whereas the labour market is expected to remain resilient. however, the relative contributions of supply and demand conditions are likely to change over time. in particular, the release of pent - up demand largely explains the recent contribution of demand to inflation. this is different from a cyclical upswing that “ feeds on itself ” [ 12 ], or a sustained increase in consumption as seen in the united states as a result of a highly expansionary fiscal policy and rapidly rising wages ( chart 4, panel a ). that is why, in the euro area, the demand - driven contribution to core inflation has emerged more slowly over time ( chart 4, panel b ). but forward - looking indicators point to a significant weakening in demand, which suggests that its contribution is likely to fade out ( chart 5 ). chart 4 evolution of private consumption and demand - driven contributions to core inflation in the euro area and the united states ( percentage points contributions ) sources : panel a ) : eurostat, fred and ecb staff calculations. panel b ) : frsf / adam shapiro, eurostat and ecb staff calculations. notes : panel a ) : the latest observation is for the third quarter of 2022, except for euro area household and non - profit institutions serving households ( npish ) final consumption expenditure for which the latest observation is for the second quarter of 2022. panel b ) : seasonally adjusted series ; based on an application of shapiro, a. h. ( 2022 ), “ how much do supply and demand drive inflation? ”, frbsf economic letter, no 2022 - 15, federal reserve bank of san francisco, 21 june ; and shapiro, a. h. ( 2022 ), “ decomposing supply and demand driven inflation ”, working papers, no 2022 - 18, federal reserve bank of san francisco, october. for euro area results see goncalves, e. and koester, g. ( 2022 ) : “ the role of demand and supply in underlying inflation – decomposing hicpx inflation into components ”, economic bulletin, issue 7, ecb. the latest observations are for august 2022 for the euro area and september 2022 for the united states. chart 5 euro area household expectations and purchasing managers ’ index sources : panel a ) : dg - ecfin and ecb staff calculations. panel b ) : s & p global. notes : panel a ) : expectations for the next 12 months, standardised

the risks of overtightening. if we were to compress demand in an excessive and persistent manner, we would face the risk of also pushing output permanently below trend, irrespective of whether the initial shocks were temporary or not ( that is, even if a harsh policy reaction was unnecessary ). and that could not be easily reversed by subsequent policy easing, not least because expansions do not rebuild supply nearly as much as contractions destroy it. second, even if we were to conclude that supply shocks will lower potential durably, we would still need to examine their effects on demand before deciding our policy stance. for instance, workers may accept some loss in real income as demand softens, costs can no longer be passed on easily to consumers and risks to job security increase. in some euro area countries, wage negotiations focus on core inflation rather than headline inflation. this can be seen as a recognition that the terms of trade loss has to be borne – at least to some extent – rather than retrieved. also, in this setting, households may choose to reduce consumption – instead of smoothing it and mitigating the hit to spending – because a permanently lower potential output would also permanently reduce their future income and wealth. recent research using endogenous growth models shows that, if supply shocks cause “ scarring ”, the prospect of lower potential output reduces investment and productivity growth. by compressing households ’ future income and their current spending, it can cause demand to drop by as much as – or even more than – supply. all told, these effects imply that, even in the face of lasting consequences of supply shocks on potential output, the implications for the output gap, inflation dynamics and optimal policy calibration can only be derived over time. and this reinforces the case that, for as long as inflation expectations remain anchored, monetary policy should adjust but not overreact. ecb staff projections published in september 2022, which foresee inflation close to 2 % at the end of their horizon, are consistent with a withdrawal of monetary policy accommodation. but the uncertainty surrounding supply and demand dynamics requires us to remain prudent as regards how far the adjustment needs to go. and we should not ignore the fact that the tightening, which has followed from our decisions since the end of 2021 and from expectations of further adjustments in our stance, is already working its way through the economy – with the usual transmission lags. estimates suggest that this tightening will on average subtract more than one