BANCODEESPANA

Eurosistema

01.05.2024

Reflections on monetary policy arising from the latest inflationary-
disinflationary episode

London School of Economics

London

Pablo Hernandez de Cos
Governor


I would like to extend my heartfelt gratitude to Ricardo Reis for inviting me to participate in
this event. It holds special significance for me, occurring just a month before the conclusion
of my six-year term as Governor of the Banco de Espafa.

Back in 2018, when I was appointed Governor, we were navigating a world economy
characterised by low interest rates and subdued inflation. Ironically, many quipped, "May
you live in interesting times!" Little did we know that these times would indeed prove to be
extraordinary. First, on account the Covid-19 pandemic and then, the largest surge in
inflation since the 1970s.

Today, I am honoured to share with you some insights gleaned from my policymaker
perspective during the inflationary-disinflationary episode in the euro area and the European
Central Bank's (ECB) response to it. In doing so, I will also point out some key aspects that,
in my view, deserve in-depth analysis in the future.

1. Why has inflation been so high? Why did we underpredict it?

The annual rate of inflation in the euro area rose from very low levels in late 2020 to 10.6 %
in October 2022, an unprecedented figure in the history of the monetary union.

THE INFLATIONARY SHOCK, A RESULT OF SUPPLY AND DEMAND SHOCKS, WAS

UNPRECEDENTED IN SCALE AND PERSISTENCE, WHICH SURPRISED ALL FORECASTERS

CONTRIBUTIONS TO HCPI INFLATION IN THE EURO (a) Heer IROSYSTEMECESTAFr PROJECTIONS) Nesmowens

Jan-21 Jul-21 Jan-22 Jul-22 Jan-23 Jul-23 Jan-24

420 Q121 Q221
Q121> Q221> Q321

= Other factors affecting HICP food inflation

1 Impact of non-energy-related assumptions

1 Indirect impact of energy prices on non-energy inflation

1 Impact of energy price assumptions and other factors affecting HICP energy inflation
SOURCES: Eurostat, European Gentral Bank and Banco de Espafia. @ Total error

a. Latest data coresponds to March 2024

b. "Total error" is the outtur minus the projection. The labels on the horizontal axis indicate the quarter in which the projections were published and the quarter to which they relate. "Indirect impact of
energy prices on non-energy inflation" is the sum of the indirect effects of oll, gas and electricity prices, using the elasticities derived from Eurosystem staff macro models for oil. "Impact of non-energy
related assumptions" relates to assumptions of short and long-term interest rates, stock market prices, foreign demand, competitors' export prices, food prices and the exchange rate.

mmm SERVICES mmm NON-ENERGY INDUSTRIAL GOODS mmm ENERGY st FOOD <= INFLATION

This surge in inflation was caused by a series of exceptional shocks that impacted the
various components of inflation (left-hand side chart of slide 1).

When the COVID-19 pandemic hit our economies in early 2020, the global supply system
was undermined by lockdowns. In early 2021, as economies reopened, inflationary
pressures emerged when the release of pent-up demand and excess savings accumulated
during the pandemic (underpinned by synchronised and highly expansionary monetary and
fiscal policies around the globe) confronted a supply system severely affected by restrictions
and bottlenecks in global value chains.


This demand-supply mismatch rapidly impacted commodity prices, especially energy ones,
which emerged as the main factor behind the inflation surge (green bar in the chart).

Inflationary pressures gathered pace in 2022, exacerbated by the impact on energy and
other commodity markets of the Russian invasion of Ukraine. As a net energy importer, the
euro area was particularly exposed to this shock. Other commodities, including food (yellow
bars) (for which energy and energy-intensive products such as fertilizers are important
production inputs) were also affected, spreading the inflationary pressures across the
consumption basket.

For much of 2021 and 2022, these factors were further compounded by a depreciation of
the euro, making imported goods and services more expensive.

In addition, the gradual materialisation of indirect effects of energy cost increases and
supply-chain bottlenecks led to a steady increase in non-energy industrial goods and
services inflation (red and blue bars).

