Germs, War and Central Banks
Public Lecture by Pierre Wunsch
Governor, National Bank of Belgium
International Center for Monetary and Banking Studies
Geneva, 8 November 2022
As prepared for delivery
Introduction
Good evening.
I would first like to thank Professor Panizza for kindly inviting me to be part of the prestigious
ICMB public lecture series. I am truly honoured. Geneva is a unique place to speak about
international finance, central banking and, given the circumstances, germs and war. After
all, Geneva is home to both the WHO and the UN.
With inflation at record-high levels, it's important to understand how we got here and to take
action to bring inflation back to the target rate.
What a difference a year makes! In the summer of 2021, inflation narratives were simple
and reassuring. As the pandemic abated, the lifting of restrictions unleashed a consumption
boom. This was too much for still fragile supply chains and stressed logistics networks to
handle. And when supply cannot keep pace with demand, our Econ 101 textbooks say that
prices must rise. This is even more true for the energy and commodities markets. Inflation
was back, and everyone applauded, for two reasons. First, the spectre of deflation was
finally dissipating and, second, since the supply disruptions were deemed temporary in
nature, it was expected that inflation would automatically fall. As central banks target
inflation over a medium-term horizon, we felt confident we could safely "see through" these
fluctuations. Like textbooks, the models told us that inflation would automatically fall.
But post-pandemic inflation turned out to be more persistent than initially thought, much
more persistent. An alternative narrative has thus developed, according to which the current
surge in inflation is attributable, at least in part, to more structural reasons, including the fact
that the inflation rate has already risen considerably. In other words, inflation can feed on
itself. In this narrative, the persistence of inflation reflects a regime shift which our workhorse
models are, by design, ill-equipped to detect. As conflicting inflation narratives are now
circulating, there is a tangible risk of a de-anchoring of inflation expectations. And if
credibility is the name of the game, we know that policy rates may have to be raised more
decisively than what any model in our toolkit would suggest.
Tonight, I will look at the possible drivers of inflation through the lens of these two narratives
and the consequences for monetary policy. I will also raise some questions about the
reference framework, which largely supports the first - benign - inflation narrative. I will
focus on the extensive reliance on New Keynesian models and the underlying notion of a
falling equilibrium real interest rate, the infamous r-star (r*). Finally, before concluding, I will
touch on some current policy issues.
Drivers of inflation and optimal monetary policy response
With regard to the drivers of inflation, let me be clear from the outset: past monetary policy
is only one factor driving the current high inflation readings. For years, central banks
conducted a very accommodative monetary policy in the face of what was believed to be
structurally low demand. And, indeed, inflation remained low and stable. It seems highly
unlikely that the effects of monetary accommodation suddenly crystalised to send inflation
through the roof. That being said, it should be recognised that an increasingly loose
monetary policy stance contributed to an environment conducive to inflation. During the
COVID-19 crisis, the scale of policy stimulus was unprecedented. That was the right thing
to do in the face of a truly unprecedented shock. What is questionable, however, is the time
it took for monetary policy to begin normalising after the start of a V-shaped recovery, the
quick tightening of the labour markets and the continuance of fiscal support. That's why
dissenting voices, including mine, were raised, notably to criticise the forward guidance on
policy rates. To be sure, seeing through does not mean turning a blind eye.
So how did we end up with such high inflation? Despite substantial uncertainty and
dissatisfaction with our models, we can still agree that inflation continues to be driven by
the combined dynamics of aggregate demand and supply!
While the inflation surge is global, some of its sources are local. In the US, a historic fiscal
stimulus package boosted demand against the backdrop of a very tight labour market
(judging from the unemployment and vacancy rates). The US GDP deflator reached 7.6%
in the second quarter of this year compared with 4.3% in the euro area. Predictably,
monetary policy tightened faster and more vigorously in the US than in the euro area. In a
way, the US story is a textbook case from the perspective of a central banker: red hot
demand pushed inflation beyond the target rate and economic activity beyond potential
output. Monetary tightening is meant to bring both variables back in line. This is the "divine
coincidence" at work.
By contrast, in Europe, there is no divine coincidence to speak of: bringing inflation down is
bound to take a toll, in terms of economic activity. The euro area was quickly overwhelmed
by a succession of supply shocks. Unlike the US, Europe is a net importer of energy and
other commodities whose prices have skyrocketed since the end of the pandemic, even
more so since the Russian invasion of Ukraine. The rapid appreciation of the US dollar did
not help. While not our currency, the dollar is our problem. Looking at recent figures, energy
(priced in dollars) accounts for about half the euro area inflation rate. Clearly, the ECB faces
greater policy challenges than the Fed.
