10.04.2023
Latest monetary policy developments in the euro area
The Brookings Institution
The Hutchins Center on Fiscal and Monetary Policy
Washington, DC.
Pablo Hernández de Cos
Governor
Good morning, it is a pleasure to visit the Hutchins Center on Fiscal and Monetary Policy
and share with you my reflections on euro area monetary policy at a still very challenging
time for central banks globally.
I will start by briefly describing the decisions that we adopted at our European Central Bank
(ECB) Governing Council meeting in March. Then, I will lay out a number of factors that will
determine our future decisions and will require close monitoring going forward.
Our March meeting took place in the context of the financial tensions related to the
banking sector in the US and in Switzerland. These tensions increased investor risk
aversion and financial market volatility and led to a global drop in bank share prices. While
the European banking sector is resilient, with strong capital and liquidity positions, the main
message from our meeting was that we are closely monitoring these financial tensions
and we stand ready to respond as and when necessary to maintain price and financial
stability in the euro area. As we emphasised in our monetary strategy review approved in
July 2021, financial stability should be seen as a prerequisite for price stability.1
In addition, we took a further step in the process of tightening our monetary policy
stance in response to the outlook for euro area inflation, which is projected to remain
too high for too long. In line with our intentions already anticipated at our February meeting,
we increased interest rates by 50 basis points (bp), bringing the deposit facility rate (DFR)
to 3%. This represents a cumulative increase of 350 bp since July last year.
As to our future monetary policy path, the financial tensions that broke out before our
meeting imply an additional element of uncertainty around the growth and inflation
baseline scenario. This extra uncertainty makes the data-dependent approach for our
decisions even more important. Our future monetary policy will depend on how the
different sources of risks, including those witnessed on the financial markets in the last few
weeks, materialise.
We also provided more detail on what will guide our assessment of the inflation
outlook and, therefore, our monetary policy decisions. In particular, we announced that this
assessment will depend on three main factors. First, incoming economic and financial
data. Second, the of underlying inflation dynamics. And lastly, the strength of monetary
policy transmission.
I will now elaborate on these three factors.
The first is our assessment of the inflation outlook in light of the incoming economic
and financial data. This assessment will be informed primarily by our staff
macroeconomic projections, on which all data are incorporated in a coherent manner.
In this regard, the staff March forecast pointed to a weakening of activity in 2023, with
real euro area GDP expected to grow by 1% in 2023 (compared with 3.6% in 2022). This
scenario is somewhat more optimistic than that of the previous projections (published
in December), reflecting better than expected recent economic data and the fall in the cost
of energy, so that real income losses are lower. Growth is expected to pick up, to 1.6%,
in both 2024 and 2025, based on a robust labour market, improving confidence and the
recovery of purchasing power. However, these growth rates are lower than projected in
December owing to a stronger tightening of financial conditions, including a larger
appreciation of the euro exchange rate. And, in any case, the accumulated growth path
expected now for 2022-2024 is significantly lower - around 2.5% lower - than that projected
in December 2021, before the war in Ukraine, reflecting the material deterioration of euro
area terms of trade.
On inflation, the baseline scenario is one of gradual convergence of inflation to our
2% target.
After peaking at 10.6% in October last year, HICP declined to 6.9% in March this year,
according to the flash estimate, on the back of lower energy prices and base effects. By
contrast, food price inflation and underlying inflation (excluding energy and food) have
continued to rise, surprising on the upside and posting high rates in March (of 15.4% and
5.7%, respectively).
Headline inflation is expected to remain high for the rest of 2023, albeit on a downward
path that will take it to 2.8% in the last quarter of the year. This drop in inflation is mainly
explained by the energy component, while underlying inflation is expected to remain
elevated. Specifically, the ECB projections point to inflation averaging 5.3% in 2023,
before decreasing to 2.9% in 2024 and to 2.1% in 2025. This downward trend would be
underpinned by the gradual disappearance of upward pressures from the reopening of the
economy, previous supply-side shocks (supply bottlenecks and high energy prices) and
euro depreciation, reinforced by increasing pass-through of the recent fall in energy prices
and exchange rate appreciation. The fall in inflation in the medium term is also explained by
a moderation in domestic demand pressures, owing inter alia to increasing dampening
effects of our monetary policy decisions.
Importantly, the staff projections incorporate a number of financial indicators that reflect
market expectations of our future monetary policy. In this regard, the inflation path in the
March staff projections was based on a risk-free forward curve that continued to point
to expectations of further interest rate increases at our subsequent meetings,
including 50 bp in March, to around 3.2%. This inferred terminal rate was 40 bp higher than
that expected at our December meeting. And analysts' expectations, as reflected in surveys
conducted shortly before the meeting, showed that the DFR was expected to peak at 3.75%
in July 2023 (up 100 bp since December) and to remain at that level until the first quarter of
2024.
