Back to the future: forward-looking considerations
on monetary policy normalization
Speech by Fabio Panetta*
Governor of Banca d'Italia
Bocconi University,
Milan, 19 November 2024
Good morning everyone.
Let me first of all thank the Rector of Università Bocconi, Professor Francesco Billari, for
inviting me here today. It is a pleasure to visit this prestigious and renowned institution.
And it is always a privilege to discuss economics with young people who are studying this
discipline today, but will shape its course tomorrow.
This meeting takes place at an interesting time for monetary policy.
The exceptional shocks of 2022-23 are gradually fading into the background, and
inflation in the euro area is not only lower, but also less volatile than it has been for a
long time (Figure 1). As a result, inflation forecast errors have also normalized (Figure 2).
The euro area has completed a long, historic journey through terrae incognitae that
began immediately after the COVID pandemic.
Figure 1
Euro-area inflation going back to normal
(percentage changes and percentage points)
12 2.5
10 2.0
8 1.5
6 1.0
4 0.5
2 0.0
0 -0.5
-2 -1.0
-4 -1.5
-6 -2.0
2003 2006 2009 2012 2015 2018 2021 2024
HICP inflation Target HICP inflation, monthly change (1)
Source: ECB and Eurostat.
(1) Right-hand scale.
*
I wish to thank Piergiorgio Alessandri and Alessandro Secchi for their valuable insights and contributions.
Figure 2
Projection errors for euro-area inflation (1)
(percentage points)
(a) One quarter ahead projection errors (b) Four quarters ahead projection errors
8 8 8 8
6 6 6 6
4 4 4 4
2 2
2 2
0 0 0 0
-2 -2 -2 -2
-4 -4 -4 -4
2004 2009 2014 2019 2024 2004 2009 2014 2019 2024
Source: elaborations on ECB data.
(1) Based on ECB/Eurosystem projections for headline inflation. Dotted lines denote an interval around zero of plus/minus two standard deviations of projection
errors realized in 2003-2020.
This return to charted territory is clearly good news. But the current economic landscape
presents its own challenges. At the global level, geopolitical tensions are high, and
political developments in a number of countries are difficult to predict. In the euro area,
the economy is stagnating and interest rates are still in restrictive territory. How should
the ECB proceed?
Today I will argue that this 'new' phase has three main implications for the conduct of
monetary policy.
First, with inflation close to target and domestic demand stagnant, restrictive monetary
conditions are no longer necessary. In the current phase we should focus more on the
sluggishness of the real economy: without a sustained recovery, inflation risks being
pushed well below target, opening up a scenario that would be difficult for monetary
policy to counteract and should therefore be avoided. In short, we need to normalize
our monetary policy stance and move to neutral - or even expansionary territory, if
necessary.
Second, we can now return to a more traditional, genuinely forward-looking approach
to monetary policy, in line with our medium-term orientation. Removing monetary
restrictions when aggregate demand is faltering is a simple example of how this principle
translates into practice; but the principle is far more general. The exceptional circumstances
of the past two years have forced central banks to give less weight to forecasts and to
live day by day (or 'meeting by meeting'). Now that the situation on the inflation front
is normalizing, the ECB should also normalize the way it calibrates its monetary policy
stance, by returning to tradition and refocusing on its medium-term reaction function. In
short, we should go 'back to the future'.
Third, and in line with the points I have just made, our communication should provide
more guidance on the expected evolution of our policy than has been the case in the
recent past. This will help firms and households to form their views on the future path of
policy rates, thereby supporting demand and the recovery of the real economy.
In the rest of my speech I will explore these issues starting with an analysis of what has
changed and why it matters.
1. A fragile global macroeconomic outlook
Inflation has been falling steadily in the main advanced economies in 2024;1 the
disinflation process has been rapid and generally less painful than in past experiences.
For economic activity the picture is more complex. A clear divide has emerged between
the two main global players, the US and China.
In the US inflation is falling, albeit unevenly, amid robust consumption and income
growth. This prompted the Federal Reserve to cut interest rates by 75 basis points
between September and November. The forthcoming change in the US administration
adds uncertainty to the inflation outlook: changes in fiscal and trade policy are likely to
have a significant impact on the economy, with implications for monetary policy.
