Mind the step: calibrating monetary policy in a volatile environment

Keynote speech by Fabio Panetta, Member of the Executive Board of the ECB, at the ECB Money Market Conference

Frankfurt am Main, 3 November 2022

The euro area is facing a sequence of unprecedented supply shocks resulting from the pandemic and Russia’s aggression against Ukraine. These shocks have compounded each other and caused the current spike in inflation. Price pressures have broadened as firms have sought to pass higher costs on to consumers as the economy reopened.

As a result, the ECB has accelerated the adjustment of monetary policy to keep inflation expectations anchored at levels consistent with its target. Across the last three Governing Council meetings, we have increased our interest rates by 200 basis points. This is the fastest rate hike in the ECB’s history.

Looking ahead, the medium-term inflation outlook presents clear upside risks in a general context of extraordinary uncertainty about the future evolution of the European economy.

Today I will argue that, at present, the direction of monetary policy is clear. A further policy adjustment is warranted in order to keep inflation expectations anchored and stave off second-round effects. However, the calibration of our stance should not rely on a one-sided view of risks − especially as we continue normalising our monetary policy in a highly uncertain economic environment. And it should remain focused on medium-term inflationary developments.

We need to bring inflation back to our 2% target as soon as possible, but not sooner.

We might otherwise create unintended effects, achieving little reduction of inflation in the short term, but causing excessive market volatility and a protracted economic slowdown beyond what is necessary to stabilise inflation in the medium term.

Implementing the correct calibration of monetary policy will be challenging. We will need to carefully consider the resilience of our economy, the implications of global monetary spillovers, and emerging threats to financial stability.

Trade-offs in setting the appropriate monetary policy stance

In the current situation, the direction of our monetary policy is clear.

Inflation in the euro area is too high and will remain above our target for an extended period. Headline inflation reached 10.7% in October. Core inflation is around 5%.^[1]

Monetary policy normalisation is necessary when repeated supply shocks drive inflation higher for longer.^[2] It signals that the central bank will not tolerate a de-anchoring of inflation expectations, reducing the likelihood of such a de-anchoring occurring. And it guards against the risk that monetary policy could exacerbate inflationary pressures by stimulating demand.^[3]

But while the direction of the adjustment is clear, its calibration is not and its end point depends on the evolving medium-term economic and inflation outlook.

The neutral interest rate provides limited guidance here. It is an asymptotic concept that describes the point when interest rates are neither accommodative nor contractionary in a situation where growth is around potential, inflation is not far from target and no transitory shocks are disrupting the inflation path. But that is not the world in which we find ourselves.

Moreover, the neutral rate is unobservable. As I have argued elsewhere,^[4] estimates of the neutral rate are imprecise and widely dispersed. They are subject to considerable uncertainty in a post-pandemic world that has undergone structural change.^[5]

Today, I find it more helpful to discuss the target-consistent terminal rate.

This is the level of the policy rate that − if reached at the end of a short normalisation phase and then held constant − stabilises inflation at target by the end of the policy-relevant horizon in the absence of new shocks. I prefer the concept of the target-consistent rate to that of the neutral rate because it emphasises that we can gear our policy to a clear state-contingent reference in order to bring inflation back to target within a clearly defined period.

Eurosystem staff regularly calculate estimates of the target-consistent terminal rate, which are an input into the preparation of our monetary policy meetings.^[6] But let me stress that these estimates are conditional on the economic and inflation outlook. They need to be continually reassessed in the light of incoming information.

Specifically, we need to navigate a complex set of risks to medium-term inflation.

On the upside, we could face the emergence of what I have called “ugly” inflation.^[7] This arises when above-target inflation de-anchors expectations, causing excessive wage and price-setting dynamics that eventually fuel further inflation increases (the second-round effects).

At present, this risk is mostly driven by high energy prices and their pass-through to prices of other items. Annual energy inflation is running at around 42%. Energy has been the main contributor to headline inflation for the past 18 months (Chart 1). Higher energy input costs have contributed to extraordinarily high food inflation. They have been a key driver of goods and services inflation (Chart 2). And by dragging down the trade balance and weighing on the economic outlook, they are contributing to the depreciation of the euro, further reinforcing inflationary pressures (Chart 3).

