.09.2022Monetarypolicyintheeuroarea:wheredowestandandwherearewegoing?vosCEDEBilbaonndezdeCosor1YourMajesty,authorities,ladiesandgentlemen,LetmestartbythankingtheorganisersfortheopportunitytoaddressyouatthisXXICEDECongress.Today,IwillelaborateonhowwecanbringpricestabilitybacktoEuropeancitizensinthecontextofcurrentturmoilasitistheresponsibilityoftheECB’sGoverningCounciltobringinflationdownto2%inthemediumterm,theinflationtargetthatoperationalisesourpricestabilitymandate.1Andwehavetodothisinnonetooeasytimes.AfterapandemicthathascostmorethanaofaggressioninUkraineEuropeanhouseholdsareexperiencingadrasticsurgeintheircostsofliving.Consumerpricesintheeuroarearoseby9.1%inAugustcomparedtothepreviousyear,anall-timehighforthemonetaryunionTheincreaseinpriceshasbeenespeciallyacuteintheenergyandfoodcomponentsoftheconsumptionbasket.Butithasbecomemoregeneralovertime,asreflectedinanunderlyinginflationrateof4.3%inAugust,anotherrecordhigh,reflectingtoalargeextentindirecteffectsofhigherenergyandfoodcommoditypricesthroughfirms’productioncosts.Asrecentresearchshows,thissurgeininflationhasaffectedsomeofthemostvulnerablegroupsinoursociety,likelow-incomeindividuals.2So,wheredowestandintermsofinflationdevelopmentsintheeuroarea?ndevelopmentsandoutlooknflationstartedrisinginearlyafterabriefspellinnegativeterritoryattheonsetofthepandemic.Energypriceshavebeenthemaindriverbehindthissharprise,duetolargeincreasesingasandoilprices.Otherimportantcontributorshavebeenanincreaseinfoodcommodityprices,andbottlenecksinglobalsupplychainscausedbydemand-supplyimbalancesaseconomiesaroundtheworldrelaxedtheirpandemic-relatedcontainmentmeasures.TheoutbreakofthewarinUkraine,theeconomicsanctionsonRussia,andtheretaliationintermsofgassupplyreductions,haveaggravatedthesedevelopments.UkraineandRussiaarealsomajorcerealexporters.3Roughlytwothirdsofthecurrentinflationareduetoenergyandfood.Lookingforward,ECBstaffprojectionspublishedthismonthexpecteuroareainflationtodeclinefromanaverageof8.1%in2022to5.5%in2023and2.3%in2024,owinglargelytodownwardbaseeffectsintheenergycomponent,predominantlyarisingfromthefuelscomponent.Fromthebeginningof2023electricitypricesand,inparticular,gaspricesareexpectedtocontributetothemoderationininflation.1IamgratefultoIrmaAlonso,PabloAguilar,SamuelHurtado,PeterPaz,andPedrodelRíofortheircontributionstotheanalyticalmaterialinthisspeech.2SeeChapter3ofthe2021AnnualReportofBankofSpain,2022,andCardoso,M.,C.Ferreira,J.Leiva,G.Nu?o,A.Ortiz,T.Rodrigo,andS.Vazquez,“TheHeterogeneousImpactofInflationonHouseholds'BalanceSheets",BancodeEspa?aWorkingPaper,forthcoming,2022.3FurtherinformationcanbefoundinBorrallo,F.,L.Cuadro-SáezandJ.J.Pérez,“Risingfoodcommoditypricesandtheirpass-throughtoeuroareaconsumerprices”,BancodeEspa?a,AnalyticalArticles,2022.2Inthecurrentcontext,however,thiscentralscenarioissurroundedbysignificantuncertainty.LetmedescribewhereIseethemainsourcesofuncertainty,inparticularinrelationtofutureinflationdynamics.First,thepotentialemergenceofsecond-roundeffects.Second-roundeffectsoccurwhenanincreaseininflationistransmittedtowageincreasesandthelatter,inturn,aretransmittedtoprices–asfirmsattempttopreserveorevenincreasetheirprofitmargins–,potentiallyleadingtoaprice-wagespiral.ThishasnotbeenthecasesofarintheeuroareaandaccordingtothelatestECBprojections,significantprice-wagespiralsarenotexpectedovertheforecasthorizon.4Growthinunitlabourcostsisexpectedtosignificantlycontributetodomesticinflationin2023,butlesssoin2024owingtoboththemoderationinwagegrowthandthepick-upinproductivitygrowth.Nevertheless,highandpersistentinflationerialisingviahigherwagesandprofitmarginsSecond,thereistheriskofinflationbecomingentrenchedduetoade-anchoringofinflationexpectations.Ifinflationexpectationsbecomede-anchored,thatwoulddramaticallyincreasethepersistenceoftheinflationaryepisode,potentiallycausingittobecomeself-sustained,andwouldrequiremoreradicalactionsbythecentralbanktoquenchit.Sofar,thereisnoclearevidenceofde-anchoringofinflationexpectations,althoughsomeindicatorsofmedium-terminflationexpectationsstandslightlyabove2percent,whichneedscloselymonitoring.MostsurveysofmonetaryanalystsandprofessionalforecastersionatorslightlyaboveThisisalsosupportedbyinflationlinkedswapratesadjustedforthepresenceofriskpremia.Bycontrast,consumerexpectationsurveysofferamoreworrisomepicture,asthemedianof3-yearaheadinflationexpectationshasrisento3%.Asinthecaseoftheriskofsecond-roundeffects,weshouldremainextremelyvigilantaboutthesedevelopments.Third,thereisalotofuncertaintyregardingfuturegeopoliticaleventsandtheirimpactonishigherandmorepersistent.Ontheotherhand,inthissamescenario,ifdemandweretoweakenfurtheroverthemediumtermduetolowerrealincomes,itwouldlowerpressuresonprices.Indeed,theECBpublishedinSeptemberanalternative“downsidescenario”.Inthisscenario,energyandfoodcommoditypricesareassumedtoincreasesubstantiallyduetoseveresupplydisruptionsassociatedwithanintensificationofthewarinUkraine,combinedwithothernegativeshockstotheEuropeaneconomy.5Theresultwouldbeaninflationrateof6.9%in2023and2.7%in2024.Letmeemphasise,however,thatdespitealltherecentdevelopmentsregardinggassupplythroughtheNordstreampipeline,onecannotassumethatwearealreadyinthedownsidescenario.Thisisbecausetheothershocksassumedinthisdownsidescenariohavenotmaterialisedyet.Indeed,severalkeycommodityprices–includingenergyprices-arecurrentlybelowtheECBbaselinescenario(andmoresoincomparisontothedownsidescenario),whichmayreflectlowerthanexpecteddemand.4Foradiscussionofsecondroundeffectsintheeuroarea,seeBattistini,N.,H.Grapow,E.HahnandM.Soudan“Wagesharedynamicsandsecond-roundeffectsoninflationafterenergypricesurgesinthe1970sandtoday”,ECBEconomicBulletin,Issue5/20225SeeBox3oftheSeptemberECBstaffmacroeconomicprojectionsfortheeuroarea,3Finally,anadditionalelementofuncertaintyisrelatedtothesynchronisedtighteningofmonetarypolicyacrosscountriesanditsimpactonactivity–includingglobalspill-overs–andinflation.6etarypolicystrategyAsIsaidbefore,itistheECB’sresponsibilitytopreservepricestabilityintheeuroarea.Giventhenatureoftherecentriseininflation,thefirstquestionweshouldaskourselvesishowourmonetarypolicyshouldrespondtoit.InJuly2021,theECBadoptedanewmonetarypolicystrategy,thecornerstoneofwhichisasymmetricinflationtargetof2%inthemediumterm.TheaimoftheECBisthereforenottostabilisecurrent,observedinflation,buttostabiliseinflationoverthemediumrun.Thismedium-termorientationrespondstotwoconsiderations.First,monetarypolicyaffectsinflationwithvariablelags.Thetransmissionmechanismofmonetarypolicyoperatesfirstbyaffectingbanks’,firms’andhouseholds’financingconditions.This,inturn,affectscredit,investment,andconsumptiondecisions.Theresultingchangesinaggregatedemandexertpressureonfirms’productionneeds,thusloweringtheirdemandforlabourandotherinputs,andhenceonproductioncosts,andwillendupaffectingprices.Thisprocesshowevertakestime.Empiricalstudiestypicallyshowthatmonetarypolicydecisionshavetheirmaximumeffectoninflationafterone-and–a-halftotwoyears.Therefore,attemptingtostabiliseobservedinflationatalltimesisafutile,andprobablycounterproductivetask,asitincreasesthevolatilityofmacroeconomicaggregates.Second,theoptimalresponseofmonetarypolicydependsonthenatureoftheshocksthatcauseinflationtorise.Forinstance,anenergyshockistypicallyconsideredasasupplyor“cost-push”shock,asitincreasesproductioncostsforfirms.Inthiscase,thecentralbankfacesatrade-offbetweeninflationontheonehand,andeconomicactivityandunemploymentontheother:ifitreactstoostronglytotheincreaseinpricesresultingfromthecost-pushshock,theoutputandemploymentlossescausedbythesupplydisturbancewillbefurtheramplified,andunemploymentwillsuffer.If,ontheotherhand,itrespondstoofeebly,inordertominimiseeconomicandemploymentlosses,inflationmayincreasetoomuch.Theoptimalpolicyinthiscaseisto“l(fā)eanagainstthewind”,tighteningpolicyenoughtoallowforacertaintransitoryincreaseininflationabovetargetaswellasareductioninoutputbelowitspotentiallevelandanincreaseinunemployment.7Thepreviousprescriptionisbasedhoweverontheassumptionthatfirms’andworkers’long-runinflationexpectationsremainanchoredatalltimestothecentralbank’starget,astheyfullytrustthecentralbank’scommitmenttoeventuallybringinflationbacktotarget.Inthisrespect,recentresearchshowsthat,whenagentslonger-runinflationexpectationsareendogenoustotheinflationenvironmenttheyexperience,theninacontextofhighand6SeeM.ObstfeldandH.Zhou,“TheGlobalDollarCycle.Brookingspapersoneconomicactivity,BPEAConferenceraftsonetaryPolicyInflationandtheBusinessCyclePrincetonUniversityPressModelsincludingmorerealisticcharacterisationsofoilorgasmarketsofferconceptuallysimilarresponses,asinforinstance,Nakov,A.,andA.Pescatori“MonetaryPolicyTrade-OffswithaDominantOilProducer”,JournalofMoney,CreditandBanking,42:1-32,2010.4persistentinflationsuchexpectationscanbecomehighlysensitivetodeviationsofrealisedinflationfromtheirownforecast.8Thus,anadequatemonetarypolicyconductshouldtakeintoaccounttheriskofde-anchoringbymovingtheinterestratemoreaggressivelythanintheabsenceofsucharisk.9Theoptimalmonetarypolicytheninvolvesastrongresponsetomovementsinagents’long-runinflationexpectation.Thisstrongresponseensuresthatwheneverthepublicissurprisedbyinflationinthewakeofrecentevents,andexpectationsstarttode-anchor,thecentralbankdoesnotallowthemtodriftabovethemedium-termanchorpersistently.Insum,themedium-termorientationofourinflationtargetrecognisesboththeimperfectcontrolofinflationbymonetarypolicyintheshortrun,owingtothevariabletransmissionlagstotheeconomyandinflation,andthefactthatcertainkindsofshocksmaycreateatemporarytrade-offbetweeninflationandeconomicactivity,asinthecaseofcost-pushshocks.Themedium-termorientationprovidesthepolicyflexibilitytoassesstheoriginofshocksandlookthroughtemporaryshocksthatmaydissipateoftheirownaccord.Byfollowingthismedium-termorientation,theECBavoidsunnecessaryvolatilityinactivityandemployment.Importantly,themedium-termorientationdoesnotimplythatcentralbanksshouldignoreshort-runinflationdevelopments.Instead,itimpliesthatthelatestinflationdatamatterinsofarastheycontaininformationregardingmedium-terminflationarypressures.Byitsverynature,themedium-termorientationrequiresprojectingthefuturepathofinflation.Surveysandfinancialmarketinstrumentsprovideuswithausefultoolinthisrespect,astheygiveusevidenceofhowdifferentagents(experts,households,firms,andfinancialmarketparticipants)seeinflationevolvinggoingforward.Inaddition,centralbanksrelyontheirstaff’sforecastsforinflationandeconomicactivity–whichtypicallydrawonahugeamountofeconomicandmonetaryanalyses–asakeyinputintheirdecision-makingprocess.Summingup,ourtaskisnottorespondtothelatestinflationdatapoint,afutileand–especiallyinthefaceofadversesupplyshocks–counterproductivetask,buttostabiliseruninflationexpectationsremainanchoredtothetarget.ReturninginflationtooverthemediumrunInthecontextofasteadyincreaseinmedium-terminflationexpectations,aseconomiesrecoveredfromtheworstphaseofthepandemiccrisis,attheendof2021westartedattheECBGoverningCouncilaprocessofprogressivenormalisationofourmonetarypolicy.ThefirststepwastowithdrawtheextraordinarypolicystimulusthatwehadlaunchedattheonsetofthepandemicTothisendinMarchwestoppedthenetassetpurchasesunderthePEPP.InourJunemeetingweconcludedthattheconditionsinourforwardguidanceforraisinginterestrateshadbeenfulfiled;wethereforecommunicatedourintentiontoraiseratesinJulyandagaininSeptember,and–consistentlywithourchainedforwardguidance8See,forinstance,Carvalho,C.,S.Eusepi,E.MoenchandB.Preston,“AnchoredInflationExpectations”,AmericanEconomicJournal:Macroeconomics(forthcoming).9SeeGáti,L.,“MonetaryPolicyandAnchoredExpectations:AnEndogenousGainLearningModel”ECBWorkingPaperNo2022/2685,2022.5betweenratehikesandassetpurchases-weannouncedthatnetpurchasesundertheAPPwouldendatthestartofJuly.Inthatmonthweraisedourratesby50basispoints,alargerincreasethanwehadsignalledinJune,basedonourupdatedassessmentofinflationrisksandthereinforcedsupportprovidedbythenewTransmissionProtectionInstrument(TPI)fortheeffectivetransmissionofmonetarypolicyacrosstheeuroarea.Earlierthismonthwehikedratesbyanunprecedented75basispoints,motivatedbyinflationlevelsthatwerefartoohighandlikelytostayaboveourtargetforanextendedperiod.10Thismajorstepfrontloadsthetransitionfromtheprevailinghighlyaccommodativelevelofpolicyratestowardslevelsthatwillsupportatimelyreturnofinflationtoourtwopercentmedium-termtarget.Asyoucansee,wedecidedtostartthenormalisationofourpolicybyraisingourinterestrates,insteadofbyreducingthesizeofourbalancesheet–theso-called“quantitativengthesizeofourbalancesheetIseethreeimportantreasons.First,weunderstandbetterthetransmissionmechanismofinterestraterisesthanthatofquantitativetightening.Wehavedecadesofexperiencewiththeformerbutwehaveneverreducedthesizeofourbalancesheetfromsuchlargelevels.Second,quantitativetighteningcouldpotentiallycausemarketturmoilincertainmarketsegments,assupplymayoutgrowdemandandliquiditymaydryup.Thiscouldimperilthepolicynormalisationpathatatimeinwhichalloureffortsshouldbefocusedonit.Third,monetarypolicytransmissionintheeuroareaisheavilydependentonbankcredit.Loanpricingistypicallybenchmarkedtoshort-andmedium-termrates.Policyratesarethusamoreeffectiveinstrumenttotightenmonetarypolicy.Goingforward,akeyquestionis:byhowmuchshouldourkeyinterestrateseventuallyaseThatiswhatisthevalueofinterestratesthatguaranteesthatinflationconvergesto2%bytheendofourmedium-termhorizon?Iwillcallthislevelthe“target-compatibleterminalrateAsecondrelatedquestionishowfastshouldthisterminalratebereached?erminalghtawayThiswouldhardlybeadvisable,however,giventhehugeuncertaintythatcharacterisesthecurrenteconomicenvironmentandalsotheuncertaintythatsurroundstheimpactofourpolicyactionsontheeconomyinthiscontext.Thesourcesofthisuncertaintyaremultiple.Wefaceuncertaintyregardingthenatureofcurrentshocks,thatis,towhatextenttheyreflectsupplyordemandfactors,whichasexplainedbeforedetermineshowswiftthepolicyreactionshouldbe.Wearealsouncertainabouttheirpersistence,whichisacriticaldeterminantoftheinflationoutlook.Wefaceuncertaintyabouthowouractionseventuallyaffectinflationalongthemonetarypolicytransmissionchannel:wedonotknowforcertainhowsensitiveoverallfinancingconditions(includingbanklendingconditions)aretoourpolicydecisions,howsensitiveaggregatedemandistofinancingconditions,andhowresponsiveinflationistoeconomicactivity–thatis,theslopeoftheso-called“Phillipscurve”.Forallthesereasons,itisverydifficulttoascertainhowmuchtighter,relativetoa“neutral”path,ourpolicyshouldbeinthenextfewquartersinordertoreturnmedium-terminflationbackto2%.epthexplanationoftherationalebehindourbprateincreaseinSeptemberseeHernndezdeCoseofothereconomicpoliciesspeechatJolyAndalucíaForum.BancodeEspa?a.6Theeconomicliteratureisalongwayfromprovidingaclearcutanswerastohowmonetarypolicyshouldreactinahighlyuncertainenvironment.Aclassicreferenceisthe“Brainardprinciple”,whichstatesthatpolicyshouldexhibitprudenceinthefaceofuncertaintyabouttheimpactoninflationofunderlyingshocksorofanypolicymis-calibration.11Itistypicallysummarisedas“inadarkroomyoumovewithsmallsteps”.Indeed,thehighertheuncertainty,thegreaterthelikelihoodthatamoreaggressivemonetarypolicyresponsetoshocksmaypushinflationawayfromthetarget.12However,thisviewhasbeenqualifiedbysubsequentresearch.Forinstance,whenthereisuncertaintyaboutthepersistenceofinflation–asisclearlythecaseinthecurrentcontext–,itmaybeoptimalforthecentralbanktorespondtorisinginflationmoreaggressivelyinordertoreduceuncertaintyaboutthefutureinflationdevelopments.13Thereasonisthatwhenthedynamicsofinflationareuncertain,theamountofuncertaintyfacingthecentralbankisgreaterthefurtherawaytheinflationrateisfromitstarget.Consequently,toreducetheamountofuncertaintyaboutthefuturepathofinflation,optimalpolicybecomesmoreaggressive,pushinginflationclosertotarget.entlinesofreasoninghelpexplainwhymostcentralbanksincludingushavefollowedatighteningpaththatcombinessomegradualism(inthesenseofreachingtheterminalrate–whicheverthatturnsouttobe–throughasequenceofinterestratehikes,asopposedtodoingsoinoneortwogoes)withacertainfront-loadingoftheadjustmentpathtowardstheterminalrate(asexemplifiedbyour75pbhikeearlierthismonth)inanefforttopreservetheanchoringofinflationexpectations.Atourlatestmeetingwealsoannouncedthatfurtherratehikeswillfollow.Howmuchwillourratesincreaseeventually?LetmecomebacktothefirstofthetwoquestionsIraisedbefore:whereisthetarget-compatibleterminalrate?Wheredowego:thetarget-compatibleterminalrateLetmebeclearaboutit:nooneknowswheretheterminalratelies.ThisisnotonlyaconsequenceoftheuncertaintyImentionedbefore:italsodependsonfutureevents,suchastheeventualcourseofthewarinUkraineandtheassociatedgeopoliticaldevelopments.This,however,doesnotmeanthatwearecompletelycluelessaboutwhatterminalrateseemsmorelikelyfromtoday’spointofview.Indeed,giventhecurrentstateoftheeconomy,wecanemployourmacroeconomicmodelstoobtainarangeofthemostlikelyrminalrateThesevaluesareconditionalontheinformationavailabletodaysotheymustbeandwillberevisedasnewinformationarrives.Butatleasttheyprovideaconditionalassessmentofhowmuchweexpectourratestoincreaseinordertobringdownmedium-terminflationtoour2%target.11SeeBrainard,W.C.