Inflation expectations and monetary policy in the euro area*
Ignazio Visco
Governor of the Bank of Italy
95th International Atlantic Economic Conference
Robert Mundell Distinguished Address
Rome, 23 March 2023
After a long period of moderate, perhaps even insufficient, consumer price changes,
inflation has returned to levels that are severely influencing the behaviour of households
and firms (fig. 1). While its underlying sources are different across the major advanced
economies, since late 2021 most central banks have progressively tightened their
monetary policy stance to ensure a timely return to price stability.
In the current macroeconomic debate, inflation expectations are in the spotlight. A proper
monetary policy response aimed at anchoring these expectations to central bank targets
is, in fact, key to minimising the risk of a wage-prices spiral that would lead to higher
and more persistent inflation. This is especially important in the face of large shocks such
as those caused by the major increase in gas prices in Europe over the last two years or
so. As an "external tax", the consequent decline in the terms of trade cannot be undone
but instead should be rapidly absorbed, ideally redistributing it in order to protect the
most fragile members of the population. Generalised backward-looking attempts at
recovering the losses in purchasing power generate the real risk of protracting the high
inflation rates resulting from the rise in energy prices. This may, in turn, affect inflation
expectations and give rise to second round effects that must inevitably be countered
with more restrictive monetary policy measures.
Therefore, the crucial question that central banks are facing today is what the most
appropriate conduct of monetary policy should be in these complex and highly uncertain
times. To tackle this question, I will first very briefly review the crucial role of inflation
expectations in the monetary transmission mechanism. I will then consider the issues
related to their measurement and interpretation. In light of these theoretical and empirical
considerations, I will discuss the recent evolution of inflation expectations in the euro
area and will finally draw some conclusions for the current and possible future conduct
of the ECB monetary policy.
Inflation expectations and the monetary transmission mechanism
Monetary policy affects the real economy and inflation with "long and variable"
lags, to use Milton Friedman's famous expression, and through a complex system of
channels known as the monetary transmission mechanism. While central banks' actions
and communications affect financial markets' interest rates and asset prices almost
immediately, their transmission to the financing conditions of households and businesses
and, subsequently, to consumer prices, tends to be much more gradual.
In this process, a key role is played by inflation expectations, namely economic agents'
beliefs or predictions about the future evolution of prices.1 Expectations, in fact, shape
the behaviour of households and businesses, which, in turn, influences overall price
dynamics. In response to the expectation that there will be a broad increase in the prices
of goods and services, for example, workers may pre-emptively request higher wages
and firms set higher prices. Under certain conditions, this may turn into a self-fulfilling
prophecy, fuel actual inflation and make it dangerously persistent.
In macroeconomic models, the role of expectations is typically summarised by the
so-called augmented Phillips curve. As is well known, while the original Phillips curve
examined the relationship between wage growth and unemployment in the UK in
the 1950s, later studies focused on consumer price inflation and unemployment. The
main idea underlying this relationship is straightforward: in a booming economy, high
employment and demand cause workers to demand higher wages and firms to raise
their prices (and vice versa in a contracting economy).2
This relationship is obviously a reduced form of more structural ones modelling the
behaviour of business and labour in the determination of production, consumer prices
and wages. With respect to wage inflation, as early as the 1950s, macroeconometric
models attempted to account for the role played by previous inflation in the bargaining
process, in efforts directed either at catching-up with actual inflation (also through
explicit indexation clauses) or at anticipating future price changes extrapolating them
from past data.3 In this sense, the notion of an augmented Phillips curve was not
new, but the aspects that had been neglected before were the importance given to
forward-looking behaviour and, therefore, the role of expectations in shaping actual
economic dynamics. Expected inflation, therefore, became the main additional factor in
"modern" augmented Phillips curves.4
Much has been added and debated over the last forty years, which I do not intend to
discuss here. As a general statement, however, I would say that, while the curve was "alive
and kicking" from the 1950s to the late 1980s, since then there has been progressively
deep uncertainty as to its empirical relevance, possibly also due to the perceived
increasing effectiveness of central banks in stabilising inflation. In particular, a substantial
reduction in the response of wage and price inflation to demand pressures in goods
and labour markets (measured by the "output gap" or the deviation of the actual rate of
unemployment from its "natural" rate) is often considered to have occurred in the years
known as the "Great Moderation", even if there appears now to be some evidence of a
possible reversal of this trend.5
In any case, the augmented Phillips curve remains a useful tool for policymakers, informing
their decisions about monetary and fiscal policy, with the goal of leading, in turn, to
more stable and predictable economic outcomes. The role played by anticipated inflation
is therefore examined with care, even if - especially in the case of the recent major
supply-side shocks - the attempts of wages to catch up with previous price "surprises"
and the movements in price mark-ups continue to be worthy of attention.