As inflation persists, the growing awareness that supply shocks could have more enduring
- perhaps permanent - effects has highlighted the need for a firm monetary policy
response.1 Global value chains could be durably affected by the memory of pandemic
restrictions and the worsening of geopolitical tensions. As firms de-emphasise efficiency
maximisation in favour of resilience (or social responsibility, for instance, when it comes to
climate change), supply chains could be shortened. The words "reshoring," "friendshoring"
and "deglobalisation" have become part of our vocabulary. Production costs may thus be
on a rising trend for some time. Likewise, energy and food supplies could remain
constrained for the foreseeable future. All other factors being equal, the bottom line is lower
potential output. Tighter monetary policy will consequently be required to align demand and
supply at a level consistent with the desired price dynamics.
More generally, supply shocks with persistent effects could well require a stronger monetary
policy response if they contribute to a de-anchoring of inflation expectations. Indeed, the
longer inflation persists, the greater the risk of people learning to live with it and adapting
their behaviours in ways that perpetuate it. Under such circumstances, decisive monetary
policy is required to prevent self-fulfilling prophecies and coordinate target expectations.2
As inflation remains stubbornly high and is testing expectations, the role of models in
policymaking is being called into question. Models depict the macroeconomy at business cycle
frequency. Shocks have only temporary effects, and expectations are rational. They also
tend to estimate r* at a low level, suggesting that policy rates do not have to be raised much
in order for monetary policy to become neutral or restrictive. I will now turn to the questions
I have about this reference framework.
Questioning the reference framework: the use of models and r*
Despite their widespread use, a number of caveats apply to models. The first is that many
models are likely to miss regime shifts - such as structural or behavioural changes - or the
consequences of tail events - like a war, pandemic or financial crisis. Models that allow for
regime shifts may need to be fed with a substantial quantity of data before they can detect
a shift. In addition, models may not detect the consequences of tail events with a reasonable
degree of precision simply because they cannot capture the empirical patterns related to
such events.
In fact, many models focus on stationary dynamics around a steady state. Eurosystem/ECB
staff projections appear to be largely based on stationary models, as shown in the left-hand
chart. In stationary models, inflation forecasts always converge to the steady state. For the
inflation variable, the steady state can be calibrated, or "hard coded" if you will, at 2% for
instance. In general equilibrium models, the assumption of rational expectations typically
implies stable inflation dynamics. This assumption postulates that agents form expectations
in a forward-looking way, meaning well-anchored inflation expectations are all that is
required.3 Broadly speaking, inflation projections invariably show "mean reversion".
This begs the question of how much weight we should give model-based projections,
especially in the context of a potential regime shift and rare event.4 Intuitively, more
uncertain projections should get less weight. Looking at the history of Eurosystem/ECB staff
inflation projections, errors are small for short horizons, as shown on the right-hand chart.
The root-mean-squared error (RMSE) for the one-quarter-ahead projection is 10 basis
points. Thus, if inflation is projected at 2% for the next quarter, the two-RMSE confidence
interval spans a range running from 1.8% to 2.2%. But errors increase rapidly over the
projection horizon. At the two-year-ahead horizon, the error is close to 100 basis points for
the period up to the COVID-19 crisis.5 If inflation is projected to be 2% for this horizon, the
confidence interval goes from 0% to 4%. If the COVID-19 period is considered, projection
errors increase further to more than 150 basis points at the two-year horizon.6 As a result,
longer-term projections should be particularly discounted in the event of a potential regime
shift or rare event, such as we may be experiencing.
More fundamentally, the use of stationary models raises the question of whether the
endogenous policy response embedded in them is appropriate. Recently, despite the fact
that a surge in inflation was already well underway, our models continued to suggest that a
mild policy response would suffice and that inflation would converge towards the objective,
even with real rates remaining largely negative.
Models are also extensively used to estimate the level of the natural interest rate or r*. Here
I mean r* as the natural rate of interest implying economic activity at the level of potential
output and inflation at the central bank's target rate in the long term.
There are two main issues related to using r* as a compass for policy decisions. First, there
is significant uncertainty surrounding the estimates. The chart refers to the US because
estimates for this country are readily available. As can be seen, however, uncertainty is high
both within and across models. "Within model uncertainty" means that the confidence
intervals for r* estimates are typically quite wide. It is not uncommon to see a 90%
confidence interval as wide as 2 percentage points below and above the estimates. "Across
model uncertainty" means that r* estimates are model-dependent, so that different models
yield different r* estimates. Overall, the level of uncertainty is so overwhelming that central
bankers should acknowledge that they don't know precisely where r* is.7
Second, the relationship between interest rates and inflation may not be so stable. The idea
of r* is that when inflation or inflation expectations are below target, real rates should be
brought below r* so as to stimulate economic activity and inflation. But there are reasons to
believe that this relationship does not apply under all circumstances. The slope of the
investment-savings (IS) curve may be different for different levels of interest rates. For
instance, when interest rates are at low levels and have been for quite some time, the
interest rate sensitivity of demand may be reduced as investment projects could be
exhausted and consumption cannot be stimulated forever.8
So, should we, as central bankers, be concerned about this? Not if we all agree that
measures of r* are indeed too imprecise to inform real-time policy-making. There now
seems to be a consensus on this point. Still, references to low estimates of r* - usually
nominal ones - still occasionally pop-up in our discussions. They are part of the argument
in favour of a moderate policy response. In any case, despite the uncertainty surrounding
model projections and r* estimates, the recent ECB strategy review largely relied on them.