Chart 1

Contributions of components of euro area headline HICP inflation

(annual percentage changes and percentage points contributions)

Chart 2

Contributions of energy-sensitive components to goods and services inflation in the euro area

(annual percentage changes and percentage point contributions)

Chart 3

Drivers of the euro-US dollar exchange rate

(cumulative changes since January 2022, percentage changes and percentage point contributions)

So far, inflation expectations have remained anchored and the risk of an incipient wage-price spiral in the euro area has been contained. Nominal negotiated wage growth has ticked up recently but is still far from compensating for the drop in real incomes caused by higher inflation.^[8] And the outlook for wage growth and unit labour costs remains consistent with our target overall.^[9] But we need to remain extremely vigilant in view of prolonged high inflation, which increases the likelihood of a pass-through to wage growth^[10], especially as labour markets are now tighter than before the pandemic.

But other forces may increasingly push in the opposite direction and contain the risk of second-round effects, as what I have dubbed “bad” inflation – the inflation resulting from supply shocks – compresses real incomes.

The reduction in real wages and purchasing power is weakening domestic demand, with several leading indicators already pointing to a likely contraction in economic activity, starting from the last quarter of this year. The euro area PMI composite output index fell in October to its lowest level since November 2020,^[11] with forward-looking indicators of activity particularly weak.^[12] Consumer confidence plummeted to historical lows.^[13] And financial and credit indicators also point to significant downside risks to GDP growth (Chart 4).^[14]

Chart 4

Downside risks to euro area real GDP growth

Lower tail of the distribution of real GDP growth forecasts for Q1 and Q3 2023 based on “GDP-at-risk” models

(quarter-on-quarter change in percentage points)

These forces pushing on the downside might be reduced if supply bottlenecks continue to ease (Chart 5) and energy commodity and electricity prices continue to fall from their highs (Chart 6).^[15] But this would then also improve the inflation outlook and reduce the likelihood of “ugly” inflation taking hold.

Chart 5

Easing of supply chain bottlenecks

PMI suppliers’ delivery times (left panel) and Global Supply Shortages Index (right panel)

(diffusion indices)

Chart 6

Spot prices of oil, gas, coal and electricity

(EUR/MWh for gas and electricity (left-hand scale), USD/barrel for oil (right-hand scale))

To sum up, the implementation of monetary policy presents us with a difficult trade-off. On the one hand, our need to ensure that inflation expectations remain anchored speaks for targeting the upper part of the range of estimates of the target-consistent terminal rate. And this range would move higher if upside risks to medium-term inflation materialised.

But, on the other hand, in setting the monetary policy response we need to keep basing our decisions on the latest evidence and factor in downside risks to the economic outlook.

Policy normalisation, transmission lags and global spillovers

In recent months, the public debate has stressed the risks of doing too little to curb inflation, since this would require a more painful future adjustment. But this should not make us underappreciate the risk of doing too much.

First, we should bear in mind that it takes time before the full impact of our measures is felt in the economy.^[16] Moreover, monetary policy is transmitted to different variables with different lags.

It immediately affects market expectations and financial market conditions through bond yields, equity prices and exchange rates. Since we started normalising monetary policy at the end of 2021, the one-year forward real rates have moved significantly higher across the entire term structure (Chart 7) and the one-year forward real rate one year ahead is now in positive territory. Likewise, nominal and real ten-year rates have increased by around 300 and 250 basis points respectively (Chart 8).

Chart 7

Change in euro area forward real interest rates

(percentage points)

Chart 8

Ten-year real, nominal and inflation-linked swap rates for the euro area

(percentages per annum)

Crucially, however, it takes longer for our decisions to be transmitted to the real economy through changes in lending conditions and, subsequently, demand and prices. The debate should thus not be distorted by an excessive focus on short-run inflationary developments, which cannot be controlled by monetary policy. The full impact of our measures will likely reach the economy when activity and inflation are already on a declining path.^[17] This implies that our tightening will need to end when inflation is still above our target.

Second, we need to factor in global monetary policy spillovers when defining the domestic stance.

