Chart 6 GDP response to demand and supply shocks (y-axis: percentage change in response to one-standard deviation demand and supply shocks, x-axis: months)  Sources: ECB staff calculations. Notes: The Bayesian SVAR includes monthly interpolated GDP, HICP, ten-year OIS rate, HICP energy and PMI suppliers’ delivery times. The SVAR is estimated using the Minnesota prior with the dummy coefficient prior. Shocks are identified using sign and narrative restriction methods. Technical details on the method can be found in De Santis, R. A. and Van der Veken, W. (2022), “Deflationary Financial Shocks and Inflationary Uncertainty Shocks: An  SVAR Investigation”, Working Paper Series, No 2727, ECB. This leads me to believe that supply factors will remain, overall, the dominant determinant of inflation going forward. The persistence of the shocks When inflation is driven mainly by supply shocks, monetary policy should respond when the shocks are persistent to keep inflation expectations anchored and avoid that inflation becomes entrenched. Understanding the reasons for the persistence of current shocks and whether they may permanently lower potential is also crucial for designing the adequate policy response. There are two alternative explanations for the persistence of the supply shocks we have experienced. The first is that the economy has been hit by a sequence of temporary supply shocks, which have jointly created a persistent effect on inflation. In this case, potential output should remain broadly unchanged. And the lingering effect of the supply shocks on economic activity through real incomes and confidence could result in a negative output gap.

The economy is experiencing large, negative supply shocks pushing output and inflation in opposite directions. The correlation between estimated output gaps and inflation has become more blurred and uncertain than in the past. And the trade-offs facing monetary policy have become more complicated. In other words, monetary policy has become significantly more complex. In designing the appropriate monetary policy response, central banks need to make two key judgements: one on the origin of the shocks hitting the economy and another on their persistence. I will argue today that euro area inflation has been driven by soaring energy prices and enduring supply constraints even as the economy reopened after the crisis phase of the pandemic, unleashing pent-up demand. But the boost to demand from the reopening is fading, and we have no evidence as yet that supply shocks are having large and permanent effects on output potential. And if supply shocks durably lowered potential, our policy response would have to consider that they also affect demand by depressing current and future real income. Against such a backdrop, monetary policy has to ward off the risk of a de-anchoring of inflation expectations, which could lead to second-round effects in the form of excessive wage and price-setting dynamics. That implies adjusting monetary conditions and frontloading rate hikes. But so long as expectations remain anchored, the calibration of our policy adjustment should take into account the unprecedented uncertainty of the post-pandemic world.