## On Inflation’s Front Line

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**Canonical URL:** [On Inflation’s Front Line](https://www.imf.org/-/media/files/publications/fandd/article/2023/march/cafe-econ-inflation-front-line-lane.pdf)

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### Overview
- The European Central Bank (ECB) has raised interest rates to 15-year highs to bring euro area inflation, which peaked at more than 10 percent in October, back to the 2 percent target.
- Inflation is expected to slow this year, while economic growth slows, consumers struggle with the cost-of-living crisis, and governments seek to finance large debts in a new era of higher interest rates.
- Philip R. Lane (ECB chief economist) emphasizes the need for governments to start rolling back fiscal support to consumers as the energy crisis triggered by Russia’s invasion of Ukraine becomes less acute.

### Importance of anchoring inflation expectations
- A prolonged phase of high inflation could cause the public to lose confidence that price stability (a 2 percent inflation target) will be maintained over the medium term.
- If the public comes to believe inflation will remain high indefinitely, high inflation expectations would be baked into price and wage setting and become self-sustaining.
- Monetary policy must be clearly set to ensure inflation returns in a timely manner to the 2 percent target.
- The ECB has been moving away from a super-accommodative monetary stance (geared for several years to address persistent below-target inflation) toward a sufficiently restrictive stance to keep longer-term inflation expectations anchored.

### Lessons from the inflation shock and monetary policy response
- The twin forces of the pandemic and the war-related surge in energy prices constituted extraordinarily large and asymmetrical shocks that generated an initial phase of high inflation.
- It warrants ongoing examination whether the ECB and other central banks could have done a better job assessing the size and duration of this inflation shock; internal and external critiques are appropriate.
- Over the last year, central banks have reversed out of quantitative easing programs and cumulatively raised interest rates quite a bit over a relatively short period.
- The conduct and effectiveness of monetary policy will be further evaluated over the coming months.

### Shrinking the ECB’s balance sheet and implications for governments
- The ECB’s asset purchase programs were primarily focused on ensuring that the long end of the yield curve contributed to monetary easing to avoid prolonged below-target inflation; they were not programs to directly finance governments.
- Moving away from quantitative easing and embarking on quantitative tightening is still too early to draw conclusive lessons from.
- Recent normalization of interest rates has coincided with high demand from many institutional investors (both European and global) to purchase euro area government bonds.
- Fiscal policy should be oriented—consistent with the EU’s economic governance framework—toward making the economy more productive and gradually bringing down high public debt.

### Fiscal support, the energy shock, and timing of rollbacks
- There is an important role for fiscal policy to shield the most vulnerable from the energy price shock; this role has moral and economic imperatives.
- Fiscal support measures to shield the economy from high energy prices should be:
  - temporary,
  - targeted, and
  - tailored to preserving incentives to consume less energy.
- As the energy crisis becomes less acute and energy prices fall, it is important to start rolling these measures back promptly and in a concerted manner.

### Impact of rising interest rates on households and the role of fiscal policy
- All households benefit from medium-term price stability; the poor are the hardest hit by persistent inflation.
- The ECB’s primary focus is the timely return of inflation to the 2 percent target while minimizing costs in terms of output and employment.
- In analyzing transmission, the ECB examines:
  - direct effects of interest rate movements, which vary across borrowers and savers and across different age groups, and
  - indirect effects through the impact of monetary policy on output and employment, which vary between workers in sectors sensitive to interest rate movements (such as construction and consumer durables) and those in less cyclical industries.
- Governments should protect the most vulnerable in society, but fiscal measures that directly offset the impact of interest rate movements:
  - can be problematic for the efficiency of monetary policy, and
  - may be less effective than other income policies.

*Source: IMF Finance & Development interview with Philip R. Lane (ECB), March 2023.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2023/march/cafe-econ-inflation-front-line-lane.pdf_