In China, by contrast, subdued demand and a protracted real estate crisis have depressed
inflation and weakened economic activity, leading to extraordinary monetary and fiscal
interventions. These measures have supported financial markets, but their effectiveness
in boosting growth and restoring price stability remains uncertain.
At the global level, activity in the goods and services sectors continues to diverge.
These two sectors took different paths in the aftermath of the pandemic, and the gap is
still pronounced: manufacturing performed poorly throughout the year, while services
generally performed better.2 After a robust expansion in the first half of the year, trade
slowed in the third quarter, partly due to the slowdown in China.
Looking ahead, the IMF forecasts that global growth will remain roughly constant at
3.2 per cent for the next two years, with a significant gap between the US and the euro
area. The IMF's medium-term forecast of 3.1 per cent remains close to its historical
minimum.
2. Theeuroarea:ashakyrecoverywithfallinginflation
Inflation in the euro area is in line with or ahead of the global trend. The disinflation
process has been faster and smoother than some had anticipated: medium-term
inflation expectations remained anchored, generalized second-round effects through
wages did not materialize, and concerns about the 'last mile' problem - the idea that
the final phase of the disinflation might for some reason be the most difficult - proved
groundless.
This rapid normalization was largely due to the unwinding of the supply shocks that
had caused prices to accelerate in the first place. The ECB's action and its credibility
contributed to the process.
Headline inflation fell below the 2 per cent target in September. It then returned exactly
to target in October, reflecting a temporary increase largely due to base effects.3 Some
ups and downs are to be expected in the coming months, again due to base effects, but
the baseline is one in which inflation continues to fall in early 2025 and remains on target
thereafter.
Economic activity remains weak. The 0.4 per cent growth rate recorded in the third
quarter of 2024 provided some respite after two years of stagnation, but we should not
read too much into this figure: the region remains on course for annual growth of at
most 1 per cent in 2024. The malaise of European manufacturing is confirmed by the fact
that industrial production has been falling for two years and is now below pre-pandemic
levels (Figure 3).
Figure 3
Industrial production in the euro area (1)
(index numbers: January 2020=100)
110 110
100 100
90 90
80 80
70 70
2019 2020 2021 2022 2023 2024
Euro area Euro area (excl. Ireland) Germany France Italy
Source: elaborations on Eurostat data.
(1) Three-month moving average.
Leading indicators suggest that the turning point for Europe's beleaguered
manufacturing sector is not in sight. In Germany, PMIs are around the levels seen in
the spring of 2020 or in 2009, neither of which are particularly reassuring benchmarks
(Figure 4.a).4 The euro area services sector is in better shape, but it benefited from
one-off events such as the Olympic Games in the summer and may now be slowing
down (Figure 4.b).ffl
Figure 4
Purchasing Managers' Indices (PMIs) in the euro area
(diffusion indexes)
(a) Manufacturing (b) Services
70 70 65 65
60 60
60 60
55 55
50 50
50 50
40 40
45 45
30 30 40 40
2010 2015 2020 2022 2023 2024
Euro area Germany France Italy
Source: Standard & Poor's Global.
The unemployment rate remains at its historical minimum of 6.3 per cent (Figure 5.a).
However, the job vacancy rate, a leading indicator of future employment dynamics,
has been on a downward trend for more than two years and is currently not far from
pre-pandemic levels (Figure 5.b).
Figure 5
Euro-area labour market indicators
(percentage points)
(a) Unemployment rate (b) Job vacancy rate
13 13 3.5 3.5
12 12
3.0 3.0
11
11
2.5 2.5
10 10
9
9
2.0 2.0
8 8
1.5 1.5
7 7
6 6 1.0 1.0
2005 2010 2015 2020 2010 2015 2020
Source: Eurostat.
In any case, it is especially the demand side of the economy that gives less cause for
optimism. Private domestic demand contracted in the first half of this year, leaving
growth entirely dependent on foreign demand (Figure 6).
The extent to which exports will continue to support GDP in 2025 is unclear at best.
The possibility that the US administration will introduce new tariffs is not reassuring in
this respect. Without a boost from exports, the euro area will need a strong rebound in
domestic demand to grow.