With central banks across advanced economies adjusting their policies simultaneously (Chart 9), they could accentuate each other’s policy impacts if they do not sufficiently factor in the feedback loop they create.^[18] ECB analysis finds that a tightening by the Federal Reserve System generates spillovers to euro area real activity and inflation that are comparable to its effects on the US economy.^[19]

Chart 9

Financial conditions indices in advanced economies and emerging market economies

(standardised indices)

It is sometimes argued that domestic inflation having a large global component should mean that domestic monetary policy needs to be tightened more forcefully to compensate for this weakened grip on prices. But if central banks across advanced economies are simultaneously tightening monetary policy – as is the case today – the opposite is true.^[20]

If central banks do not fully factor in the effects of other central banks’ policies, the current phase of global adjustment may give way to a more severe slowdown than anticipated. In recent decades, episodes of highly synchronised global monetary policy tightening have been associated with subsequent global recessions (Chart 10).

Chart 10

Inflation surges, tightening synchronisation and global recessions

(percentages of countries)

Such a scenario could have particularly negative implications for the euro area. Our economy is not only more vulnerable than others to the energy crisis, it is also more open than economies such as the United States, China and Japan, and thus more exposed to a global recession. And because it is less flexible than the US economy, reversing course may be more difficult if demand and production weaken too much.^[21]

Avoiding unintended effects in a volatile market environment

Incorrectly calibrating our monetary policy could also have unintended effects for financial stability and the transmission of our monetary policy.

The highly uncertain outlook has increased the sensitivity of market rates to new developments and shifts in risk sentiment. In turn, higher rates are exacerbating risk aversion, exposing the vulnerabilities of certain highly leveraged segments – such as residential property markets^[22] – and some types of non-bank financial intermediaries^[23]. These segments are vulnerable to adverse loops, with falling prices and rising rates feeding into higher debt refinancing costs, especially as falling real incomes make those costs less affordable.

This market volatility is being compounded by global financial spillovers (Chart 11). These come mainly from the United States^[24], but were also visible in the reaction of euro-denominated yields to the recent episode of market repricing in the United Kingdom.

Chart 11

Global component in yields

Correlation of sovereign bond yields in advanced economies, expectations components and term premia

(correlation coefficient)

In the euro area, an additional source of volatility is the risk of financial fragmentation along national lines, which can impair the homogenous transmission of monetary policy throughout the euro area.

The current environment therefore requires us to be prudent in adjusting our monetary policy across all instruments. There are three key considerations here.

First, our decisions and communication on the pace of normalisation should avoid amplifying market volatility.

There is a case for frontloading our policy adjustment given the need to keep expectations anchored, especially in view of the very accommodative stance from which normalisation started. But such frontloading should remain commensurate to the benefits and risks it creates.

When it comes to managing inflation expectations, ECB staff analysis finds that the benefits of surprising markets with bigger-than-expected rate increases is limited in the euro area.^[25] And if these bigger-than-expected increases are interpreted as signalling a higher terminal rate, rather than simply frontloading the normalisation, we could have a stronger impact on financing conditions – and ultimately on economic activity – than intended.

Additionally, a bigger-than-expected rate increase may heighten volatility and have a stronger impact in the current highly leveraged environment after a decade of very low rates and ample liquidity. So when calibrating our stance, we need to pay close attention to ensuring that we do not amplify the risk of a protracted recession or trigger market dislocation.^[26]

Second, we must be clear about the sequencing of the normalisation process. We should avoid “cliff effects”, continually monitor the market response to our measures and consider the feedback between our different instruments.

Currently, our policy rate remains a suitable marginal instrument of normalisation. It is the instrument we know best. We have a comparatively limited understanding of the effects of reducing the size of our balance sheet.^[27]

The size of our balance sheet will be significantly reduced as targeted longer-term refinancing operations (TLTROs) mature and banks likely make early repayments after the decision we took last week to adapt the TLTROs’ terms and conditions to the current monetary policy context.

We should take the necessary time to assess the impact of our rate hikes and of phasing out the TLTROs. As we normalise our monetary policy, we should expect bank lending conditions to tighten. What we need to avoid, though, is a sudden stop in the supply of credit to the broad economy.