In late 2022 inflation embarked upon a downward path supported initially by a sharp
correction of energy inflation, and over time by the effect of monetary policy tightening and
the gradual unwinding of adverse supply shocks.

In the euro area, this disinflationary process is fairly advanced but has yet to be completed.
Inflation stood at 2.4 % in April 2024 and, based on ECB staff projections, the inflation rate
will continue to ease, although with a somewhat bumpy profile in the short term. Indeed,
energy base effects, the unwinding of crisis-related fiscal measures and the relatively slow
moderation of services inflation, will cause inflation rates to fluctuate during 2024, before
reaching our 2 % target in mid-2025.

Forecasting the dynamics of inflation, even within short-term horizons, during this period
has been very challenging.

Indeed, forecasters were first surprised by the strength of the inflation surge, and then by
the speed of its initial decline. The right-hand chart of slide 2 shows the quarter-to-quarter
errors in ECB/Eurosystem staff inflation projections over time and decomposes them into
various factors.

Large and rising positive forecast errors were observed until the second quarter of 2022,
shortly after the start of the Ukraine war'. Forecast errors then began to decline after the
third quarter of 2022 and especially during 2023, coinciding with the disinflationary process,
when errors became small and even negative at times.

Initially the underprediction of inflation mainly reflected upward surprises related to the
dramatic increase in energy commodity prices and their direct impact on consumer prices
(orange bars)."

' With Eurosystem/ECB staff forecasts broadly in the middle of the range of projections see Lane (2024) for more evidence
on this issue.

? Aside from energy prices, supply bottlenecks also contributed to inflation forecast errors, especially in the second half of
2021, induced by stronger than expected economic recovery and supply chain disruptions.


In early 2022, food prices started to play a significant role as well, while the speed and
intensity with which energy and food inflation passed through to core inflation (i.e. inflation
excluding energy and food, labelled "HICPX" in the chart) was higher than expected. In
2023, the contribution to total projection errors coming from energy commodity prices was
also significant, but in the opposite direction, contributing to an overprediction of inflation.®

An important takeaway from this exercise is that, even after controlling for the successive
upward surprises in energy commodity prices and other technical assumptions underlying
the projections, inflation forecast errors have remained positive and account for around 30
% of total forecast errors during the period 2020 Q4-2023 Q3.

This finding suggests that our main forecasting models, had a hard time capturing how the
large shocks I have described are transmitted to inflation over time. This finding is not unique
to ECB/Eurosystem projections, as it has also been observed in other jurisdictions.*

Our own research suggests possible reasons why model-based forecasts did not accurately
capture the transmission of those large shocks to inflation.

For instance, econometric evidence and simulation exercises show that standard linear
forecast models do not properly capture the transmission of large commodity price shocks
to non-energy inflation®. In fact, large positive energy and food price shocks tend to increase
core and food inflation, respectively, by a greater degree than is normally predicted by linear
models.

Indeed, one possible explanation for these non-linearities is that, when facing large shocks
to their input costs, firms tend to update their prices more frequently and hence pass on the
cost increases to selling prices more quickly.° This makes inflation increase more intensively
than in 'normal' times of low and stable inflation, thus further hindering the accuracy of linear
model-based predictions.

All in all, a first key lesson from this inflationary episode is that central banks should
endeavour to make their forecast machinery better equipped to handle large shocks and
project their impact on inflation over the medium run.

In fact, we are already taking steps in that direction. Our efforts are multilayered, involving
not only a revision of our more traditional forecasting models, but also the development of
a diverse set of complementary tools and analysis techniques that inform our projections.

3 For a comprehensive analysis and monitoring of forecast errors by the Eurosystem during this period, see Chahad et al.
(2022, 2023 and 2024).

4 See, for instance, the IMF working paper by Koch C., and D. Noureldin (2028) for a worldwide analysis, including advanced
and emerging economies, or Bank of Canada staff paper by Kryvtsov, O. et al (2023) and Reserve Bank of Australia (2022),
among others, for a more country-specific analysis.

5 As can be seen from simulations exercises for energy shocks in Burriel and Odhendal (2024) and Gonzélez Minguez,
Hurtado, Leiva-Ledn and Urtasun (2028), and for food shocks in Borrallo, Cuadro and Pérez (2024).

