate, our main policy rate, from -0.5% to 4%. In line with our revised
strategy, we intended to tame inflation over the medium term by preventing high
inflation from leading to elevated inflation expectations and potentially to a wage-price
spiral. In my view, this goal has largely been achieved.
Some argue that we should have acted sooner. I can say that many of us policymakers
were indeed ready to raise rates earlier due to soaring inflation. However, Russia's
invasion of Ukraine in February 2022 reintroduced the era of brutal geopolitics and
created a massive cloud of stagflationary uncertainty over Europe's economy. While the
ramifications were felt globally, and still are, the impact was more severe for Europe
than, for example, the United States. This is something to keep in mind in all
postmortems of the recent poly-crisis years.
Looking at the latest policy decisions, progress in lowering inflation has enabled us to
make three 25 basis-point cuts to interest rates since June 2024. The most recent cut
was unanimously decided last Thursday, as we now have greater confidence that
inflation is converging towards 2% on a sustained basis. Disinflation in the euro area is
well on track.
All in all, a soft landing seems plausible in the euro area. However, growth is expected
to remain sluggish, as shown in the right-hand graph. The growth outlook has
weakened quite clearly in the past few months, which could also increase disinflationary
pressures.
Based on the current outlook, and as our rates still are at the restrictive territory, the
direction of rate changes is clear. The speed and scope of rate cuts will depend on our
overall assessment of the trend in three variables: the inflation outlook, the dynamics of
underlying inflation and the strength of monetary policy transmission.
Slide 7. Reflections on the ECB's next strategy review in 2025
Based on the experience of recent years, the symmetric, medium-term 2% inflation
target has served us well. It has provided a clear anchor and enough pre-calibrated and
meaningful flexibility in terms of both the timing and instruments of policy. We have not
had to take the drastically contractionary policy actions that the old target might have
implied. And we didn't need to show Volckerian stubbornness, with all respect to him,
thanks to the fact that inflation expectations remained well-anchored.
Thus, in my view, the inflation target itself does not need to be revisited now. As the
saying goes, don't fix it if it ain't broke. However, we do need a deeper understanding of
inflation dynamics and the secular trends that are transforming the operational
environment of monetary policy, such as geopolitical fragmentation, climate change,
labor market transition and other structural drivers of the natural rate of interest.
Geopolitical tensions have risen substantially with Russia's illegal war in Ukraine, the
tragic war in the Middle East, and China's strategic aims, both technological and
military. Trade wars, protectionism and geoeconomic fragmentation are the byproducts
of these tensions, and so are the diversion and relocation of global value chains.
Key questions for central bankers are, how significant are these developments, and do
they have implications for the level of the long-term real natural rate of interest, or the
equilibrium interest rate, r*?
To answer these questions, it is useful to look at whether production is being reshored
or transferred back home at substantial levels. In other words, is globalization indeed
reversing?
Slide 8. Geopolitics is shaping the operating environment - along with other
secular trends
Yes, we are witnessing signs of trade fragmentation. Given the steep rise in trade
barriers and protectionism, the ramifications to the world economy, not least the
EMDEs, should not be underestimated. But so far, no fully-fledged reversal of
economic globalization has taken place.
What we are mostly seeing is the lengthening of global value chains. Even if direct
trade between China and the West is in modest decline, Chinese value-added
imported by the U.S. and EU have not diminished - our BOFIT staff analysis indicates
that, in between 2018 and 2023, Chinese value added remained stable in US
manufacturing imports and slightly increased in Europe - as shown in the left-hand
graph. It seems that value chains have simply been rerouted via connector countries,
such as Mexico and Vietnam.
Smaller countries like Finland and the other Nordics have greatly benefited from
deepening economic integration. Multilateral trading system has been a win-win and a
key building block of the strategic community of liberal democracies. Economic
cooperation with the United States remains crucial for this achievement and alliance,
even if this fact has not been overly prevalent in the U.S. presidential elections. Trade
wars would only damage this bond. Suffice it to say that we Europeans are forced to
pre-emptively prepare for different options.
Thanks to Finland's accession to NATO, our ties with the US and our trade partnership
has strengthened, also in strategic areas (right-hand graph). Notable cases are cruise
ships and tech products exported to the US, and on the imports side, the new American
F-35 fighter jets that will replace soon our cherished but aging F-18 Hornets.
The biggest increase in Finland's trade with the US has come from trade in digital
products and IT services. In my view, this underlines the substantial mutual benefits of
this economic partnership.
Slide 9. Estimates of the natural rate of interest in the euro area
The precise implications of geoeconomic fragmentation for inflation, growth and
productivity, and therefore for monetary policy, warrant careful consideration in our
ongoing strategy review.
A key question is the level of the long-term real natural rate of interest, r* or the
equilibrium interest rate. R-star is a most pertinent analytical framework for thinking
about the economy and monetary policy, even though it is not truly viable as a concrete
policymaking tool.
Some argue that the natural rate is rising due to significant investment needs for the
green transition, artificial intelligence and defense spending. Meanwhile, others believe
it is declining due to weak productivity growth, aging populations and geoeconomic
fragmentation. The true trajectory of the natural rate remains unclear and requires
plenty of further and deeper analysis and continuous research.
