2/8  BIS - Central bankers' speeches  Meanwhile, the high levels of government debt following the pandemic, alongside the tightening of financial conditions, represent a vulnerability and limit the space to adopt fiscal expansion measures. This setting is also subject to an extremely high level of uncertainty, stemming, above all, from the course of the war in Ukraine and its economic repercussions, which are hard to predict. However, inflationary pressures also pose a genuine risk. Whether they increase further depends not only on the course of the war, but also on internal factors, such as a possible persistent rise in inflation expectations, or higher-thanexpected increases in wages or mark-ups. More persistent inflation would require a sharper tightening of monetary policy, which would render those public or private agents in a less sound economic and financial position more vulnerable. This could have a greater-than-expected impact on their spending levels. 1. The economic policy response Against this backdrop, I would like to share my opinion on how economic policy should respond. First, I would like to underscore that the current situation is far different from that triggered by the pandemic. We then faced a temporary but highly adverse shock, in a setting free of inflationary pressures. That environment warranted a forceful monetary policy response, in order to create conditions that were conducive to an equally extraordinary fiscal expansion which would guarantee the income of households and firms and thus minimise the crisis-induced structural damage to employment, productive capacity and growth.

Yet demandside factors, linked, above all, to the re-opening of the economy after the pandemic and the depreciation of the euro, have also played a role in the increase in inflation. Overall, it is estimated that close to 75% of the increase in euro area inflation in 2022 was caused by the direct and indirect effects of energy and food prices. However, the supply shocks and the depreciation of the euro have been passed through faster than in prior episodes, prompting inflationary pressures to spread. Thus, underlying inflation (i. e. excluding energy and food) reached an all-time high of 5.2% last December. These inflationary pressures have elicited a forceful response from the main central banks, which is causing global financial conditions to tighten significantly. The war has also fuelled uncertainty regarding the security of Europe's energy supply and even made a major escalation in global geopolitical tensions a more likely prospect. These four factors have brought about a considerable slowdown in activity globally and an across-the-board downward revision to the outlook for economic growth, despite the European economy proving more resilient than expected a few months ago, particularly the labour market, where the unemployment rate stands at record-low levels. Overall, the latest European Central Bank (ECB) projections forecast an additional slowdown in activity in the short term. However, assuming the energy market rebalances, uncertainty decreases and household real income improves – as inflation progressively decelerates –, activity is expected to gradually improve in the second half of the year.