Euro-area GDP growth rate and contributions of domestic and foreign demand
(percentage changes and percentage points)
2 2
1 1
0 0
-1 -1
2021 2022 2023 2024
GDP growth (1) Net foreign demand Domestic demand
Source: elaborations on Eurostat data.
(1) Quarterly percentage changes.
The question is, how likely is this rebound?
Consumption has been a recurrent disappointment so far. The recovery embedded in
past Eurosystem projections has repeatedly failed to materialize: households have proved
reluctant to spend, partly because of high real interest rates (Figure 7).5
Figure 7
Model-based decomposition of the change in the saving rate (1)
(percentage points)
3 3
2 2
1 1
0 0
-1 -1
Q4 2022 Q1 2023 Q2 2023 Q3 2023 Q4 2023 Q1 2024 Q2 2024
Labour income Net wealth Consumer confidence Saving rate
Other income Short-term interest rate Residuals
Source: P. Lane, 'Inflation and monetary policy in the euro area', Seminar at Columbia University, 22 October 2024 (updated estimates).
(1) Decomposition based on an error-correction model for private consumption, including real household labour and other income, real net wealth, real interest rate and
household confidence. Real interest rates are computed as the difference between the nominal three-month EURIBOR and households' inflation expectations one-year ahead.
Investment also remains weak. This is partly due to uncertain growth prospects. However,
tight financing conditions are also increasing the cost of capital for companies. In addition
to dampening demand in the short term, a persistently high cost of capital (relative to
5
Preliminary data suggest a possible strengthening of consumption in the third quarter, but its precise
extent and resilience remain to be seen.
labour and intermediate goods) prevents the adjustment in the capital-to-labour ratio
that would be necessary to raise productivity.6
Last but not least, restrictive fiscal policies are likely to compress demand in 2025.7
This interpretation of the data points to downside risks to growth, and hence inflation.
As always, there are alternative interpretations of the possible course of events, some
of which are associated with an emphasis on upside risks. In the absence of major
shocks, two factors could keep inflation persistently above target: service prices and
labour costs. The ECB should certainly remain vigilant on these fronts.
But how likely are services and wages to be a primary concern going forward?
Services inflation remains high, at 3.9 per cent in October. However, services prices
are notoriously sluggish: for a large proportion of the services in the consumption
basket,8 prices adjust to past inflation with a lag. Since inflation is now much lower, it
will not lead to further large increases in services prices. Moreover, services inflation
has historically always been higher than goods inflation. This means that the ECB does
not need services inflation to reach 2 per cent to meet its target.9
As regards wages, after the robust catch-up in 2023 and 2024, which was inevitable
given the previous rise in inflation, their dynamics are now normalizing. Wage growth
is evolving in line with Eurosystem projections. Moreover, business surveys suggest
that wage pressures will ease going forward, in line with the projections. If history is
any guide, the recent decline in the vacancy-to-unemployment ratio also points to a
less tight labour market, and hence to a moderation in compensation per hour in the
near future (Figure 8). Indeed, against the backdrop of subdued economic growth, it is
unlikely that we will see a new acceleration in wages next year.
Private sector inflation expectations are broadly consistent with the predominance of
downward risks to inflation. For example, inflation-linked swaps suggest that inflation
will fall below 2 per cent in early 2025 and will remain around that level for the rest
6
F. Panetta, 'Monetary policy in a shifting landscape', dinner speech at the Inaugural Conference
of the Research Network on 'Challenges for Monetary Policy Transmission in a Changing World'
(ChaMP), Frankfurt, 25 April 2024. See also P. Cipollone, 'Some like it hotter: the conditions for
a cyclical recovery in euro area productivity', contribution to the Centre for European Reform's
annual economics conference on 'A European path to higher economic growth', Ditchley Park,
15 November 2024.
7
These may be driven by fiscal rules (such as the debt brake in Germany) and/or efforts to rein in high
deficits (e.g. in Italy and France).
8
Sluggish items (or 'latecomers'), such as insurance policies or health services, account for around 40
per cent of the total services basket and 20 per cent of the total HICP basket. Last September, they
contributed 1.7 percentage points to an overall services inflation of 3.9 per cent.
9
F. Panetta, 'Monetary policy after a perfect storm: festina lente', speech delivered at the Bank of Finland
International Monetary Policy Conference on 'Monetary Policy in Low and High Inflation Environment',
Helsinki, 26 June 2024.