We should ensure that TLTRO repayments have been absorbed before we stop fully reinvesting the principal payments from maturing securities purchased under our purchase programmes. And when considering how we would then reduce the size of our bond portfolios, a controlled reduction – whereby only redemptions above a cap are not rolled over – is preferable to active sales, which may unsettle markets in an already volatile financial environment.^[28]

Third, we must ensure the smooth transmission of our stance as we normalise monetary policy.

Maintaining ample liquidity in the system will help ensure smooth money market functioning. This will allow us to continue tightly steering money markets through changes in our deposit facility rate.

But preserving smooth transmission also means being ready to intervene in a timely manner to counter unwarranted market dysfunctions, should they arise.

Our reinvestment flexibility under the pandemic emergency purchase programme – alongside the availability of the Transmission Protection Instrument, if required – protects the transmission of our monetary policy to all parts of the euro area, allowing us to set the appropriate stance. Recent months have shown that a credible ex ante commitment helps to establish a good market equilibrium, where higher yields do not drive spreads to higher levels that are disconnected from fundamentals.

We also need to stand ready to address collateral issues. Collateral scarcity has recently impaired the pass-through of our policy rates to repo rates.^[29] The change in TLTRO III conditions should help alleviate tensions in the repo market^[30], but we will continue to monitor the situation closely.

The importance of a consistent policy mix

As recently seen in other economies, an inconsistent policy mix can prove destabilising. So a successful normalisation process requires other policies to be consistent with monetary policy. For instance, well-designed energy and fiscal policies can make a key contribution to dampening short-term inflationary pressures, thereby helping to keep inflation expectations anchored^[31] and reducing the amount of monetary tightening necessary.

To take a concrete example, the measures that have been taken to find alternatives to Russian gas, reduce gas demand and refill gas storage are likely playing an important role in bringing down gas prices. Likewise, joint initiatives at European level, common purchases and the redistribution of surplus energy sector profits can mitigate the impact of supply disruptions on energy prices. At the same time, energy policies should preserve price incentives and support energy efficiency.

Fiscal policies should aim to cushion the impact on the most exposed and fragile households and firms, while not hindering the necessary trend reduction of energy demand and adding to inflationary pressures. At the same time, they should protect economic potential and ensure that the energy shock does not permanently reduce productive capacity. Just as excessively high energy demand would risk keeping inflation high for longer, so would a slump in economic potential.

In response to the pandemic, Europeans acted together with consistent policies to protect productive capacity during the downturn.^[32] To tackle the energy shock effectively, we can take inspiration from some of the EU pandemic-era instruments – such as SURE – to protect jobs and businesses that may be forced to temporarily reduce their activity. Common interventions at European level would preserve a level playing field, avoiding competitive distortions that would otherwise be detrimental to economic efficiency and the integrity of the Single Market.

Beyond targeted support in the short term, however, fiscal policy will need to focus on investment to reduce the European economy’s exposure to supply shocks, strengthen its strategic autonomy and support potential growth. Here we could take inspiration from the Next Generation EU (NGEU) instrument and move beyond reshuffling existing funds in the financing of Repower EU, matching additional investment and reform needs with adequate resources.^[33]

But we should also ensure that we are implementing, in full, the agreed investments and reforms that are tied to NGEU. This will contribute to economic resilience and debt sustainability, which are crucial in view of the prevailing interest rates and growth outlook.

Conclusion

Let me conclude.

We find ourselves in an exceptionally volatile environment, with multiple and complex risks for the inflation outlook and the appropriate monetary policy response.

We are normalising our monetary policy to keep inflation expectations anchored and bring inflation back to 2% over the medium term.

But we cannot ignore the sizeable challenges that we are facing.

So we must calibrate our monetary policy carefully to ensure that inflation durably returns to our target, while also guiding market expectations and limiting excess volatility.

Our policy stance must remain evidence-based and adapt to changes in the medium-term inflation outlook, avoiding an excessive focus on short-run developments and fully taking into account the risks emanating from the domestic and global economic and financial environment.

This approach will allow us to successfully navigate the risks we face while avoiding the danger of tripping over unintended effects.

Let’s therefore mind the step in adjusting our monetary policy, so we can proceed steadily through the current shocks and bring the economy back to price stability and solid growth.