Speech Klaas Knot  In resolute pursuit of price stability
 November 
General
 DNB
become a key issue for everyone. In his keynote address at the  Frankfurt
European Banking Congress, Klaas Knot spoke about the ECB's resolute pursuit
of price stability.
Datum:  november 
Spreker: Klaas Knot
nd
Locatie:  Frankfurt European Banking Congress, Frankfurt
In the runup to any big football tournament, newspapers, podcasts, and TV presenters
overload you with facts and figures, performance levels and prognoses. But amidst all those
stats and stories, they usually forget one golden rule: in the end, Germany always wins.
At the ECB, we play a different ballgame. But just like in football, to beat the current economic
challenges, to normalise inflation, and to safeguard the sustainable welfare of people in
Europe, we team up. We defend and strike together. And we won't forget the golden rule of
our game: in the end, we only win if all of us win.
For a long time, inflation was hardly on anyone's mind. But today, inflation has returned with
a vengeance and has become a key issue for everyone.
Three years ago, in , headline inflation in the euro area stood at a seemingly unshakable
%. A year later, it even dipped below zero. A mere year ago, as the economy rebounded from
the pandemic, headline inflation approached an unprecedented %. And yesterday, for the first
time in its history, Eurostat reported doubledigit headline inflation of .%, and even more
worrisome from our perspective, core inflation excluding energy, food, alcohol & tobacco
reached an alltime high at .%.

What is driving this inflation surge? Of course, there are energy prices and oneoff factors
Figure . But the persistence of high inflation  both headline and underlying  has surprised
many experts. ECB forecasters, markets and analysts have kept revising up their inflation
forecasts and now expect inflation to peak in the fourth quarter of  Figure . It is
projected that inflation will only return towards the ECB's % target in the course of
.
These forecasts are surrounded by unusually high levels of uncertainty. This means that
gauging risks to the inflation outlook becomes particularly important. Overall, these risks
remain tilted to the upside. One major risk factor is upward surprises to energy prices due to
scarce and uncertain supplies. This is especially the case in Europe. And especially for natural
gas, given the ongoing geopolitical risks. Over a slightly longer horizon, there is another upside
risk to inflation. Government policies that aim to cushion the impact on households of the
high energy prices may be inflationary to the extent that they do not merely target those
people that lack the financial resources to pay the higher costs. And of course, there is the
very real risk of second round effects, that I will come to later.*
At the same time, growth is slowing down. According to the flash estimate, euro area real
GDP grew by .% qoq in the third quarter of this year. This is down from .% in the
previous quarter but slightly higher than expected by ECB staff in September. Looking
forward, according to ECB staff forecasts from September, growth is projected to decline
further in the fourth quarter of , then come to a standstill, and start recovering in the
second quarter of . Incoming soft data since September suggest that the economic
outlook has deteriorated further and that the risk of a recession has increased.
So, what is weighing down on growth? There are at least four factors: high inflation, high
uncertainty, rising interest rates, and the fading effects of the reopening from the Great
Lockdown.
Slower growth is necessary to bring inflation down, but it is far from certain that slower
growth or a mild recession alone will be enough to drive inflation back to levels around %.
There are two main arguments for being resolute about pursuing price stability. And by being
resolute I mean that we will persist in our efforts until we have reached our goal, no matter
how difficult this proves.
First, in an uncertain environment in which inflation is persistently high and continuously
underestimated, high inflation may get entrenched in people's minds.
Let me explain.
The longer inflation remains above target, the greater the risk that it will affect firms' and
households' expectations and economic decisions. These secondround effects would reflect a
switch from a regime of "rational inattention" in which firms and households largely ignore
inflation numbers, to a regime of "rational attention" with high inflation firmly on their minds.
Note 
History has shown that this switch is typically sudden. But once this shift occurs, inflation
would remain above the ECB's inflation target for a prolonged period, even when there are no
additional inflation shocks. Taming inflation will then become increasingly more difficult and
costly.
In monitoring risks of second round effects, central banks pay close attention to wage
developments and inflation expectations. Subject to the caveat that information on wage
formation is not as granular and timely in the euro area as it is for example in the United
States, current wage developments do not reveal clear evidence of a wageprice spiral in the
euro area. Although nominal wage growth has been picking up, its pace is not sufficient to
keep up with rising consumer prices.
This said, persistently tight labour markets point to rising risks of a further acceleration of
wage growth. Figure  shows for the Netherlands that nominal wage growth has indeed been
picking up and the forwardlooking wage indicator points to higher future wage growth.