The dominant theme was the combination of a low r* and the presence of an effective lower
bound. In order to reach a symmetric 2% inflation objective, the monetary policy response
must be asymmetric. That is to say, it must be "especially forceful or persistent" when the
economy is close to the lower bound. This will help to avoid the entrenchment of negative
deviations from the inflation target. The resulting revised forward guidance, issued in July
2021, was predicated on these notions, with the forecasts suggesting that inflation would
smoothly converge back to 2% from below.
As a result, the strategy review overlooked the historical asymmetry according to which high
inflation has occurred more often in modern times than deflation. So, we might also have to
be more "forceful and persistent" when inflation is on the rise.
Moreover, despite the strategy review recognising that "financial stability is a precondition
for price stability", the revised forward guidance seemed to have disregarded potential side
effects in practice. For one, if r* is estimated to be low, there is no problem in keeping
interest rates low. In addition, models often do not allow for the possibility of long-term
financial stability risks. These are rare events that are difficult to capture. Still, the reality is
that low interest rates generate financial stability risks because they make it easier to
borrow. The empirical evidence is clear: credit aggregates contain valuable information
about the likelihood of future financial crises.9 In addition, prolonged periods of low financial
market volatility, potentially promoted by accommodative monetary policy, have predictive
power over the incidence of banking crises.10
I therefore believe that more attention should be paid to the impact of monetary policy on
financial stability. That being said, as our mandate focuses on inflation and our models
typically ignore financial stability aspects, discussing trade-offs remains difficult, both in
theory and in practice.
Current policy issues
So, what does this mean in terms of policy-making in the coming weeks and months?
The most obvious observation is that uncertainty is very high. Beyond that, I am afraid that
policy-making is becoming a matter of faith. Informed faith, but faith nonetheless.
The greater the reliance on standard models and low r* estimates, the greater the
temptation to argue in favour of a gradual and moderate monetary policy response.
Conversely, the greater the criticism of models and r* estimates, the greater the temptation
to look to the oil shocks of the 1970s and 1980s for inspiration. Neither models nor the past
can serve as an ideal guide in the current setting, but I am afraid we don't have much else
to go by.
Another way to frame the debate is between a repeated shock narrative and a regime shift
narrative. Both could explain the higher inflation persistence observed over the past year,
but with quite different policy implications.
I could stop here, of course. In a way, all has been said. But many, the press in particular,
tend to take a very pragmatic approach to monetary policy and are concerned with "what,
when and how much". So I will try to be a little more specific.
If you adhere to the repeated shocks narrative, the recommended course of action is to
normalise monetary policy by raising rates to a level slightly above r*. Assuming the nominal
neutral rate is around 2%, the policy rate will need to be brought slightly above that level to
bring inflation back to 2% within a reasonable timeframe.
While this outlook is possible, I believe it to be overly optimistic.
On the other hand, if you believe in the regime shift narrative, the situation is potentially
more complicated. Broadly speaking, there are two types of regime shifts: one related to
fundamentals and the other to inflation dynamics. In the former, the supply shocks we are
experiencing could have persistent - or even permanent - effects. Whether this will be the
case depends on known unknowns: a resurgence of the pandemic, spillovers from the war
in Ukraine on global value chains, a rocky energy transition, deglobalisation and/or
unsustainable fiscal trajectories.
In the second type of regime shift, inflation could get out of control without a change in
fundamentals. This could happen if, for instance, inflation expectations were to de-anchor.
De-anchored inflation expectations would most likely require a more forceful policy
response, with a greater cost of waiting, in terms of economic activity, reminiscent of the
"Volcker shock" in the 1980s.
Looking at measures of inflation expectations, as shown on the slide, the evidence leans in
favour of expectations remaining anchored, although some risks have started to appear.
Market-based measures and the ECB's surveys of professionals indicate that long-term
inflation expectations are broadly anchored. However, there is some evidence of
deanchoring in consumer expectations surveys and tentative signs of de-anchoring in the
distributions of market and survey-based measures.11
The possible de-anchoring of consumer expectations is worrisome because it could trigger
a wage-price spiral. If inflation persists, consumers could become more attentive to it, more
"backward looking" when forming expectations. This is nicely captured in the IMF's latest
World Economic Outlook, which presents the results of a model with more persistent
inflation produced by a shift towards more backward-looking behaviour.