5 In a model with state-dependent price-setting, Costain, Nakov and Petit (2022) show how firms increase their frequency of
price changes when inflation is higher. Empirically, the analysis of the microdata on consumer prices for Spain and other euro
area countries reveals a notable increase in price adjustment frequencies during the inflationary episode (Gutiérrez and Roldan,
2024; Gautier et al, 2023). See also Dedola et al (2024).


This strategy includes elaborating specific models for certain components, such as
commodities, or introducing new techniques, such as non-linear econometric models.

Additionally, we have learnt that complementing the baseline projection scenarios with
alternative scenarios (characterized, for example, by paths for key external assumptions that
differ from those in the baseline) are extremely helpful in a context of high uncertainty like
the one we are still experiencing. '

2 How should monetary policy respond in a context of negative supply-side
shocks?

My second point concerns the nature of the shocks that dominated the inflation surge in the
euro area.

THE MAIN DRIVERS OF INFLATION IN THE EURO AREA HAVE BEEN SUPPLY-SIDE SHOCKS, WITH A MORE LIMITED
ROLE FOR DEMAND SHOCKS COMPARED TO THE US

=tmDEMAND @SUPPLY @#HICP/CPI

EA HICP (%, cummulative change) US CPI (%, cummulative change)

2020q4-2022q2 2022q2-202344 2020q2-2022q2 2022q2-2023q4

Sources: FRED St Louis, Eurostat, Bank of Spain and own calculations.
Notes: Historical decomposition (mean deviations) based on a structural VAR model using quarterly data from the US (19902 to 202304) and the euro area (200701 to 202304) of the following variables:
real GDP, HIGP/GPI, Spot Oil Price (WTI or Brent), effective funds rate from the effective federal funds rate or the ECB deposit facility rate (DFR) and the bottleneck indices from Bumel et al (2024)
'Structural shocks are identified through exclusion and sign restrictions, see Kataryniuk, Martinez-Martin, Pappa and Rast, 2024 (forthcoming). Demand structural shocks aggregate demand and monetary
policy shocks, while supply shocks aggregate cost-push, oll and bottenecks shocks. Following Serena Ng (2021) Covid-19 cases entered the model as exogenous.

Research shows that the main drivers of inflation in the euro area have been supply-side
shocks, with a more limited role for demand shocks.® This is in contrast to the US case,
where inflation was dominated by demand-side forces (see slide 2).

The nature of the shocks driving inflation is not an academic curiosity, and in fact determines
how central banks respond to those shocks in practice.

Indeed the ECB Monetary Policy Strategy Review back in 2021 stated: "As different types
of shock may move inflation and real economic activity in the same direction (as in the case
of demand shocks) or create a temporary trade-off (as in the case of supply shocks), the

? Recent external evaluations of central banks' forecasting procedures stress the importance of complementing the baseline
scenarios of projection exercises with alternative scenarios that, among other aspects, convey the degree of uncertainty
surrounding the baseline. See e.g. Milesi-Ferretti, Onorante and Vidalis (2028) for an independent review of the Banco de
Espafa's macroeconomic projections, and Bernanke (2024) for the recent independent review of the Bank of England's

economic forecasting.

8 See, for instance, Arce et al. (2024), Banbura et al. (2024) and Kataryniuk, et al. (2024).


medium-term orientation provides the policy flexibility to assess the origin of shocks and
look through temporary shocks that may dissipate of their own accord, thus avoiding
unnecessary volatility in activity and employment."

The above paragraph encapsulates two key considerations when confronting adverse
supply shocks.

First, in the face of a negative supply shock, inflation increases while output typically falls
below potential. That introduces a meaningful trade-off for monetary policy: an aggressive
reaction to quench inflationary pressures may produce an excessive contraction in
economic activity. That justifies being more patient in the face of supply shocks as opposed
to situations in which inflation is more demand-driven?.

Of course, patience does not mean inaction. This brings me to the second consideration.
Whether a central bank should look through temporary supply shocks hinges critically on
whether such shocks are expected to have a very transitory effect on inflation or, instead,
are expected to affect inflation over the medium-term, which is the relevant horizon for
monetary policy.