A new monthly wage growth tracker developed by my colleagues from the Central Bank of
Ireland based on job postings also reveals that growth in euroarea posted wages accelerated
in  and reached .% yearonyear in October.
Besides, the wage tracker shows that like inflation, wage growth has also become increasingly
broadbased.Note  We will need to be on high alert for any feedback loop to prices.

Moreover, measures of inflation expectations for several types of agents point to mixed
evidence on their anchoring to the ECB's inflation target.
For professional forecasters and market participants, mean or median expectations have
increased since mid to levels slightly above %. And their sensitivity to shortterm
inflation expectations has remained stable in recent months.
For households on the other hand, both median longterm inflation expectations and their
sensitivity to shortterm expectations have increased visibly. Note  This suggests a weaker
anchoring.
When we look at the whole distribution of inflation expectations, however, we can detect
signs of a weaker anchoring of expectations not only by households but also by market
participants and professional forecasters. Uncertainty and disagreement on future inflation
have increased for all agents, and so has the probability they attach to high inflation over the
long run Figure .
This is a risk we need to monitor. Evidence from the Great Inflation in the s demonstrates
why. Up to , the mean of professional forecasters' inflation expectations in the United
States suggested firmly anchored expectations.
However, looking at the full distribution of household expectations might have revealed that
as early as  the anchor was becoming loose. The increase in disagreement across
households and the shift in the skewness of their expectations towards higher inflation were
simply overlooked. This proved a costly mistake because they turned out to be a leading
indicator of the period to follow when inflation expectations went completely adrift. Note 
Aside from the risks of disanchoring inflation expectations, I have a second argument for being
resolute in the pursuit of price stability. And this has to do with demand factors in recent
inflation dynamics. Obviously, in the euro area context supply factors are highly relevant. But
two types of evidence point to an additional, significant role of demand factors. First,
inflationary pressures have increased across the board, and not only for energy and traded
goods affected by strained supply chains and the war in Ukraine. This broadening of inflation
to a wide spectrum of goods and services points to aggregate demand factors also being at
work Figure .
The second piece of evidence builds on the strong positive association between forecast errors
in inflation and output in the euro area. Since the second half of , not only has inflation
been surprisingly high GDP growth has also consistently turned out higher than expected
been surprisingly high, GDP growth has also consistently turned out higher than expected.
Note  Figure  shows that demand shocks to an important extent explain these inflation
surprises. Note 
So now that I have elaborated on the risks to the inflation outlook, the logical question
follows: how to bring it down?
I would begin by recalling that we have already taken important steps. Persistently above
target inflation in combination with clear upside risks led us to normalise our monetary policy
stance so that demand becomes better aligned with reduced supply. In December , the
Governing Council decided to discontinue net asset purchases under the PEPP by the end of
March , and bring APP purchase volumes back, as soon as possible, to prepandemic
levels. In July , net purchases for the APP were ended. Since then, policy rates have been
raised by bps. And the Governing Council also decided to change the terms and conditions
of the TLTROIII operations. This was needed to ensure its consistency with the broader
normalisation process and to reinforce the transmission of our policy rate increases to bank
lending conditions. All our instruments need to work in the same direction.
Looking back, we did not know exactly where monetary policy was headed, but we were sure
that we had to leave accommodative territory as soon as possible. In football terms, our
tactics reflected some sort of kickandrush spirit, with rate hikes of bps and bps
reflecting the desire to frontload our action and reach a more neutral stance of our policy
rates as soon as possible.
Looking forward, I expect us to reach broadly neutral territory at next month's policy meeting.
At that moment, we are no longer stimulating economic growth, but we are also not yet
slowing it down. Neutral territory is like halftime in a football game, when coaches gather all
their players around a white board and draw the game plan for the second half. The team that
comes back on the field might then play in a different way, for example more tikitaka than
continued kickandrush.
For the ECB, the overall game plan remains obvious. Our response needs to be resolute,
implying that monetary policy needs to enter restrictive territory to dampen demand. We
need to address high inflation persistence and growing risks of it becoming entrenched in
people's minds, which would make inflation more costly to tame. How fast and far ongoing
rate increases will bring us into restrictive territory is surrounded by uncertainty and will be
evaluated meeting by meeting. As the stance of monetary policy tightens further, it will
become more likely that the pace of increases will slow. In any case, our priority going forward
will be the need to rule out the risk of persistently high inflation.
This also reflects the switch to more varied tactics, with more instruments coming into play.
The level to which the policy rate will be increased also depends on the calibration of these
instruments, such as the rolloff of our bond holdings. It would not be consistent to keep a
large balance sheet to compress the term premium, while at the same time tightening policy
rates above neutral. Once more, all our instruments need to work in the same direction.