All these elements together supported our assessment that, if the baseline scenario in the
March projections is confirmed, we will still have ground to cover to make sure that
inflation pressures are stamped out.
However, as I have said, these projections are subject to various sources of uncertainty.
And this is why we are emphasising that the rate path is data-dependent. This means, ex
ante, that we are neither committed to, nor finished with, further rate hikes.
Let me highlight some of the sources of uncertainty.
The first is related to the resilience of the euro area economy. In the second half of 2022
the euro area economy proved more resilient than expected and the slowdown in the fourth
quarter the year was less severe than anticipated. Indeed, the qualitative data available for
the first quarter of 2023 point to an improvement in consumer and business confidence.
This has occurred in a setting in which a significant reversal of previous supply shocks was
observed, households and firms had substantial buffers, the post-COVID rebound in
demand continued to generate positive effects and monetary policy had not yet been fully
passed through. However, there is much uncertainty about the continuity of these factors.
In particular, the sharp decline in European gas prices reflects unusually mild weather,
together with energy-saving measures and strong inventory levels which mitigate supply
risks for next winter. The commodity market tensions in 2022 were caused by the Russian
invasion of Ukraine and, therefore, a prolongation of the war is still a major source of
uncertainty for Europe. And, more generally, the future course of the world economy is also
a matter of concern, against a backdrop of global monetary policy tightening and significant
geopolitical risks.
Second, in relation to the recent stress in the banking sector, so far the implications
have been contained, leading to a certain tightening of overall euro area financial
conditions, mainly through its impact on risk premia2. However, should they persist or
heighten, these tensions could lead to a sharper than expected tightening of credit
conditions and erode confidence and give rise to a scenario of more moderate economic
growth and more rapidly declining inflation.
A third element that adds a certain degree of complexity to the inflation outlook relates
to fiscal policy. In 2022 and 2023, euro area countries significantly increased their fiscal
policy support measures to protect businesses and households from rising energy prices
and inflation, bringing the total gross stimulus to close to 2% of euro area GDP in both
years. While these measures helped to contain inflation in 2022 and are expected to do so
in 2023, the extent of their impact this year is still uncertain. And the withdrawal of these
measures will push consumer prices upwards in the coming years, especially in 2024.3
In this regard, it is important to stress that, in the current high inflation setting, an appropriate
policy mix requires a fiscal stance that, at the aggregate euro area level, is not at odds with
the tightening of our monetary policy. This means that government support measures
should be temporary, targeted and tailored to preserving incentives to consume less energy,
and they should be gradually rolled back as energy prices fall. Otherwise, we are at risk of
driving up medium-term inflationary pressures, which would call for a stronger monetary
policy response.
Let me move now to the second input, underlying inflation dynamics, which serve as a
complementary cross-check of our forecast.
Core inflation, which excludes energy and food prices, is a standard indicator of underlying
inflationary pressures. Over 2022, core inflation averaged 3.9%, and reached 5.7% in
March 2023, an all-time high. Meanwhile, the core inflation outlook for 2023 has been
successively revised upwards in recent staff projections exercises, from 2.8% in June 2022,
to 3.4% in September, 4.2% in December and 4.6% in the most recent exercise in March
of this year.
In the current environment, the indirect effects from past commodity price increases,
which have been much larger than expected, are a first key driver of core inflation.
This is a reflection of the exceptional nature of the commodity price shock in terms of its
magnitude, its persistence and its broad-based character, affecting commodities across the
board, including notably energy but also food commodities.4 It has to be taken into account
that, although the shock has been global, Europe has been particularly exposed due to its
high dependency on the supply of essential inputs - notably gas - from Russia.5
Indeed, given the magnitude and persistence of the shock, indirect effects have penetrated
more deeply into the economy, firms have tended to adjust final prices more often6 and this
has triggered a more extensive spread of price rises across the different categories of goods
and services.7
In addition, the upward effects of energy and food commodity prices could still be
significant in 2023. In the case of food commodities, the transmission of increasing costs
along the supply chain could take up to a year8. In the case of gas prices, the pass-through
from wholesale prices to final retail prices for consumers varies significantly across countries
depending on the regulations in place, the types of contracts used in each national retail
electricity market and profit margin developments in the face of rising energy input costs.