As mentioned before, the adverse supply shocks that hit the euro area back in 2021 and
2022 had rather persistent effects on inflation, affecting the medium-term inflation outlook
and therefore justifying a forceful monetary policy response by the ECB once it started.

By raising interest rates in response to such a shock, the central bank reduces the deviation
of inflation from target not only during the energy inflation spike, but also after it. In sum, an
active monetary policy response to energy (and more generally, supply) shocks produces
less inflation volatility than an alternative 'looking-through' policy.

This analysis shows how important it is for central banks to have an accurate assessment
of how ongoing supply shocks are likely to affect inflation over the policy-relevant horizon.
In this regard, the lesson to be learned is closely related to the previous one. It is of
paramount importance for central banks to improve their forecasting tools and their
knowledge of how different shocks are passed through to inflation over the forecast horizon.
This will allow us to better decide how patient or impatient to be in the face of different types
of shocks, whether supply ones or otherwise.

This lesson is particularly relevant in the case of supply shocks, as there are good reasons
to believe that they may become more frequent in the future." In this respect, having a better
understanding of the macroeconomic transmission of supply shocks strikes me as a key
issue to be addressed in upcoming monetary policy strategy reviews by central banks
around the world.

° For further elaboration of this point, see Tenreyro et al (2028).

1° See for example Lagarde (2023).


3 How should monetary policy respond in a context of high uncertainty?

In practice, central banks do not know how persistent a given supply shock will be. Nor do
they know whether a supply shock will be followed by another. Theory is far from providing
a clear answer as to how monetary policy should react in a highly uncertain environment.

The classic Brainard (1967) attenuation principle states that monetary policy should be
conservative in the face of uncertainty about the impact of underlying shocks on inflation
and/or the impact of any policy mis-calibration on inflation.'' Indeed, the greater the
uncertainty, the higher the probability that a more aggressive monetary policy response to
shocks may move inflation and output away from target.-'

An alternative strand of literature, usually referred to as 'robust control', provides guidance
pointing in the opposite direction. If shocks are persistent and second-round effects
materialise, it pays off to be more aggressive and keep longer-term expectations well-
anchored." Indeed, the experience of the 1970s showed that shocks can be concatenated,
especially when they originate on the supply side of the economy, with strong additive
effects on economic variables. In this case, theory suggests that monetary policy should be
more reactive in order to prevent backward-looking behaviour from becoming embedded in
economic expectations.

My own takeaways from the extensive literature on monetary policy and uncertainty are: (i)
monetary policy should not be paralysed in the face of uncertainty (i.e. central banks need
to remain pre-emptive and forward-looking); (ii) there is no general rule for monetary policy
to be either attenuated or more activist in an uncertain environment; and (iii) a risk
management approach is crucial.

The latter requires pragmatism and judgement, which must be based on a critical
examination of the evidence and the realisation that patterns observed in the past can
change rapidly. In this respect, as I mentioned earlier, when making decisions in the present
it is crucial to be well equipped not only with a baseline projection scenario, but also with
alternative scenarios and simulation exercises easing the different assumptions underlying
the baseline scenario.

The ECB's reaction to the current inflationary and disinflationary episode, which has been
fraught with uncertainty, has been based to a large extent on these principles. The concepts
of optionality, gradualism and flexibility that have guided our policy are a good example of
this approach. Indeed, we have responded to this new context by increasing optionality and
emphasising that we will act in a data-dependent manner in order to deliver on our mandate
of price stability.

Finally, I would like to emphasise the importance of supply-side policies in making
economies more resilient to supply shocks. Achieving this calls for a more balanced
approach to policymaking, a topic I will address in the last part of my speech.

" See H. Pill speech on "Monetary policy with a steady hand" on 9 February, 2022.

12 It will depend on the degree of persistence of the shocks that hit the economy, as shown by Ferrero et al (2019).

'8 For empirical evidence showing that central banks' excessive caution may shift inflation expectations away from their
inflation target, see Dupraz et al. (2023).