As far as central banks are concerned, inflation expectations are of primary importance,
especially for the setting and assessment of the monetary stance. In fact, although
money is normally borrowed and lent at a nominal interest rate, what matters most
for consumption and investment decisions is the real interest rate, namely the nominal
return adjusted for expected inflation. Its gap with respect to the "natural" or equilibrium
real rate is also often considered a crucial variable that should inform monetary policy
makers working towards maintaining price stability.6 In particular, as consumption and
investment decisions span over longer horizons, it is suggested that central banks should
not only seek to set the current level of the short-term rate of interest but also monitor
- and in some cases provide guidance on - its expected future values, thus influencing
long-term real interest rates. It goes without saying that, quite apart from its role as a
reference point, the natural rate of interest (like the natural rate of unemployment or the
potential level of output) is not observed and very hard to estimate with a reasonably
restrained quantitative approximation.
In any case, these considerations provide additional proof that inflation expectations, in
contributing to determining real interest rates, are a crucial ingredient for the identification
of the most appropriate stance for monetary policy. In general, credibility in its pursuit
of price stability and, in turn, the anchoring of longer-term inflation expectations, is one
of the most precious assets of any central bank. When expectations are firmly anchored
to the central bank's target, monetary policy can protect price stability from supply and
demand shocks, and address their effects in labour, goods and financial markets over
time in a swift and efficient manner, with lower costs in terms of economic activity. On the
contrary, when inflation expectations become de-anchored, a stronger monetary policy
reaction to any shock is required, with possibly elevated costs for the real economy.
Indeed, the need to enhance credibility and guarantee a solid anchoring of inflation
expectations underlies one of the most important developments in central banking over
the last few decades, namely the increasingly widespread adoption of the monetary
policy framework known as (flexible) inflation targeting. The existence of a clear and
credible anchor for inflation expectations has proved to be a fundamental ingredient to
keep actual inflation closer to the price stability objective.7
Measuring inflation expectations
Despite their key role for monetary policy, measuring, and sometimes interpreting, inflation
expectations is not simple. First, the large variety of data that has become available over
the years has confirmed that there is no one, single measure of inflation expectations,
since different economic agents - households, firms, professional forecasters, market
operators - all have heterogeneous perceptions about the future dynamics of prices.
A second challenge is connected with understanding how inflation expectations affect
economic decisions and what their formation mechanism is, including which variables
provide insights into their evolution.
The availability of direct data on inflation expectations has recorded substantial progress
in the last three decades, building on the seminal surveys and research produced after
World War II and until the 1980s. Notwithstanding the initial poor designs, the qualitative
(or "tendency") rather than quantitative nature of many of the responses, the prevalence
of short time horizons and the lack of information other than the average of individual
expectations, many important insights have been obtained over the years. These ranged
from initial attempts to derive the best possible measures for modelling their formation
to tests for their unbiasedness, efficiency and rationality.