Figure 8
Compensations and vacancies in the euro area
(percentage changes and ratio)
5.5 0.50
4.5 0.45
3.5 0.40
2.5 0.35
1.5 0.30
0.5 0.25
2022 2023 2024 '25
Compensation per hour Vacancy/unemployment ratio (1)
Source: Eurostat.
(1) Right-hand scale. The vacancy-to-unemployment ratio is shifted three quarters ahead.
of the year;10 beyond one year, they signal risks of undershooting our target. In recent
months, restrictive monetary policy has played a key role in pushing these expectations
below 2 per cent (Figure 9).11
Figure 9
A model-based decomposition of inflation expectations in the euro area (1)
(basis points and per cent)
150 3.5
100 3.0
50 2.5
0 2.0
-50 1.5
-100 1.0
2022 2023 2024
EA demand EA monetary policy US macro 5Y inflation swap rate (2)
EA supply US monetary policy Global risk appetite
Source: elaborations based on C. Höynck and L. Rossi, 'The drivers of market-based inflation expectations in the euro area and in the US', Economic Letters, 232,
2023, also published in Banca d'Italia, Questioni di Economia e Finanza (Occasional Papers), 779, 2023.
(1) Changes relative to 3 January 2022. - (2) Right-hand scale.
The policies implemented by the new US administration may of course have an impact on
the inflation outlook, but we know too little today to speculate on the likely impact. There
could be inflationary pressures from a generalized increase in tariffs and a depreciation
10
Around 60 per cent of the analysts surveyed by the ECB (SMA) see inflation risks in 2025 as 'balanced', but
35 per cent now believe that they are tilted downwards. Consumers' inflation expectations are declining
too. According to the ECB-CES data for September 2024, one-year ahead inflation expectations declined to
2.4 per cent (from 2.7 per cent), and three-year ahead expectations fell to 2.1 per cent (from 2.3 per cent).
11
It is worth noting that market-based inflation expectations did not move much after the US elections.
This reflects the widespread view that the policies adopted by the new administration could, if anything,
affect the growth prospects of the euro area (for instance through a reduction in exports) rather than
its inflation outlook.
of the euro. But these could be offset by the recessionary effects of a decline in trade
flows, higher economic uncertainty and lower commodity prices due to lower global
activity. In this case, the overall impact on euro area inflation could even be negative.
3. Implications for monetary policy
How should monetary policy respond to the economic environment I have just described?
First and foremost, the overarching objective should be a timely normalization of the
monetary policy stance. As outlined above, weak domestic demand continues to weigh
on economic activity, while the outlook for external demand is far from encouraging.
In a scenario where demand remains subdued, inflation could fall well below 2 per cent.
Tackling this situation with a restrictive monetary stance would be a mistake, as it would
exacerbate the undershooting of the inflation target. Instead, the ECB should face this
situation with a neutral stance. This way it could pause rate cuts if the undershooting is
likely to be temporary - or cut rates further if the undershooting appears likely to persist.
When discussing this issue, one is often confronted with the objection that the so called
r* (or 'r-star', namely the threshold that determines whether the stance is restrictive,
neutral or expansionary) is an elusive concept: nobody knows exactly what its value is.
The objection is factually correct, but I do not think it is relevant at this stage.
We are probably a long way from the neutral rate.12 Moreover, we may need to cut
policy rates to below r* if the cycle deteriorates. There is nothing exotic about this
possibility: lowering policy rates below the neutral level at the trough of the cycle is
a standard policy prescription, which both the ECB and the Fed have adhered to in
the past (Figure 10). The question is not whether the ECB can, but whether it must.
Figure 10
Real short-term interest rates and r* in the euro area and in the US (1)
(per cent and percentage points)
(a) Euro area (2) (b) United States (3)
4 4 10 10
8 8
2 2
0 0
-2 -2
6420 6420
-4 -4
-2 -2
-6 -6
-4 -4
-8 -8
-6 -6
-10 -10 -8 -8
2000 2005 2010 2015 2020 1970 1980 1990 2000 2010 2020
Real rate r* Real rate - r*
Source: elaborations on data from the Board of Governors of the Federal Reserve System, the ECB, Eurostat, the Federal Reserve Bank of New York and the US
Bureau of Economic Analysis.