4 Why has the sacrifice ratio apparently been so low and how does it relate to
(anchored) inflation expectations?

A striking feature of this episode is that the disinflation process has taken place without a
major loss of economic activity.

Of course, much of the disinflation is due to the dissipation of the very supply shocks that
created the inflation surge in the first place (and which adversely affected output), meaning
that some of the headwinds to activity have also subsided.

But the disinflation also reflects the ECB's forceful monetary policy response.

It is true that euro area GDP decelerated notably in 2023, growing by an anaemic 0.4%, and
that the outlook for this year is also relatively weak. But given the scale of the monetary
tightening, it can be argued that the 'sacrifice ratio' of bringing inflation down has been
relatively low so far.

The US case is arguably even more puzzling, given the relatively minor role of supply shocks
there. In sum, disinflation on both sides of the Atlantic has happened with apparently little
impact on employment and activity, in what is commonly referred to as "the immaculate
disinflation".

Let me now highlight two possible reasons why the sacrifice ratio appears to have been so
low so far.

LONG-RUN INFLATION EXPECTATIONS IN THE EURO AREA HAVE REMAINED ANCHORED

EURO AREA: LONG-TERM INFLATION EXPECTATIONS (a) EURO AREA
BASED ON ANALYSTS AND MARKET SURVEYS I LONG-TERM INFLATION EXPECTATIONS:

23

2.0

15 18
Jan-22 sJul-22 Jan-23 Jul-23 Jan-24 16

- SWAPS 5Y5 PREMIUM ADJ. - SPF(S years) Jan 22 Mar22 May22Jul22. Sep 22

PREMIUM ADJ.

- CONSENSUS (6-10 years) SMA (long run) 2Y2 PREMIUM ADJ

a) The Survey of Professional Forecasters (SPF) inflation expectations are for a period of 4/5 years. The last SPF is from March and it refers to the year 2028. The last Survey of Monetary Analysts (SMA)
is from April 2024 and it refers to the long run expectations, interpreted as the horizon over which the effects of all shocks will have vanished.
'Sources: Refinitiv, BCE and Gimeno and Ortega (2022) Modelling inflation expectations: the value of mixing information and frequencies, Bank of Spain Working Paper (forthcoming)

First, the severity of the output-inflation trade-off crucially depends on_ inflation
expectations. In the New-Keynesian Philips curve, a rise in inflation expectations shifts the
relationship between the short-term output gap and inflation upwards. This implies that
stabilising output at potential does not suffice to bring inflation back to target: instead, the
central bank must depress output below potential in order to achieve the inflation target.


In the case of the latest inflationary episode, there was a very real risk that the sharp and
persistent rise in inflation would eventually lead to a de-anchoring of medium- and long-
term inflation expectations above target.'* However, at least in the euro area, inflation
expectations over medium- and long-term horizons have remained broadly anchored to the
ECB's 2% target (slide 3). This fact is one of the main reasons why the sacrifice ratio has
been relatively small compared to previous inflationary episodes where supply shocks
predominated, such as the oil price shocks of the 1970s and the subsequent costly
disinflation.

Second, the output-inflation trade-off also depends on the slope of this relationship, i.e. how
much output has to fall to bring inflation down (for given inflation expectations). In the basic
New Keynesian model, this slope is higher the higher the frequency with which firms adjust
their prices to changes in their cost and demand conditions.

Earlier I argued that one consequence of the recent episode of high inflation was that firms
changed their prices more frequently, accelerating the transmission of shocks to inflation.
But by the same token, faster repricing by firms implies that inflation is more sensitive to
changes in aggregate demand.'> In other words, the Phillips curve becomes steeper,
allowing the central bank to achieve the same reduction in inflation with smaller output
losses, hence reducing the sacrifice ratio.

The optimal monetary policy prescription in this situation has been analysed by a joint team
of ECB, Banco de Chile and Banco de Espajfia researchers: the central bank should "strike
while the iron is hot", in other words, fight inflation by countering firms' inflationary
aspirations, thereby achieving a lower sacrifice ratio."

Allin all, in my view, the recent inflationary episodes vividly illustrate the crucial importance
for central banks of acting and communicating in a way that keeps inflation expectations
well anchored to their objectives in the face of inflationary shocks.