Among the best known were (and still are), for the United States, since 1946 the quantitative
Livingston Survey of professional economists and since 1948 the qualitative survey of
households conducted by the University of Michigan (which became semi-quantitative
in 1966 and fully quantitative in 1977). In Europe, the oldest surveys were the monthly
review of the tendency of entrepreneurs' expectations undertaken since 1950 by the
IFOInstitute of Munich, and the twice-yearly semi-quantitative survey of Italian businessmen
conducted by the economic magazine Mondo Economico. In 1961, a monthly survey of
consumer expectations was instituted in the UK by the Gallup Poll, and in 1971 monthly
surveys of manufacturing enterprises of member countries started being co-ordinated
and published by the Commission of European Communities.8
For the euro area, information on inflation expectations can be inferred from the
surveys currently conducted among professional forecasters (the ECB Survey of
Monetary Analysts, the ECB Survey of Professional Forecasters, Consensus Economics,
Euro Zone Barometer, among the others), households (the ECB Consumer Expectations
Survey, European Commission) and firms (European Commission). While the surveys of
professional forecasters and, more recently also the ECB Consumer Expectations Survey,
provide quantitative expectations for horizons up to many years ahead, those for firms
are mostly qualitative in nature, refer to relatively short horizons and to producer rather
than consumer prices. An exception in this respect are the surveys conducted by the Bank
of France and the Bank of Italy, which are at the forefront in the quantitative assessment
of firms' expectations.9 In what follows I will draw on results gathered by some of these
surveys.
An important step forwards for the analysis of inflation expectations has been made, more
recently, with the availability of data from financial markets. In January 1997, in particular,
the United States began issuing Treasury Inflation-Protected Securities (TIPS).10 This is
now the largest component of the global inflation-index bond market, which includes
securities whose prices are explicitly linked to nationally-recognised inflation measures.
The inflation-linked swap (ILS) rates, which are quoted for horizons that span from the
very short term (one month) to the very long term (30 years), are a further source of
market-based expectations. An ILS is an agreement between two parties to swap, at a
pre-established future date, a floating rate linked to an inflation index (future realised
inflation) to a fixed rate coupon in the same currency. The fixed-rate coupon, which is
set at the beginning of the contract, reflects genuine inflation expectations plus a
timevarying unobservable inflation risk premia.
Between survey- and market-based sources, the advantage of the former is that they report
the genuine expectations of participants directly, while the latter, as just mentioned, are
always influenced by risk premia, which complicate their interpretation. While inflation
risk premia can be estimated on the basis of theoretical models, the uncertainty that
surrounds these estimates is usually non-negligible. In addition, surveys often include
participants' views on the economic outlook and financial market developments, which
can be used to deepen the understanding on the drivers of inflation expectations. The
main drawbacks of the surveys, instead, are related to their low frequency and the large
lags with respect to market data, which instead provide information continuously and
in real time. Another potential limitation is the relatively small size of the sample of
participants and of the number of forecast horizons considered. The "quality" of the
answers is also difficult to assess. Some studies, in fact, claim that market-based sources
could be more reliable as investors "have more skin in the game".11
Since the early 1970s, especially since what is known as the "rational expectations
revolution", many studies have attempted to provide causal evidence on the extent to
which expectations, specifically towards inflation, affect agents' economic decisions.
In the past few decades, in particular, improvements in the availability of data have
prompted a proliferation of empirical studies on this issue, spurred on, too, by the fact that
monetary authorities have paid greater attention and devoted more time and energy to
future-oriented communication policies. Understanding the effects of inflation
expectations is not an easy task, as there are not many sources of exogenous changes
allowing us to derive causal implications.
Inflation expectations seem indeed to have proved to be a relevant factor in shaping
economic decisions, such as households' consumption of durable and non-durable
goods as well as firms' pricing strategies, capital accumulation expenditure and labour
demand.12 This has allowed us to obtain some insights into how inflation expectations
filter into economic decisions. However, much more still needs to be understood, as
unexplained heterogeneity in the responses to changes in inflation expectations remains
significant: in some cases, for example, higher expected inflation leads agents to increase
their spending, in other cases it leads them to contract it.13 These opposite results might
reflect the perception of the difference in the drivers causing the rise in expected inflation,
for example due to a positive demand change as opposed to a negative supply shift.
Moreover, the specific economic environment in which agents operate, be it a high- or a
low-inflation regime, could shape the effects of inflation expectations differently.
