Philip R Lane: Monetary policy and the disinflation process
Speech by Mr Philip R Lane, Member of the Executive Board of the European Central
Bank, at the Banking & Payments Federation Ireland (BPFI) National Banking
Conference, Dublin, 11 June 2024.
* * *
Slides accompanying the speech
Let me begin by offering some comments on the economic outlook, before discussing
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our decision last week to cut the key ECB interest rates by 25 basis points. The latest
Eurosystem staff macroeconomic projections foresee economic growth at 0.9 per cent
in 2024, 1.4 per cent in 2025 and 1.6 per cent in 2026, while inflation is projected to
average 2.5 per cent in 2024, 2.2 per cent in 2025 and 1.9 per cent in 2026. Relative to
the average annual inflation rates in 2022 and 2023 of 8.4 per cent and 5.4 per cent
respectively, considerable disinflation has already occurred, with the latest inflation
figure at 2.6% in May. For inflation excluding energy and food (often termed core
inflation), staff project an average of 2.8 per cent in 2024, 2.2 per cent in 2025 and 2.0
per cent in 2026. Since core inflation stood at 3.9 per cent and 4.9 per cent in 2022 and
2023 respectively, the outlook for 2024-2026 also indicates considerable core
disinflation is in train. The current task for monetary policy is to ensure that full
disinflation is secured, with inflation returning to our two per cent target in a timely
manner and settling at this level on a sustainable basis.
Rather than provide a full analysis of all the factors that determine inflation dynamics,
let me briefly discuss wage dynamics, which play an especially important role in the
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final stages of the disinflation process. Wage growth is still elevated, primarily driven
by the ongoing adjustment to the past inflation surge. The growth rate of compensation
per employee ticked up from 4.9 per cent in the fourth quarter of 2023 to 5.0 per cent in
the first quarter, largely reflecting an increase in negotiated wage growth from 4.5 per
cent to 4.7 per cent. This stronger growth in the first quarter includes very large one-off
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payments in the German public sector. More broadly, the design of some multi-year
wage settlements specify large increases in 2024 (to compensate for the lack of earlier
pay adjustments to the inflation surge) but much smaller increases in 2025. The set of
forward-looking wage trackers also signal that wage dynamics will remain elevated in
2024 but will decelerate in 2025. The Indeed wage tracker declined to 3.4 per cent in
April; similarly, firms participating in the Corporate Telephone Survey expect wages to
rise at a rate of 4.3 per cent in 2024, compared to 5.4 per cent in 2023.
This negatively-sloped profile for wage growth helps to underpin the projected decline in
inflation in 2025, with less pressure from labour costs next year. Over time, disinflation
will also continue to be supported by the restrictive monetary policy stance and the
fading impact of past inflation on ongoing price pressures, while the countervailing
impact from the reversal of fiscal support measures will fall out of the inflation data.
While wage growth is set to be a primary driver of inflation in 2024, the net impact of
labour cost increases on prices is being buffered by a lower contribution from profits. In
particular, by dampening demand and containing inflation expectations, our restrictive
monetary stance is constraining the ability of firms to pass through cost increases to
consumer prices. This is evident in the data for the first quarter, which show unit profit
growth turning negative. In turn, this contributed to the decline in the "GDP deflator"
inflation rate (which reflects the prices of goods and services produced in the euro area
economy, net of the value of intermediate inputs) from 5.1 per cent in Q4 2023 to 3.6
per cent in Q1 2024. The ongoing compression of unit profits will play an important role
in keeping the disinflation process on track, even while the final stages of catch-up
dynamics mean that wage growth remains elevated this year.
Let me now turn to last week's monetary policy decision. After nine months of holding
the deposit facility rate (the primary policy rate that steers money market conditions) at
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4.0 per cent, we cut it to 3.75 per cent. Over the interval since our September 2023
monetary policy meeting, the projected timely return of inflation to our target has been
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reconfirmed in the December, March and June projection rounds. For instance, over
the last four forecast rounds, the projected fourth quarter-on-fourth quarter HICP
inflation rate for 2025 has oscillated within the very narrow interval of 1.9 per cent to 2.0
per cent. As 2025 draws closer, the timeliness of the projected return to target looms
larger on the horizon. In addition, in terms of the sustainability of maintaining inflation at
the target, the inflation outlook for 2026 has been reconfirmed over the last three
projection rounds.