Overall, de-emphasising model-based narratives seems warranted to me at this stage. In
addition to repeated surprises and worrying signs in terms of expectations, inflation has
become more broad-based, another indication of increased persistence. But a
consequence of leaving models behind is that the "end game" for monetary policy becomes
less clear. With no r* to target and no more specific forward guidance, there is less
predictability.
This higher uncertainty is reflected in market pricing of future policy rates, as shown on the
slide. The €STR forward curve indicates market pricing for the ECB's deposit facility rate in
a de facto floor system. In December 2021, the curve suggested that the deposit facility rate
would stay "low for long", specifically "negative for long". Today, the curve suggests that the
€STR will stabilise at around 3% by the end of 2023. This significant repricing suggests that
the policy rate is chasing an unobserved and moving target.
My personal take on interest rates is - and has been for a number of months - that we need
at least to bring real interest rates back to positive territory. It is indeed difficult to believe
that raising real rates slightly above zero could do much damage to the economy.
And, indeed, slightly positive real rates are currently priced in by the markets. Looking at
the long end of the €STR forward curve, the real policy rate stands at about 1% if inflation
expectations remain anchored at 2%. Therefore, the €STR increases that are currently
priced in seem reasonable, provided wage growth remains in check. But this condition may
not be met in the future and I cannot exclude the possibility that real rates will have to be
raised more forcefully in order to rein in inflation.
Additional rate forward guidance would probably not be useful at this stage. The level of
uncertainty is high, as reflected by recent fluctuations in the €STR forward curve. As my
fellow central banker François Villeroy de Galhau has stated, "[...] the greater the
uncertainty, the shorter the forward guidance should be".12 With that in mind, it seems
appropriate to make decisions following a meeting-by-meeting approach.
Aside from policy rate increases, reducing the size of the Eurosystem's balance sheet
should also be part of the normalisation process. From a stance perspective, there is
imperfect substitutability between scaling down the balance sheet and hiking policy rates.
Balance sheet policies have a greater effect on longer-term rates, while conventional rate
policies tend to affect shorter-term rates. Hence a balanced mix of the two is warranted at
the current juncture. The Governing Council will discuss key principles for the reduction of
its asset purchase programme portfolio at its next monetary policy meeting in December.
Conclusion
In conclusion, the recent surge in inflation has been triggered by unexpectedly persistent
supply disruptions, very supportive fiscal policies and rising geopolitical tensions. In this
environment, monetary policy was slow to react at first but is now clearly focused on
reaching our 2% inflation target over the medium term.
The jury is still out, however, as to what it will take to get inflation back to target or, put
differently, how we can avoid a costly de-anchoring of inflation expectations.
Importantly, what we end up doing will depend on what other policymakers do. In particular,
fiscal policy, a key transmission channel for monetary easing during the pandemic, should
stop feeding aggregate demand. It should start doing so now, with a net reduction of
structural deficits, allowing for targeted measures to support the most vulnerable segments
of our economies.
I know that this is easier said than done. After a long period of cheap money, people expect
the government to protect them from external shocks. But all else being equal, loose fiscal
policies ultimately provoke a stronger monetary policy response. And if anyone has doubts
as to the outcome of a face-off between fiscal and monetary policies, they need only look
to the recent UK experience (or rather experiment).
More generally, one reason why inflation could be more persistent than initially thought or
estimated by our models is that workers and firms still have to agree on who foots the bill
for higher energy prices. Firms will try to protect their margins and workers their purchasing
power. Both have market power, and it may take a few iterations or, worse, a deeper
recession before they can agree on how to share the burden. Thus far, employees have
been willing to take most of the hit. But like others, I am not sure that bygones are bygones
and therefore expect the pass-through of inflation to wages to increase in the coming
months.
In any case, our monetary policy response will ultimately depend on the severity of the
coming economic slowdown. Two main scenarios could materialise. If the slowdown is
shallow and accompanied by a further rise in inflation - and inflation expectations - real
interest rates will have to move above the current market consensus. On the other hand, if
the slowdown is more severe and leads to lower inflation, leaving expectations broadly
anchored, real rates could stabilise at a level close to zero.
In closing, my most important takeaway from the current inflation episode is that we know
much less about inflation than we thought. We will of course do what needs to be done to
avoid a de-anchoring of inflation expectations. But it is quite clear to me that we, as
policymakers, have lost our moorings. Not only have our models performed poorly but our
conceptual framework may need to be revisited. Over the past ten years, our 2% target has
been met for only a few months. Perhaps our ambition of stabilising inflation within a narrow
range has become, well, a bit too ambitious.
Thank you for your attention.
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