(1) The natural rate (r*) is estimated according to the Holston, Laubach and Williams methodology. - (2) EONIA and Euro short-term rate (€STR) deflated by one
quarter ahead annual inflation. - (3) Effective federal funds rate deflated by one quarter ahead annual inflation.
12
Most estimates place it near zero, and in any case below 0.5 per cent. See C. Brand, N. Lisack and
F. Mazelis, 'Estimates of the natural interest rate for the euro area: an update', European Central Bank,
Economic Bulletin, 1, 2024, pp. 66-69.
Answering this question requires a constant and careful examination of the evolution
of the macroeconomic outlook.
Second, policy decisions should once again be guided by a truly forward-looking view of
economic developments and inflation. The prescription to normalize the monetary stance
is, in fact, a corollary to this principle. So far, the strong reliance on actual outcomes has
been justified by the exceptional shocks and the associated high uncertainty observed in
the period 2020-23. Now, the supply shocks of recent years have been absorbed, inflation
volatility and forecasting errors have declined and macroeconomic relationships have
become more stable. In this context, inflation projections based on a genuine economic
analysis of the fundamental drivers of inflation are more relevant than price indicators,
such as "underlying inflation" estimates. All indicators have a place in a central bank's
toolkit, but their relative relevance naturally changes over time.13
Finally, communication matters. After three rate cuts, with inflation around the target and
economic activity stagnant, the tightening bias in our official description of the monetary
stance is no longer necessary.14 Furthermore, the emphasis on 'meeting-by-meeting,
data-dependent' decisions does not fit well with the renewed focus on a forward-looking
approach. It would continue to place the ECB at the far end of the spectrum ranging from
'no guidance' to 'full commitment'.
There is an obvious trade-off between the two: 'no guidance' leaves a central bank
free rein, but creates uncertainty about the path of policy rates; 'full commitment' is
more effective in anchoring expectations, but can create undesirable constraints and
reputational costs. We deliberately chose to maximise our freedom in the eye of the
storm, choosing the first option - but the situation has changed, and it is now time for
the ECB to give more explicit indications of its intentions.
Some are extremely cautious. I understand that position, but I am also aware that 'no
guidance' carries its own risks, as it can make interest rates highly sensitive to economic
news. For example, interest rate expectations took a nosedive in October: a handful
of new numbers was enough for markets to price a much higher chance of a rate cut
(Figure 11). The Fed had a similar problem in August, when weak job reports led to
market volatility and an abrupt downward revision in interest rate expectations. These
reactions may indicate that - despite their best efforts - central banks are seen as 'data
point dependent' rather than 'data dependent'. Clearly, this incorrect perception needs
to be addressed. A more explicit element of guidance would achieve this.
A 'directional guidance' would help to stimulate consumption and investment, thereby
reducing the likelihood of a weak-demand scenario. It would help households and firms to
take more informed longer-term decisions. After all, the purchase of durable or capital goods
Figure 11
Probability of a 25 basis points cut by the ECB in October 2024 (1)
(percentage)
100 100
HICP FR, ES
80 80
60 60
PMI EA
40 40
20 20
0 0
16 September 23 September 30 September 7 October 14 October
Source: elaborations on LSEG data.
(1) Market-based probability.
is a form of commitment. If the central bank is not prepared to abandon the 'no-guidance'
approach, it becomes more difficult for households and firms to make commitments.
4. Conclusions
After a long journey in terrae incognitae, the euro area economy has returned to more
normal conditions.
The supply shocks of recent years have been absorbed, inflation volatility has declined
and inflation is close to target. Macroeconomic relationships have become more stable
and the real economy is likely to come (back) to the fore as a key driver of inflation
dynamics.
In this context, the ECB can afford to normalize its monetary policy. It should do so by
bringing its policy rates to a neutral level, in line with the economic and inflation outlook,
so as to avoid the risk of undershooting the target; by returning to a more traditional,
genuinely forward looking approach to monetary policy, in line with its medium-term
orientation; and by adapting its communication in order to provide the necessary
guidance to consumers and investors.
This requires taking a brave step: we should brace ourselves and go 'back to the future'.
Thank you for your attention.
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