“UncertaintyandtheEffectivenessofMonetaryPolicy”,AmericanEconomicReview57(2),pp.7.12Itwilldependonthedegreeofpersistenceoftheshocksthathittheeconomy,asshownbyFerrero,G.,M.Pietrunti,andA.Tiseno.“Benefitsofgradualismorcostsofinaction?Monetarypolicyintimesofuncertainty”,Bancad’ItaliaTemidiDiscussioneWorkingPaperNo1205,2019.13SeeS?derstr?m,U."MonetaryPolicywithUncertainParameters,"TheScandinavianJournalofEconomics,vol.pages5,2002.7BancodeEspa?astaffhaveconductedsuchanexerciseusingasuiteofmacroeconomicmodels.TheexerciseassumesthatECBratesincreaselinearlyuntilMarch2023,andthenstaythereformostof2023and2024.14Thelevelofshort-terminterestratesinMarch2023consistentwitha2%projectedinflationratebyend-2024wouldbetheterminalrate.Theresultsshowthat,onthebasisofcurrentinformation,themedianterminalratevalueacrossmodelsisat2.25%-2.50%.Indeedthisisestimatedwithsignificantuncertainty,asillustratedbythewiderangeoftheestimatedterminalrateacrossmodels15.Letmeemphasise,inparticular,thatthesemodelscannotcapturetheriskofexpectationsbecomingunanchoredortheseverityofsecond-roundeffectsandhowtheyareaffectedbychangesintheterminalrate.Couldtheseestimatesbeconsideredtoamounttoacommitmentconcerningtheterminalrate?Ofcourse,not.Again,itisjustamodel-basedforecastbasedoncurrentinformation.Beingaforecast,thisrangeisentirelydata-dependentandmaychangeastimegoesby.anceregardinghowmuchweexpectourinterestratestoadjustinordertofulfilourpricestabilitymandate.Noticethatthistarget-compatibleterminalrateisnotnecessarilythesameasthenaturalorneutralrate.Thenaturalrateistherealinterestratethatiscompatiblewithinflationatitstarget.Whenrealratesareabovethenaturalrate,themonetarypolicystanceiscontractionary,andwhentheyarebelow,monetarypolicyisexpansionary.Theproblemisthatthenaturalratecannotbeobserved.Atbestwehavesomeestimatesaboutitslong-rangefromtoequivalenttolongrunnominalratesThisrangeisconsistentwiththelong-runexpectationsofmarketparticipants,whichiscurrentlyat1.5%.16Ourcurrentestimateofthetarget-compatibleterminalrateisthushigherthanthelong-runnaturalrate.Thisimpliesthatnominalrateswillovershootthelong-run(nominal)naturalrate,andhenceitisexpectedthatrateswilldecreaseagainovertimeIwouldliketoflagafinalconsideration.ThisrangefortheterminalratehasbeenobtainedassumingthattheEurosystemmaintainsthesizeofitsassetportfolioundertheAPPandPEPPconstantoverahorizonconsistentwithourcommunicationonthePEPP(forwhichreinvestmentsareforeseentoextenduntilend2024)andwithsurvey-basedexpectationsonAPP(forwhichthereinvestmenthorizonismoreopen-ended).However,inthecaseoftheAPPtheECBcouldpotentiallydecidetostartreducingitsassetstockearlierthanmarketscurrentlyanticipate.Givenourunderstandingofthewayassetpurchaseprogrammeswork,suchacourseofactionwouldhaveadownwardeffectontheterminalrate.17Thisisbecause,ifweannounceourintentiontoinitiatetheunwindingofourAPPportfolioearlierthanexpectedbyinvestors,bondyieldswillincrease,especiallythoseatWeconsiderbothfullystructuralDynamicStochasticGeneralEquilibriumDSGEmodelssemistructuralmodels,likedlargemacroeconometricmodelsestimatedtoreplicatetheeuroareaeconomyInthecaseoftheDSGEandthemacroeconometricmodel,wesetthemtoreproducetheSeptemberECBMPEprojectionsandthenconsidercounterfactualpathsforrates,whereasinthatoftheNiGEMweemployitsbuilt-inprojections.AgentsintheDSGEmodelhaverationalexpectations.NiGEMissolvedbothwithrationalandadaptiveexpectations.Adaptiveexpectationsbyalongperiodofbelow-