Also, we estimate that indirect effects from a gas price shock are quite persistent, peaking
after one year.9 Thus, even if gas prices have returned to levels close to those at the start of
the war in Ukraine, the upward effects of gas prices on core inflation could still be significant
in the short term.
Moreover, the transmission of inflationary pressures reflects specific demand and
supply-side factors linked to the pandemic and the lifting of mobility restrictions. For
4
See F Borrallo, F, L. Cuadro-Sáez, M. Pacce and I. Sánchez. (2023). "Consumer food prices: recent developments in the euro area and
Spain". Economic Bulletin - Banco de España, 2023/Q2, 01.
5
See Alonso I, L. López, D. Santabárbara and M. Suárez-Varela (2022) "The EU economies' natural gas inventories in 2022 and 2023
under two hypothetical scenarios". Box 2, "Quarterly report on the Spanish economy", Economic Bulletin 4/2022, Banco de España.
6
See Costain J, A. Nakov and B. Petit (2022), "Flattening of the Phillips curve under state-dependent prices and wages", Economic
Journal 132 (642), pp. 546-581.
7
See González Mínguez, J., S. Hurtado, D. Leiva-León and A. Urtasun. (2023). "The spread of inflation from energy to other components".
Economic Bulletin - Banco de España, 2023/Q1, 02.
8
Borrallo, F., L. Cuadro -Sáez and J. J. Pérez (2022). "Rising food commodity prices and their pass-through to euro area consumer
prices", Analytical Articles, Economic Bulletin 3/2022, Banco de España.
9
López, L., S. Párraga and D. Santabárbara (2022). "The pass-through of higher natural gas prices to inflation in the euro area and in
Spain", Box 4, "Quarterly report on the Spanish economy", Economic Bulletin 3/2022, Banco de España.
instance, the presence of global supply chain bottlenecks, the rapid intensification of
demand once restrictions were lifted or the impact of changes in work and living habits,
which led to increased consumption of housing-related goods and services.
According to our estimates, demand factors were of minor importance at the beginning
of 2022, but their contribution increased until the summer, stabilising at high levels
thereafter. Supply-side factors - which were predominant at the beginning of 2022 - now
explain around half of the deviation of euro area core inflation from its historical average.
All in all, some core inflation components are beginning to show a certain degree of
stabilisation, but the data suggest that inflationary pressures continue to broaden.
By way of illustration, during most of 2022, pressures on core inflation were highly
concentrated on specific expenditure items, such as household equipment and
maintenance, transport, and activities involving more social contact.10 The aggregate price
index of these items indicates some stabilisation in its year-on-year growth rate at the
beginning of this year, albeit at high levels, over 7%.11
Excluding these expenditure components, the remaining basket of core items, which has a
weight of over 30% in the HICP, has shown a very contained inflation rate throughout the
inflationary episode. However, that rate is now heading upwards, rising from around 1.5%
in mid-2022 to 3.6%12 in February this year.
At some point, however, the fall in energy prices, the improvement in supply chains
and the moderating demand, owing to tighter financial conditions should begin to
gradually produce reverse effects on inflation.
Thus, at the current juncture, we could well be nearing some sort of crossroads, where the
lagged effects of the past increases in commodity prices and exchange rate depreciation
are still present, but diminishing, while the first effects of the most recent decreases and
appreciation may be emerging and on the rise. However, when this crossroads is reached,
and how strongly it will support a decline in inflation, will depend on the extent of the
symmetry between the impact of higher and lower costs on prices. In this regard, the
impact of cost decreases on inflation may not be fully symmetrical to the impact of cost
increases13. This is an open question and hence a dimension that should be carefully
monitored.
Our attention is now also turning to the possible emergence of second round effects
on inflation.
In 2022, compensation per employee increased by 4.6%, which implies a significant fall in
real wages, with some heterogeneity across countries. In parallel, firms' profit margins
have expanded in many sectors since the beginning of 2021 (after falling significantly in
2020), indicating a high rate of pass-through of cost increases to selling prices.
The baseline projection scenario assumes that workers will gradually recover their
pre-shock purchasing power at the end of the forecast horizon,14 while the increase in
firms' unit labour costs is expected to be lower than the increase in wage payments - taking
into account projected productivity gains so that firms' profit margins could remain steady
over the forecasting period as a whole.