This naturally calls for a deeper understanding of the formation mechanism of inflation
expectations. In many models, the dominant approach relies on the full-information
rational expectations paradigm that became popular in the 1970s and 1980s, replacing,
to an extent, schemes that relied on (and at times tested) extrapolative, adaptive and
regressive mechanisms of the formation of expectations. Empirically, however, this
paradigm has had limited support throughout the years. According to some econometric
evidence, individuals used information efficiently before the first oil shock of the 1970s
and inefficiently thereafter, possibly as a consequence of the large shock that hit inflation
and led to some confusion between permanent and transitory effects.14 Even more recent
survey-based evidence appears increasingly at odds with the full-information rational
expectation assumption.15
Several established empirical facts about survey-based inflation expectations for
both households and firms are difficult to reconcile with the full-information rational
expectations paradigm: the presence of systematic biases in expectations; the predictability
of ex-post forecast errors; the large amount of cross-sectional disagreement over future
inflation. Furthermore, it has been shown that agents form inflation expectations based
on several different factors, including some that in principle should not matter in the case
of full rationality, such as their previous buying experience, their exposure to low or high
inflation environments and various socio-economic characteristics.16
All these considerations led to a departure from the full-information rational expectations
paradigm only a few years after its ideation. A stream of studies has, in particular,
maintained the assumption of rational expectations but proposed deviations from the
full-information assumption due to data gathering and elaboration rigidities that naturally
create heterogeneity in beliefs. Examples are the sticky information approach, in which
agents update their knowledge infrequently because acquiring information is costly, and
the rational inattention approach, which instead assumes that agents actively decide not
to pay attention to all the news available to them. In this vein, at the end of the 1970s,
Cukierman and Wachtel developed a macro-economic framework in which expectations
are formed rationally, but at the same time people in different markets have different views
about the future rate of inflation because they are exposed to different information.17
Other authors have, instead, put aside the rationality assumption and incorporated the
insights gained from the behavioural economics literature resorting to forms of adaptive
learning. According to these scholars, agents experience cognitive limitations and thus
rely on ad-hoc forecasting models to form expectations that are updated in every period
using observed data, or embedding sources of systematic biases, such as optimism and
pessimism or overreaction and underreaction to news.18
In light of the high uncertainty around the most appropriate approach for the analysis
of inflation expectations, central banks currently base their assessments and their
decisions on a large set of different macroeconomic models, which include forward- and
backward-looking components. This constellation specifically allows us to take into
account inflation expectation mechanisms based on extrapolation as well as to consider
the risks implicit in models that lead to a mechanical return to "normality" or to forms of
mean reversion.
The recent evolution of inflation expectations in the euro area
With all these caveats in mind, let us analyse the recent dynamics of inflation expectations,
building on the aforementioned array of data available for the euro area. Short-term
inflation expectations derived from financial market prices - the most updated data
source - fell sharply from the peak observed in the second part of 2022 (fig. 2). However,
their dynamics remain very volatile. The increase observed between February and the
beginning of March due to renewed fears on the persistence of inflation, has indeed
been recently followed by a drop caused by the recent elevated tensions in financial
markets. ILS currently indicate that inflation is expected to stand at 3.5 per cent in early
2024 and then quickly fall to levels very close to 2 per cent.
According to the same data source and on the basis of our estimates of inflation risk
premia (which tend to be larger at longer horizons), annual price changes should stand
at 2 per cent also in the long term (fig. 3).19 This evidence is substantially in line with
what experts are saying. The results of the ECB Survey of Monetary Analysts conducted
in early March suggest that inflation in the euro area will be at 5.6 per cent in 2023, 2.5
in 2024 and 2.0 in 2025 as well as in the long run. The anchoring of long-term inflation
expectations is also confirmed by the results of the Survey of Professional Forecasters
conducted in early January, which signals that they have decreased slightly to 2.1 per
cent.
Indications of a decline in inflation expectations, in particular at longer horizons, also
emerge from the ECB Consumers Expectations Survey (ECB-CES). However, the median
household still foresees inflation at relatively high levels: slightly less than 5 per cent in the
next 12 months and, despite the sharp decline from the previous round, at 2.5 per cent
between two and three years ahead (fig. 4). These values stand somewhat above those
of market participants and economic experts, possibly reflecting a greater relevance of
backward-looking elements in the expectation formation mechanism of households.
A more granular analysis provides support to this conjecture, as it shows that the upward
revision of inflation expectations (over all horizons) has been more intense on average
for the less affluent households whose consumption basket includes a relatively higher
share of the most volatile inflation components, namely energy and food items.20 In other
words, the observed higher expectations from household surveys may, in large part,
mirror what is happening in the energy and food sectors, and may therefore be subject
to reversal as soon as pressures on the price of these items decrease. The most recent
results of the ECB-CES point in this direction.
