Monetary policy in an unusual cycle: the risks, the path and the costs

The ECB has come a long way in the fight against inflation, and while the work is not complete and we need to remain vigilant, this progress allows us to reflect on the path behind us. There are three specific features that have defined this policy cycle.

1.?????? The risks

In a typical policy cycle, inflation expectations are usually not at risk. But this low risk applies only when shocks are moderate and short-lived. In the most-recent episode, two features could have provided fertile ground for people to lose confidence in the monetary anchor.

·?????? The shocks were large enough to make many households switch their attention to inflation.

·?????? The inflationary impact of the shocks risked becoming endogenously persistent, owing mainly to the staggered wage bargaining process in the euro area.

So, monetary policy had to send a strong signal that permanent overshoots would not be tolerated. As a result, we put a strong emphasis on our determination to ensure a “timely” return to target.

2.?????? The path

It was clear from the outset that merely communicating our commitment to our target would not have been enough. When we first started raising rates, we knew that we were far away from where we needed to be. The most important factor was therefore to close the gap as quickly as possible.

But as policy rates moved towards restrictive territory, the challenge shifted to calibrating the path precisely. We needed to set a path that both delivered a “timely” return to 2% and did so with a high degree of confidence.

Faced with multiple large shocks, there was significant uncertainty about how to interpret and rank the information we were receiving from the economy. So we constructed a framework to hedge against the uncertainty. In this reaction function, our assessment of the inflation outlook is informed by but not limited to projections; underlying inflation is gauged by various measures; and when assessing the strength of monetary policy we consider banks, capital markets and the real economy.

This framework helped us to navigate the “tightening” and “holding” phases of our rate cycle and it gave us the confidence to deliver a first rate cut at our last policy meeting.

3.?????? The costs

Given the magnitude of the shock to inflation, a “soft landing” is still not guaranteed. If we look back at historical rate cycles since 1970s, we can see that when major central banks hiked while energy prices were high, the costs for the economy were usually quite steep.

But this cycle has so far not followed past patterns. Inflation peaked at a much higher point than in past soft landings, but also decelerated faster. Growth is within the range of previous soft landing episodes, if near the bottom. The labour market has been exceptionally benign.

The strong labour market means that we can take time to gather new information, but we also need to mindful that the growth outlook remains uncertain. All this underpins our determination to be data dependent and take our policy decisions meeting-by-meeting.

Conclusion

Our policy decisions have successfully kept inflation expectations anchored, and inflation is projected to return to 2% in the latter part of next year. Considering the size of the inflation shock, this unwinding is remarkable in many ways.

Even though millions of businesses and workers have been independently striving to protect their profits and incomes, our 2% inflation target has remained credible and has continued to anchor the inflation process.

This speaks to the value of the policy frameworks that central banks have built up over the last 30 years, focusing on price stability and central bank independence. And it is why we will not waver from our commitment to bring inflation back down to our target for the benefit of all Europeans.

This LinkedIn article is based on my speech at the ECB Forum on Central Banking in Sintra, Portugal on 1 July