However, the pressure of workers' efforts to regain lost purchasing power and the
pick-up in profit margins could be stronger than anticipated. Wage negotiations are
taking place in a tight labour market, with the unemployment rate at a historical low and
labour shortages increasing in some countries, despite labour-market participation growing
robustly since early last year.15 And some wage indicators show stronger wage pressures
than those derived from aggregate wage statistics.16 This is already having an impact on
core inflation, since the contribution of wage-sensitive items17 to core inflation has more
than doubled in recent months. Indeed, services inflation (which accounts for two thirds of
core inflation, with wages making up around 40% of the direct input costs of services)
reached 5% in March this year, up from 2.7% a year ago.
Moreover, although economic weakness should lead to a squeeze on profit margins, the
indicators available up to the end of 2022 do not yet show clear signs of any such squeeze.
There is considerable heterogeneity across sectors and the cyclical situation of the economy
and demand conditions will play a key role in the degree to which higher wage costs are
passed through to final prices, as well as in the behaviour of profit margins going forward.
13
Ferrucci, Jiménez-Rodríguez and Onorante (2012, , "Food price pass-through in the Euro Area: Non-linearities and the role of the
common agricultural policy" International Journal of Central Banking ) find asymmetries between positive and negative shocks in the food
inputs, Borrallo, Cuadro and Pérez (2023, forthcoming) confirm these results for the euro area by extending the sample to the present
time. In the case of oil, Kilian and Vigfusson (2011, Quantitative Economics, "Are the responses of the U.S. economy asymmetric in energy
price increases and decreases?") show that there are no significant asymmetries in the United States. However, Garzón and Hierro (2021,
Economic Modelling " Asymmetries in the transmission of oil price shocks to inflation in the Eurozone") find that asymmetries do exist in
the euro area.
14
According to the ECB's March forecast, nominal wage growth, as measured by compensation per employee, will increase from 4.6%
in 2022 to 5,3% in 2023, before declining to 4,4% in 2024 and 3,6% in 2025.
15
This has happened in a context of a sharp increase in public employment, whose growth has accounted for about half of total
employment growth since the end of 2019.
16
The ECB experimental tracker of negotiated wages shows a clear upward shift in wage increases agreed for 2022 and 2023. Contract
negotiations during 2022 delivered wage increases around 4,4% and 4,8% for 2022 and 2023 respectively, with higher increases the
more recent the agreement is. Additionally, a second wage growth tracker based on wages offered in new jobs also showed strong
increases during 2022 suggesting strong wage momentum, though last readings show tentative signs of stabilitation. See P. Lane (2023):
Underlying inflation, lecture at Trinity College Dublin, 6 March 2023.
17
Defined as those items in the core inflation basket for which wages account for more than 40% of input costs.
It is important to remember that a large part of the high inflation in the euro area has
stemmed from the surge in commodity prices that has led to a significant deterioration in
the terms of trade. This entails a loss of wealth and welfare for the euro area economy as a
whole that is unavoidable in the short and medium term. If this loss is distributed fairly
between workers and employers the inflationary spiral that will arise if they both attempt
unilaterally to avoid this loss by maintaining their real wages and profit margins could be
averted.
Against this backdrop, to avoid the emergence of second round effects, it is essential to
ensure that inflation expectations remain anchored at levels consistent with the price
stability objective. The February vintage of the Consumer Expectations Survey shows
three-year ahead inflation expectations coming down again, to 2.4%, suggesting that
consumers interpret current inflation as having a high temporary component. Moreover,
professional forecasters expect inflation to return to close to target over the medium term.
And market-based measures also indicate a rapid decline in inflation over 2023 and 2024,
while the cost of inflation protection remains slightly above 2% at longer horizons (as
reflected in the 5yr5yr rate). This is largely due to a positive inflation risk premium which
reflects the high uncertainty surrounding inflation dynamics.
The third factor that we are closely monitoring is the strength of monetary policy
transmission.
The ECB's current rate hiking cycle is unprecedented in terms of its intensity and speed,
with one-year-ahead expected real rates into positive territory. We generally assess the
impact of our measures based on the historical evidence of previous rate hiking cycles. It
can be argued, however, that some of today's macro-financial conditions differ from
those prevailing in previous cycles, especially as a consequence of the long period of
expansionary monetary policy that preceded the current episode. In addition, tightening
monetary policy as sharply and as swiftly as we have could also have potential
nonlinear effects on the economy.
One factor that might point to a slower transmission of monetary policy than in the past is
related to the debt burden of the non-financial private sector, which has become less
sensitive to interest rates hikes. Between 2012 and 2022, the share of households' bank
debt with an interest rate fixation period of up to one year fell from 35% to 25%, while for
non-financial firms the proportion of bank debt either maturing within a while a year or with
an interest rate fixation period of up to one year declined from 70% to 59%.18
A second factor could be related to a slower pass-through of market rates to retail
deposit rates than in previous episodes, which could weaken the standard intertemporal
channel through which rising interest rates discourage savers from spending.19 This slower
pass-through could come from the fact that, during the period with negative rates, the
remuneration of retail deposits was above market interest rates, as banks were unwilling to
reduce it below zero. Additionally, the current ample liquidity available to commercial banks
reduces the pressure on them to increase the remuneration of retail deposits.
