On Inflation’s Front Line

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ECB policymakers have raised interest rates to 15-year highs to bring euro area inflation back to the 2 percent target.
Euro area inflation peaked at more than 10 percent in October.
Inflation is expected to slow in 2023, while economic growth slows and governments face financing in a higher-rate environment.
Philip R. Lane (ECB chief economist) emphasizes steering inflation expectations back to 2 percent, shrinking the central bank’s balance sheet, and lessons from recent monetary moves.

Central banks’ worst-case scenario: a prolonged phase of high inflation that causes the public to lose confidence that price stability (in practice, a 2 percent inflation target) will be maintained over the medium term.
If the public believes inflation will remain high indefinitely, high inflation becomes baked into price and wage setting and becomes self-sustaining.
Monetary policy has moved from a super-accommodative stance (geared for several years to address persistent below-target inflation) toward a stance sufficiently restrictive to ensure inflation returns to target and keeps longer-term inflation expectations anchored.

The pandemic and the war-related surge in energy prices constituted extraordinarily large and asymmetrical shocks that generated an initial phase of high inflation.
Ongoing examination is warranted to assess whether central banks could have better assessed the size and duration of the inflation shock.
Over the last year, central banks have reversed quantitative easing programs and cumulatively raised interest rates quite a bit over a relatively short period.
Continued learning is expected about the conduct and effectiveness of monetary policy in the coming months.

ECB’s asset-purchase programs were designed to ensure the long end of the yield curve contributed to monetary easing and were not programs to directly finance governments.
Moving away from quantitative easing and toward quantitative tightening is still too early to draw conclusive lessons from.
Recent normalization of interest rates has coincided with high demand from institutional investors (both European and global) to purchase euro area government bonds.
Fiscal policy advice:
- Fiscal policies should be oriented toward making the economy more productive and gradually bringing down high public debt, in line with the EU’s economic governance framework.
- Fiscal support to shield the most vulnerable from the energy price shock has an important moral and economic role but should be temporary, targeted, and tailored to preserve incentives to consume less energy.
- As the energy crisis becomes less acute, it is important to start rolling these measures back promptly in line with the fall in energy prices and in a concerted manner.

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.
- Indirect effects via output and employment, which vary between workers in interest-rate-sensitive sectors (such as construction and consumer durables) and those in less cyclical industries.
Governments should protect the most vulnerable, but fiscal measures that directly offset interest rate movements can be problematic for the efficiency of monetary policy and may be less effective than other income policies.

Interest rates raised to 15-year highs.
Inflation peaked at more than 10 percent in October.
ECB inflation target: 2 percent.
Inflation rose to highs not seen for 40 years.
Monetary policy had been geared for several years toward addressing persistent below-target inflation.
Central banks have reversed quantitative easing and are embarking on quantitative tightening.

Source: On Inflation’s Front Line (F&D Magazine, March 2023).

F&D March 2023: CAFÉ ECONOMICS: On Inflation’s Front Line
- F&D March 2023: CAFÉ ECONOMICS: On Inflation’s Front Line (Markdown version)
- F&D March 2023: CAFÉ ECONOMICS: On Inflation’s Front Line (PDF)