5 How has monetary policy transmission worked?

The last monetary policy tightening has been exceptional in terms of both its size and
speed" and followed a long period of unconventional expansionary monetary policy and
negative interest rates. Furthermore, since the previous interest rate hiking cycle in 2005,
there have been structural changes in the euro area economy and its banking system. Banks
are now better capitalised and have higher liquidity ratios than in the past. Moreover, the
last monetary policy tightening took place in a context of adverse supply shocks, weak
growth and high uncertainty, in contrast to the positive demand shocks that predominated
during the 2005 monetary policy tightening cycle.

"4 As argued in the BIS Annual Report 2022 and Carstens (2022), in the context of an inflationary episode such as the recent
one, the risk of a transition from a low- to a high-inflation regime should not be underestimated.

'5 Cavallo et al. (2023) show how the frequency of price changes increases dramatically after a large shock.
'® Karadi P., A. Nakov, G. Nuno, E. Pasten, and D. Thaler (2024).

1? Between July 2022 and September 2023 (i.e. in 14 months) policy rates rose by 450 bp and were accompanied by a
significant reduction in our balance sheet.


All these features may potentially have altered the strength and speed of the monetary policy
transmission mechanism in the euro area in the recent tightening process compared with
previous tightening cycles.'®

The evidence accumulated so far shows that, the unprecedented scale and speed of the
last rate hiking cycle in a context of adverse supply shocks, weak growth and high
uncertainty appears to have contributed to amplifying the tightening of financing conditions
through higher risk premia and tighter credit standards. As a consequence, non-linearities
may have emerged, as the observed slowdown in credit flows has been more intense than
predicted by linear models based on historical patterns'? (slide 4).

MONETARY POLICY TRANSMISSION TO CREDIT STANDARDS AND NET CREDIT FLOWS HAS BAN

BEEN STRONGER THAN IN OTHER TIGHTENING EPISODES

CHANGE IN EURO AREA BANK LENDING STANDARDS (a) LOAN PROJECTIONS (YoY). SPANISH NON-FINANCIAL FIRMS (b)

TGHTENNG

EASING

TONON-FINANCIAL  TOHOUSEHOLDS FOR CONSUMER CREDIT AND 6

FIRMS HOUSE PURCHASE OTHER LENDINGTO Mar-21 Juk21 Nov-21 Mar-22 Juk22 Nov-22 Mar-23 Juk23  Nov-23
HOUSEHOLDS

"N

INTEREST RATE Hii

"GLOBAL FINANCIAL Cr

06.03

MAR23 JUN-23

= SOVEREIGN DEBT CRI
= INTEREST RATE Hk

SOURCES: European Central Bank and Banco de Espafia
'a. Average ofthe net percentage forthe corresponding period (percentage of banks reporting a tightening less percentage of banks reporting an easing).
b. Inall forecasting exercises the explanatory variables are those observed at December 2023.

However, there is also evidence that the strong growth in nominal income, in a context of
robust employment and profit growth, has slowed the increase in the percentage of
vulnerable indebted households and firms. As a result, the credit risk deterioration still falls
short of what would be expected on the basis of historical regularities, following a worsening
economic outlook, higher interest rates and rising bankruptcies. All in all, these results
suggest there is a lack of amplification mechanisms across the banking system for the
transmission of monetary policy tightening in the current cycle.

As to the evidence on the second link of the monetary policy transmission mechanism from
financial conditions to activity and inflation, since the start of the recent monetary policy
tightening cycle, the Eurosystem staff macroeconomic projections have systematically
overestimated GDP growth, and these downward surprises do not seem to be fully
explained by errors in the technical assumptions, including the changes in the fiscal and
monetary policy stance. This evidence might be signalling a stronger transmission of
monetary policy to macroeconomic variables than in the past. However, the labour market
has demonstrated remarkable resilience over the past two years, as illustrated by lower than
expected unemployment rates compared with staff projections.