There are clear benefits of such a wellbalanced tightening package. From a stance
perspective, passively rolling off our bond portfolios in addition to raising the shortterm rate,
helps to transmit the tighter policy stance more evenly to the real economy. Model
simulations conducted by DNB staff show that an earlier start of socalled Quantitative
Tightening QT lowers both peak inflation and the required terminal rate via its effect on the
term premium.
When thinking specifically about QT, our decisions should rest on four principles. First, policy
rates should remain the primary instrument to adjust our monetary policy stance. Our balance
sheet size should act as a "backburner" tool. Second, APP holdings should be distinct from
PEPP holdings. The former exclusively steers the monetary stance, while PEPP continues to
serve a dual purpose, by also countering fragmentation risks to monetary transmission.
Therefore, decisions about unwinding these two programmes do not have to run in parallel. I
expect the APP rolloff to start significantly earlier than that of PEPP, for which reinvestment
is communicated to last until the end of . Third, I see a case for caution. To me, this calls
for an early but partial stop to reinvestments, to test the waters before calibrating the
ultimate pace of the rolloff. And finally, QT should be predictable, like watching paint dry, as
the saying goes. Note 
Let me sum up.
"Football is a simple game. Twentytwo men chase a ball for  minutes and at the end, the
Germans always win." Dixit Gary Lineker, former striker for England.
The game we are currently playing is approaching halftime. And so far, the ECB has used
several tactics to beat its opponent. Between December  and today, we started
normalizing monetary policy. We did this by discontinuing net asset purchases under the
PEPP, reducing APP volumes to prepandemic levels, and eventually ending all net purchases.
And then we scored longshot goals with interest rate hikes of  and  basis points.
As we head into the second half, our game plan is likely to change from long shots on target
to short passes and agile moves. So, it will become more likely that we slow the pace of
interest rate increases, which also enables us to use the full palette of our instruments making
our tactics more varied. Our goal still being that we want to rule out the risk of persisting high
inflation and avoid it becoming entrenched in people's minds.
Gary Lineker was not far from the truth when he uttered his famous quote. But it makes you
wonder why. And I think it comes down to the dedication and determination of the
Mannschaft. To giving it all you have got. To play the game until the very final whistle.
And rest assured, this is exactly what the ECB will do.
Notes
 The hypothesis of rational inattention has been discussed recently by J.H. Powell .
Monetary policy and Price stability . Speech delivered at "Reassessing Constraints on the
Economy and Policy," an economic policy symposium sponsored by the Federal Reserve Bank
of Kansas City, Jackson Hole, Wyoming,  August . The analysis of rational inattention
goes back to C. Sims . Implications of Rational Inattention . Journal of Monetary
Economics  : . For an indepth discussion, see e.g., Coibion, O. and Y.
Gorodnichenko . Information rigidity and the expectations formation process: A Simple
Framework and New Facts . American Economic Review,  : .
 P. Adrjan and R. Lydon . Wage Growth in Europe: Evidence From Job Ads. Economic
Letter. Central Bank of Ireland. November .
 Evidence for Dutch households is presented in G. Galati, R. Moessner and M. van Rooij
. Reactions of household inflation expectations to a symmetric inflation target and high
inflation . DNB WP .
 This point was stressed by R. Reis . Losing the Inflation Anchor . Brookings Papers
on Economic Activity, Fall and picked up by I. Schnabel . Monetary policy and the Great
Volatility . Speech at "Reassessing Constraints on the Economy and Policy," Federal Reserve
Bank of Kansas City, Jackson Hole,  August.
 This phenomenon has been documented for the euro area by a recent analysis by ECB and
DNB staff, for the United States and more generally advanced economies by the IMF in the
recent WEO. See E. Gonçalves and G. Koester . The role of demand and supply in
underlying inflation  decomposing HICPX inflation into components . In ECB Economic
Bulletin, September; International Monetary Fund . World Economic Outlook, October
: Countering the CostofLiving Crisis. Washington, D.C.
 E. Gonçalves and G. Koester . The role of demand and supply in underlying inflation 
decomposing HICPX inflation into components . In ECB Economic Bulletin, September;
International Monetary Fund . World Economic Outlook, October : Countering the
CostofLiving Crisis. Washington, D.C.
 See J. Yellen . Transcript of Press Conference,  June , and P. Harker .
Economic Outlook: The Labor Market, Rates, and the Balance Sheet . Remarks at the
Market News International MNI Connect Roundtable, New York, NY,  May.