Moreover, the overall speed of disinflation has been faster than expected. Over this
period, inflation has come down by 2.6 percentage points. While at the start of the
holding phase, staff saw inflation averaging 5.6 per cent in 2023 and 3.2 per cent in
2024, inflation turned out to average 5.4 per cent in 2023 and, for 2024, it is expected at
2.5 per cent in the latest projection exercise (0.7 percentage points lower than projected
last September). The set of underlying inflation indicators also shows considerable
progress compared to the start of the holding period, with most gauges drifting lower
towards two per cent.
This improvement in the inflation profile has reduced the risk to the stability of inflation
expectations posed by "too high for too long" inflation, including through its impact on
future price and wage resets. Compared to last September, measures of shorter-term
inflation expectations have declined, while measures of longer-term inflation
expectations have remained broadly stable, with most standing at around two per cent.
In parallel, the evidence indicates that our monetary stance has been clearly restrictive.
Mortgage rates are measurably lower compared to their autumn peak but indices of
affordability of mortgage credit still point to restrictive conditions. In particular, compared
to the start of the holding period, real lending rates to firms and households have risen
markedly and are expected to remain significantly higher than assumed in the
September 2023 projections, suppressing demand for external finance. Activity is
recovering, although not sufficiently in those segments of demand that are most
sensitive to interest rates, such as construction - beyond the temporary factors
supporting construction activity in Germany and Italy - and business investment. In
addition, consumer confidence, while gradually recovering, remains subdued. Overall,
the incoming data on financing conditions signal that the monetary stance remains
restrictive, which will help maintain the disinflation process.
An interest rate decision should be robust across a wide range of scenarios. The
baseline projections reflect the market yield curve, which envisages a set of rate cuts in
2024 and 2025. However, at a still clearly restrictive level of 3.75 per cent for the
deposit facility rate, the realisation of even a substantial margin of upside shocks to
inflation could be addressed by a slower pace of rate reductions compared to the
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baseline rate path embedded in the projections. At the same time, a policy rate level of
3.75 per cent also offers more protection against downside shocks compared to
remaining at 4.0 per cent.
It should be clear that the high level of uncertainty and the still-elevated price pressures
that are evident in the indicators for domestic inflation, services inflation and wage
growth mean that we will need to maintain a restrictive monetary stance, following a
data-dependent and meeting-by-meeting approach to determining the appropriate level
and duration of restriction. Over time, the incoming data should be informative about the
balance between backward-looking price level adjustment dynamics (that should
gradually die out) and the more problematic and persistent underlying component in
inflation. In connecting the inflation data and the broader economic and financial data,
the evolution of cost dynamics and domestic pricing power will depend on the strength
and composition of the cyclical recovery.7
That is to say, our data-dependent approach requires us to carefully analyse and
interpret the incoming information in the context of our three-part evaluation framework
in order to assess the implications for the inflation outlook (both in terms of the baseline
and risk scenarios), the dynamics of underlying inflation and the state of monetary
policy transmission.
We are determined to ensure that inflation returns to our two per cent medium-term
target in a timely manner, and we will keep policy rates sufficiently restrictive for as long
as necessary to achieve this aim. We are not pre-committing to a particular rate path
and will continue to take a meeting-by-meeting approach to determining the appropriate
level and duration of restriction.
1
See also Lagarde, C. (2024), "Why we adjusted interest rates", The ECB Blog , 8 June.
In addition, a set of background slides is available on the ECB website.
2
For instance, see more detailed inflation analysis in Lane, P.R. (2024), "Inflation in the
euro area", Speech at the Institute of International and European Affairs, Dublin, 27
May.
3
For details see Holton, S. and Koester, G. (2024), "Tracking euro area wages in
The ECB Blog
exceptional times ", , 23 May.
4
The other key policy rates are the rates on the main refinancing operations and the
marginal lending facility at which banks can borrow from the ECB.
5
Each projection round takes into account the prevailing market view of the future path
of interest rates, as embedded in the market yield curve.
In addition to the occurrence of new shocks (including geopolitical events), inflation
surprises could also be generated by higher-than-expected persistence in domestic
inflation and services inflation or weaker-than-expected monetary transmission. The risk
assessment section of our monetary policy statement elaborates on the set of risks to
the economy and inflation.
7
For instance, productivity growth is intertwined with cyclical recovery. See Arce, Ó.
and Sondermann, D. (2024), "Low for long? Reasons for the recent decline in
productivity ", The ECB Blog, 6 May.