As far as firms are concerned, the evidence is scanter and more mixed. According to
the qualitative results of the survey conducted by the European Commission, firms'
intentions to increase their own selling prices over the following three months fell in
January to their minimum since around early 2021 (fig. 5). Even the firms that participated
in the 2022Q4 round of the Survey on Inflation and Growth Expectations conducted by
the Bank of Italy reported, on the whole, forecasts of a deceleration in their sales prices,
but maintained relatively high inflation expectations for a prolonged period of time. Our
evidence suggests that they were particularly affected by the information, provided to
the survey participants, about the latest data published on actual inflation, which was
still very high and turned to be a major extrapolative factor at that time. However, the
fact that for both firms and households the "expectations curve" is downward sloping
is somewhat reassuring evidence against the risk of de-anchoring, as medium- to
long-term inflation expectations remain well below current inflation levels.
Close attention must indeed be paid not only to current levels of (short-term) price
(and wage) expectations, but also to their prospective dynamics. An assessment of the
risk of a de-anchoring of expectations from the inflation target based merely on their
current level could, in fact, be misleading. Since a de-anchoring could occur abruptly and
non-linearly, expectations must be assessed both in terms of their convergence towards
the price stability objective as well as their responsiveness to shocks and their dispersion.
From this perspective, evidence is mixed.
On the one hand, expectations from market data and survey responses over the last
two years have shown a relatively low sensitivity to inflation surprises in general. Indeed,
the increase in long-term inflation expectations observed after the conclusion of the
ECB strategy review in July 2021 seems more to reflect a re-anchoring to the 2 per cent
inflation target than an upward de-anchoring.21 On the other hand, in many surveys
the distributions of expected inflation have shown an increasing skewness towards
high consumer price changes and a rise in uncertainty, suggesting a greater, albeit still
currently moderate, risk of an upward shift in the entire distribution (fig. 6).22 Similar
evidence emerges from the analysis of inflation options, which currently suggest that, in
the next 5 years, the probability of inflation remaining on average (slightly) above target
tends to be higher than the opposite. Although these features of expected inflation could
merely be a consequence of the repeated upward surprises in actual inflation related
to the unforeseen persistence of the energy shock over the last two years, they should
nevertheless be monitored carefully.
Inflation expectations and the ECB monetary policy
As I have recently observed,23 evidence suggests that long-term inflation expectations
in the euro area are substantially anchored (reflecting the overall credibility of monetary
policy) and short- to medium-term expectations, while still remaining very volatile, are
clearly on a downward trend. Similarly, the risk of wage-price spirals seems so far to be
contained, although the requests for elevated wage increases in some euro-area countries,
where the labour market is tighter, should be continuously and carefully assessed. In this
context, the pricing strategies of companies will also play a central role. In particular, we will
need to closely monitor whether, after the pass-through of the much higher energy costs
observed in 2022, firms will allow final prices to reflect the most recent and substantial
cost reductions, which would imply a less intense tightening of financial conditions. This
will be a critical step in achieving a lasting reduction in underlying inflation.
A quantification of the structural drivers of inflation expectations in the euro area, as
measured by ILS and obtained by breaking down their daily fluctuations into domestic
and global shocks, confirms that the role of supply factors remains very important, but
also suggests that the contribution of demand factors is gaining weight (fig. 7). This
analysis focuses on the effects of changes in policy, demand and supply with respect
to historical regularities. The results show that, since the start of the war in Ukraine, the
inflation rate predicted over a five-year horizon has increased mostly in response to
supply shocks; the much smaller contribution of demand shocks rose progressively over
the course of 2022, reflecting improved business cycle conditions. Over the last year, very
strong spillover effects of US monetary policy on euro area inflation expectations were
registered. However, since the second half of 2022, we have received confirmation that
the ECB's monetary policy tightening is having, over time (and, I would add, with lags
that, as expected, are relatively long and perhaps also variable...), the desired effects. The
recent drop in energy prices, in particular that of natural gas, as well as the loosening of
the bottlenecks, are therefore likely to reduce inflation expectations and, consequently,
also facilitate the return of actual inflation to 2 per cent.