Estimates of r* for the euro area are currently slightly above zero, or broadly between 0
and 1, as shown in this graph. At the Bank of Finland, we also regularly examine the
evolution of natural rate, of course acknowledging the significant uncertainty associated
with estimating r*. Our researchers currently estimate the euro area natural rate to be in
the range of 0.2-0.8%, which is in the same ballpark as the estimates in this graph and
somewhat above that of the New York Fed with its broadly recognized
Holston-LaubachWilliams model.2
Slide 10. Productivity growth is Europe's Achilles heel - we need decisive actions
Let me finally turn to the marked slowdown in productivity growth, which is the real
Achilles' heel of Europe. This is an issue that is closely linked to the natural rate and
monetary policy, but also to the longer-term economic success of Europe (and other
nations for that matter).
Europe's long-lasting productivity gap to the U.S. has widened further in the past few
years, as shown in the left-hand graph. A key reason for this is the energy shock
resulting from Russia's war in Ukraine, as it adversely affects competitiveness
specifically in the euro area - unlike past oil shocks that tended to hit all firms globally.
The right-hand graph shows that the producer prices for energy rose much more in the
euro area than in the US, but they have also remained higher.
In Finland, we have adjusted to the loss of Russian energy imports by increasing
domestic production of renewable and nuclear power. Thus, energy prices did not
increase so drastically in Finland as in some other countries and have indeed already
returned to their pre-pandemic level.
A major reason for Europe's slow productivity growth in recent years is
weak
investment, driven by the uncertainty from Russia's war in Ukraine and the energy
crisis, and possibly tight financial conditions.
As to the determinants of productive investment, the distinction between structural and
cyclical is never crystal clear - it's rather a line drawn in water. It is true that the current
clouds of both brutal geopolitics and trans-Atlantic and intra-European uncertainty are
weighing on the European economy in the form of confidence-damaging effects.
Still, if I may paraphrase a certain giant of economics: "In the long run we are all retired.
But in the meantime, we need more investment."
In other words, even though Europe's longer-term growth and competitiveness
challenges cannot be solved by monetary policy tools, we know that investment is
driven by many factors, not least by aggregate demand, which is obviously affected by
financial conditions. Thus, in the shadow of recent supply shocks and current slow
growth, an easing in financial conditions should help avoiding scarring effects in
3
investment that is needed to increase longer-term productivity .
The need to pursue stronger productivity growth on all fronts is the key message in the
recent report on EU competitiveness by ex-President of the ECB, Mario Draghi. The
Draghi report is a clear-eyed and even brutal diagnosis of Europe's weak growth and
weak competitiveness. It makes important proposals for closing the innovation gap and
combining climate goals with industrial competitiveness, as well as enhancing security
by pooling defense capacities in the EU.
Likewise, Draghi calls for cutting the red tape and speeding up structural reforms at
both national and EU levels. We must support better diffusion of new technologies,
improve access to finance and remove existing barriers to services across countries.
Cutting-edge research and innovation, including AI, will play a key role in the pursuit of
these goals.
Slide 11. Conclusions
Let me conclude. Many crucial issues for Europe are at stake now, and they also matter
for the United States, Europe's closest ally and partner.
First and foremost is unity and determination in the face of Russia ́s imperialist
aggression. This is an existential issue not only for European security but for the whole
free world. Our support to Ukraine must remain unwavering, and we must work with all
our partners to strengthen international security and cooperation.
Second, the rise in geopolitical tensions is contributing to an increasingly uncertain and
volatile global environment and has significant implications for economic policy in
Europe-and beyond. The changing geopolitical landscape, along with other long-term
trends, shapes the new normal that we must consider when we develop our monetary
policy strategy.
Finally, reinforcing the structural foundations of the European economy - i.e.
productivity growth and industrial competitiveness - is of paramount importance. While
we face many challenges, with determined national action and EU-wide cooperation
Europe can revitalize its productivity growth and lay a solid basis for sustainable growth
and employment.
A key part of this effort will be fostering mutually beneficial partnerships with
likeminded countries, especially the United States.
Thank you for your attention! I am looking forward to your questions and what will no
doubt be an interesting discussion.
References
Haavio, M., Heikkinen, J., Jalasjoki, P., Kilponen, J., Paloviita, M. and Vänni, I. (2024),
Reading between the lines: Uncovering asymmetry in the central bank loss function,
Bank of Finland Research Discussion Papers 6/2024 and SUERF Policy Brief No. 992.
Paloviita, M., Haavio, M., Jalasjoki, P. and Kilponen, J. (2021). What Does "Below, But
Close To, Two Percent" Mean? Assessing the ECB's Reaction Function with Real Time
Data. In: International Journal of Central Banking 17.2, pp. 125-169.
Rostagno, M., Altavilla, C., Carboni, G., Lemke, W., Motto, R., Guilhem, A. and
Yiangou, J. (2021). Monetary Policy in Times of Crisis: A Tale of Two Decades of the
European Central Bank. Oxford University Press.
1
See Rostagno et al. (2021), Paloviita et al. (2021) and Haavio et al. (2024).
2
Kortelainen and Vilmi: Recent insights into r*: an analysis using the modified HLW
model , forthcoming.
3
Fornaro and Martin Wolf, The scars of supply shocks: implications for monetary
policy. Science Direct 2023. Link: https://www.sciencedirect.com/science/article/pii
/S0304393223000417?via%3Dihub