18 For further details, see Hernandez de Cos (2024).

19 For further details, see Lane (2023) and Garcfa-Posada and Paz (2024).


TIGTHER FINANCIAL CONDITIONS HAVE TRANSMITTED MORE FORCEFULLY TO ACTIVITY AND

(ALTHOUGH NOT SIGNIFICANT TO) INFLATION THAN IN PREVIOUS CYCLES ON AVERAGE

TIME-VARYING IMPACT OF A 100 BPS SHOCK ON GDP OVER THE FIRST YEAR TIME-VARYING IMPACT OF A 100 BPS SHOCK ONHICP OVER THE SECOND YEAR

Year-on-year (%) Year-on-year (0)

Od ah oO ah WO WO Mh WO WO gh » :
SPX ge sr GP ph oh oo gw? ot ot SEES S LS SSK Sg PS MS
mes 68% CI - -cONSTANT COEFFICIENTS wenn sm 68% C1 - CONSTANT COEFFICIENTS neon

SOURCE: Banco de Espafia
NOTES: Impact of a 25 bps (non-systematic) monetary policy shock based on recursive estimates of a Structural VAR (SVAR) model extension from Brandt et al (2019). Structural shocks are identified
through sign restrictions,

Complementary econometric evidence shows that, in the recent tightening cycle, the
transmission of monetary policy to GDP growth and inflation may have been somewhat
more intense than observed on average before this unprecedented tightening cycle *° (slide
5). This is especially the case for growth, whereas the evidence for inflation is less
conclusive. 2!

All in all, this analysis confirms that a stronger than expected monetary policy impact
remains a downside risk to the euro area growth outlook, which, in turn, is an important
factor behind our assessment that the risks to the inflation outlook are now balanced.

6 What have we learnt from our experience with Quantitative Tightening (QT)?

The macro-financial effects of Quantitative easing (QE) have been extensively analyzed."

The theory shows that QE mainly impacts yields through anticipation effects: investors react
to their expectations about how much debt the central bank will extract over time from the
market, so that risk-averse market participants will not have to hold it. In part, this involves
the extraction of duration risk - the risk related to changes in a bond's market price over its
remaining life due to changes in short-term interest rates.?°

°° The in-house evidence is based on recursive estimates on the impact of (non-systematic) monetary policy shocks by means
of a Structural VAR (SVAR) model extension from Brandt et al (2021), identified through sign restrictions.

21 An additional lesson that we can learn from the US experience is based on recent research by Canova and Perez-Forero
(2024), who show evidence on how two types of monetary policy shocks impact the US economy under high versus low
inflation regimes. They focus on conventional policy disturbances (which alter aggregate conditions by adjusting short-term
nominal interest rates) and liquidity disturbances (which modify the money supply by affecting the long end of the term
structure of interest rates) and conclude that in high inflation regimes, the peak response of output growth, unemployment,
and inflation is smaller, but the effects persist longer.

2 See, for instance, Aguilar et al (2020, 2022, 2024), and Altavilla, Carboni and Motta (2021), Eser et al (2023).

°8 Vayanos and Vila, (2021), Eser et al (2023), op. cit.

10

In the euro area, duration risk extraction is reinforced by the extraction of sovereign credit
risk.24 In this regard, QE has proved to be a useful tool for combatting unwarranted
fragmentation of financial conditions across member states, which may be crucial for
ensuring the smooth transmission of monetary policy throughout the euro area, especially
at times of financial market distress.

But now that central banks are embarked in quantitative tightening (QT), we still need to
understand the impact of central banks reducing their asset portfolios. In this regard, there
are many reasons to expect that the observed effects of QT will not just be the mirror image
of QE. Even if central bank purchases and sales of assets have a fundamentally symmetric
impact on market conditions, nonetheless the manner and circumstances of QE expansions
and QT contractions may cause their observed effects to differ.

First, QE policies were often implemented at moments of high market stress, when their
effects are larger,?° whereas central banks have waited for times of market tranquility before
embarking on QT.

Furthermore, QE took the form of outright purchases, but QT can now take the form of a
passive run-off of bond portfolios."'

Lastly, the announcement of large-scale QE programmes, such as the ECB's pandemic
emergency purchase programme (PEPP), often came as a surprise to the market, while the
current QT