The monetary tightening is already having a clearly visible impact on credit and money
dynamics too. On the one hand, the 3-month (annualised) growth of loans to firms in
the euro area became negative in January (-1.3 per cent; fig. 8), from a peak of almost
13 per cent last August, while loans to households also continued to decelerate. On the
other hand, M3 is slowing down markedly (3.5 per cent in January on an annual basis,
from 6.3 last September) and M1 growth became negative in January (-0.7 per cent, a
historical minimum). When assessed in real terms, the dynamics of both aggregates are
in deeply negative territory and at historical minima. If protracted, the fall in money, and
the related freezing of funds in more illiquid forms of savings, could limit consumption
and investment, helping to dampen short-to-medium term inflation expectations.
This would further reinforce the reasons for a cautious conduct of monetary policy.
Indeed, while the Brainard principle states that when the central bank is uncertain about
the effects of its actions, it should move conservatively,24 an exception to this principle
is the case of uncertainty around the persistence of inflation. When persistence is high,
in fact, a strong monetary reaction may be required to avoid high inflation becoming
entrenched in agents' mind-sets.25 While this possibility should be carefully monitored,
data on market- and survey-based inflation expectations - including their recent decline
at short horizons and their decreasing profile, the marked deceleration of headline prices
on a 3-month annualised basis observed since last October and the weakness of credit
and money dynamics, may call into question the persistence of inflation at high levels in
the euro area and suggest a more gradual monetary normalisation. In this respect, it will
be crucial to observe a gradual fading away of the effects of the past shocks, also in the
measures of underlying inflation.
In this context, and with the aim of ensuring a timely return of inflation to the 2 per
cent symmetric medium-term target, a week ago, the Governing Council of the ECB
further raised its three key policy rates by 50 bps, bringing the overall increase since last
July to 350 points and the deposit facility rate (the flagship rate in a regime of excess
liquidity) to 3 per cent. Since the beginning of March, we have also been reducing the
assets held in the monetary policy portfolio at a measured and predictable pace, through
the partial reinvestment of the principal payments from maturing securities. This was
intended to ensure that the contribution of this monetary instrument is also aligned with
the monetary policy stance implied by the key interest rates.
Looking forward, the Governing Council has reinforced the importance of a
datadependent approach to the subsequent policy rate decisions, taking into account the
elevated level of uncertainty brought about by recent financial market tensions. The
Council's reaction function and its future decisions will be guided by the evolution of the
inflation outlook, in light of the incoming economic and financial data, the dynamics of
underlying inflation, and the strength of monetary policy transmission.
With risks to medium-term price stability increasing sharply in 2022, the pace and
scale of the adjustment of the official interest rates has been unprecedented. As the
hiking cycle is progressing further, the ECB Governing Council will need to find the
right balance between two risks: the risk of stopping too early before the "job is done",
which could cause inflation to remain persistently elevated and entrenched in price and
wage setting processes, and that of overtightening monetary conditions, which would
result in significant repercussions for economic activity, financial stability and, ultimately,
medium-term price developments.
Given the high volatility observed in financial markets over the last few weeks, including
the shocks generated by the dismal bank developments in the United States and in
Switzerland, and considering the substantial amount of tightening in the pipeline, a
cautious approach should guide future monetary policy decisions, also from a financial
stability perspective. This does not mean that monetary policy will be subject to financial
dominance; quite on the contrary. It simply reflects the fact that price and financial
stability are two strictly intertwined goals, as also the recent drop in market-based
inflation expectations clearly signals. This also explains why effective regulation and
diligent supervision are needed, as are backstops for crises.
Monetary policy, however, should not be, nor should it be perceived as being, the only
game in town. Indeed, as we have seen, inflation expectations do not only reflect the
actions of the central banks: the return to price stability and the anchoring of inflation
expectations will, in particular, greatly benefit from fiscal policies and negotiations
between workers and firms operating in the same direction as monetary policy. What
I stated at the beginning of this lecture must therefore be fully understood: the energy
shock is like a tax on the