Other factors point to a potentially faster monetary policy transmission compared to past
episodes.
First, the current hiking cycle comes after the strong negative shock prompted by the
pandemic, which adversely impacted firms' financial situation by increasing their debt
levels. This leaves them more vulnerable to interest rate hikes, and their expenditure
decisions may be more sensitive to monetary policy changes. Conversely, however,
households still have around €900 billion in excess savings built up during the pandemic
and they are benefiting from sizeable fiscal policy support.
Second, there has been a shift from bank to bond funding over the last decade, with bond
debt increasing from 16% to 24% of non-financial corporations' total debt.20 This, together
with the faster monetary policy pass-through to bond rates than to bank rates, implies faster
transmission than in the past.
Third, the residential real estate market is a key area to monitor, in particular given that
some euro area countries have experienced a significant increase in house prices over the
last decade, with signs of overvaluation.21 Housing represents a major part of household
wealth and bank assets. Thus, a potential decrease in house prices would weigh negatively
on banks' portfolios, by reducing the value of the collateral provided to banks by households
and firms, which might ultimately affect credit developments.
Turning to the data, indeed a sluggishness in households' time deposit rates has been
observed in some countries.22 This can be explained by banks' specific characteristics, by
the structure of the banking sector and the competitive environment. Specifically, banks
with larger liquidity buffers react to a lesser extent to increases in market interest rates.23
And we have seen a significant shift of funds from overnight deposits to other less liquid but
better remunerated instruments (mainly time deposits), thus reducing the liquidity available
for economic transactions. In fact, M1 annual growth turned negative in January 2023 for
the first time since the creation of the monetary union.
In addition, the increase in bank lending rates in the euro area has been very significant,
mainly reflecting the faster pace of policy rate hikes, and has been accompanied by a
tightening of credit supply standards. In particular, in the ECB's latest euro area bank
lending survey (BLS), banks reported a substantial further tightening of credit standards
and credit terms and conditions for loans to firms in the fourth quarter of 2022. This was
the largest tightening reported since the euro area sovereign debt crisis. And banks
expected a net tightening of a similar magnitude also for the first quarter of 2023 and
reported a continued tightening of credit standards for loans to households.
The evidence available shows a strong correlation between credit standards (as
measured in the BLS) and loan growth developments a couple of quarters later, and
likewise between credit growth and GDP growth.24 The first link in the chain (between
credit standards and credit growth) is already evident. In particular, credit growth to firms
has dropped markedly since the third quarter of last year. And, indeed, there is evidence of
mortgage credit growth decelerating at a faster pace in those countries with initially larger
house price overvaluations25.We should expect to see the latter link to real activity assert
itself soon. In fact, although euro area activity avoided contraction in the last quarter of 2022,
national accounts data have revealed notable weakness in domestic demand, with marked
declines in both private consumption and investment.
Finally, special attention will have to be paid to the incoming data from the financial
sector in order to closely monitor the impact of recent events and tensions. The
implications of recent financial sector tensions have been contained so far. But, if these
tensions persist or intensify, a scenario could materialise of significantly tighter credit and
financial conditions and worsening confidence, with downward effects on economic activity
and prices. In this respect, special attention will have to be paid to data on the supply of
bank credit, as measured for instance by the BLS.
Conclusions
Let me conclude by highlighting two main takeaways from my words today.
First, at the ECB Governing Council we stand ready and have the instruments available to
respond as and when necessary to maintain price and financial stability in the euro area.
Second, in March we took a further step in the process of adjusting the monetary policy
stance to the euro area inflation outlook, but uncertainty is high and future decisions will
continue to be data-dependent.
Inflation in the euro area is slowing and will continue to do so markedly in the coming
months. But there are factors affecting underlying inflation that may delay its return to
the 2% target in the medium run and that we will therefore monitor closely going forward.
In addition, the strength of the transmission of our monetary policy actions to the
economy is highly uncertain, due to the extraordinary pace of our rate hikes as well as
changes in the euro area macro-financial landscape that could accelerate or delay the policy
pass-through. Recent financial tensions originating in the banking sector add an
element of uncertainty and reinforce the importance of a data-dependent approach.
Thank you very much.