clarity on our monetary policy reaction function and then being guided by that reaction function in our decisions. we should respond to incoming information on the medium - term inflation outlook and the balance of risks surrounding it. and we should keep our policy tight until we see inflation firmly converging back to 2 % over our policy horizon, taking into account the lags with which our monetary policy operates. when we were normalising rates the pace of adjustment was key. but with rates now moving into restrictive territory, it is the extent and duration of monetary policy restriction that matters. by smoothing our policy rate hikes – that is, moving in small steps – we can ensure that we calibrate both elements more precisely in the light of the incoming information and our reaction function. this framework will allow us to return to our target without undue delay. and it will allow us to do so at minimal cost to the economy and employment, reducing the risk that we tighten too much. the uncertain economic environment the current uncertain economic environment makes forecasting inflation particularly challenging. the medium - term inflation outlook was revised substantially upwards in our staff projections last december. headline inflation was projected to stand at 3. 4 % in 2024, before falling to 2 % in the third quarter of 2025 ( chart 1 ). and core inflation was expected to remain above target throughout our horizon, declining to 2. 4 % on average by 2025. the risks to this outlook were primarily on the upside. chart 1 euro area hicp headline inflation and inflation projections ( annual percentage changes and percentage point contributions ) source : eurosystem staff macroeconomic projections for the euro area, december 2022. notes : the dashed yellow line denotes projections. the latest observations are for the fourth quarter of 2022. but key assumptions underpinning economic projections can change quickly. in fact, recent surveys and the latest european commission forecast see headline inflation significantly below our december projections for 2024. [ 5 ] and risks have become more balanced. let me now review the key factors making projections difficult in the current environment. energy prices energy inflation has slowed more than projected in december. as a result, headline inflation is also falling : in january it was well below what we expected in december, driven by the energy component ( chart 2 ). if the drop in energy prices is sustained, headline inflation may fall below 3 % towards the end of the year. chart 2 inflation in the euro area ( annual percentage changes and percentage point contributions ) sources : eurostat

generating significant carry - over effects for 2025. and this delayed the moment at which inflation was projected to return to our 2 % target, with important implications for our monetary policy decisions. moreover, according to the projections, most of these measures would not be limited to vulnerable population groups, potentially creating an expansionary impulse for demand. as i argued recently [ 11 ], this risked creating a highly inefficient interaction between monetary and fiscal policies. fiscal measures that were introduced to protect consumers ’ purchasing power might paradoxically trigger a contractionary monetary policy reaction that would hit the real economy, reducing household incomes and increasing the interest bill for governments. this would be like giving with one hand and taking away with the other. this assessment of the inflationary effects of the fiscal measures is however surrounded by high uncertainty. discretionary fiscal spending is hard to predict accurately, and the measures could be adjusted to avoid inefficient interactions with monetary policy. indeed, some governments have announced that they may reduce spending on energy price brakes or move to more targeted income - based measures. moreover, falling energy prices are likely to imply that energy support measures will be less extensive than foreseen in the december projections. this is also contributing to the rebalancing of risks to inflation. wage developments another factor that drove up our projections was wage growth. as workers sought compensation for high inflation, we expected wages to accelerate. this robust wage dynamic boosted the baseline projection and the risks surrounding it, as accelerating wages coupled with a tight labour market could raise the spectre of a wage - price spiral. wages are still a source of upside risk. in the seven countries covered by the ecb ’ s wage tracker, recently concluded agreements signal that wage pressures are rising ( chart 6 ), albeit remaining consistent with the december projections. chart 6 wage developments ( annual percentage changes ) sources : left panel : eurostat, ecb, national sources. the difference between the ecb wage tracker and negotiated wage growth series in 2022 is mostly due to different series of negotiated wage growth for france, with the ecb euro area tracker using wage growth in sectoral negotiations in france. data on indeed wage trackers can be found here. right panel : calculations based on micro data on wage agreements provided by bundesbank, banco de espana, the dutch employer association awvn, oesterreichische nationalbank, bank of greece, banca d ’ italia and banque de france. data for fr are based