Introduction

It is a pleasure to be here today, at the sixth European Central Bank Simulation Conference. I would like to thank the “Get Involved” student group for organizing the conference, as well as all the participants for your interest.

I would especially like to thank and welcome Boris Vujčić, Governor of the Central Bank of Croatia, who is with us today, just a few days before an important milestone for Croatia: its entry into the euro area on 1 January 2023. This is an impressive achievement, as the country has made the transition from a centrally planned economy to a market economy, achieving a significant monetary reform and a remarkable degree of sustainable economic convergence.

For this achievement, the citizens of Croatia deserve congratulations, as well as you, Boris. Boris has been serving the Croatian Central Bank for 25 years, ten of which as Governor. For seven years, he was the Deputy Head of the accession negotiations for Croatia, a process that was successfully concluded in 2013 when the country became the 28th Member State of the European Union. Since then, he has contributed to shaping Croatia’s strategy for joining the euro area. In 2018, Boris received two important awards: he was named Central Banker of the Year for Central and Eastern Europe by Global Markets and Best Central Banker in Europe and the World by The Banker.

Boris, it is a great pleasure for me to welcome you to the Eurosystem. We are in the third decade of the euro, which is now a major global currency, after the US dollar, and is used by over 340 million Europeans. Let me, however, briefly reflect on its history.

During the first decade of our monetary union, economic conditions were favourable, allowing the euro area to achieve strong growth and relatively stable inflation, in line with the Eurosystem’s objective of price stability. Then, however, the global financial crisis and the ensuing sovereign debt crisis weighed on economies across the board. Monetary policy faced serious challenges, as the euro area entered a recession and inflation remained persistently low. The European Central Bank (ECB) responded by adopting a policy of negative interest rates and implementing unconventional monetary policy measures. These innovative tools supported the economic recovery and contributed to a significant reduction in inflation.[1] At the same time, reforms to the institutional and supervisory framework of the financial sector and to the EU’s economic governance have strengthened the architecture of our Economic and Monetary Union and its resilience.

Closer to today, the recent 20th anniversary of the euro almost coincided with the devastating outbreak of the pandemic crisis, during which the ECB implemented further monetary policy measures to prevent the possibility of economic stagnation. And as the euro area recovered from the pandemic, Russia’s invasion of Ukraine triggered a wave of high inflation, dampening economic growth.

In the following, I will refer, first, to recent trends and factors that contributed to the increase in inflation in the euro area, second, to the Eurosystem’s monetary policy response and, third, to some key policy considerations in the period ahead.

Ιnflation – causes and trends

Inflation in the euro area has been on an upward trend since late 2020. From a negative level of -0.3% in December 2020, it recorded a rapid increase and peaked at 10.6% in October 2022, before declining to 10% in November. Energy prices contributed mainly to this increase. At the same time, core inflation, as measured by the Harmonized Index of Consumer Prices excluding energy and unprocessed food, increased significantly from 0.4% in December 2020 to 6.6% in November 2022.

The strong rise in inflation is attributed to the surge in oil and gas prices, as well as significant supply chain disruptions caused by successive waves of the pandemic, which also contributed to an increase in the prices of other commodities, i.e. raw materials used as inputs for the production of other goods and services. The war in Ukraine had significant repercussions on international trade and energy, which exacerbated supply problems and caused further increases in gas, electricity and commodity prices. The rise in fuel prices has hit the euro area much harder than other major economies (such as the United States) that are less dependent on imported energy. Consumer goods prices have also risen, as high raw material costs have made their production more expensive.

In addition, the recovery in demand has strengthened since the lifting of lockdowns to contain the pandemic, and as a result, upward price pressures have broadened and strengthened.

Not surprisingly, the combination of these developments creates significant uncertainties in our forecast of the peak and duration of inflation. In the short term, inflation is expected to remain elevated. According to the latest ECB forecasts, inflation is expected to average above 8% this year, before declining in the coming years as the factors that fuel it subside. According to the Eurosystem forecasts, inflation will approach the desired levels towards the end of the monetary policy horizon.

This inflation path is also reflected in inflation expectations, which appear to be stable at just above 2%. Stable inflation expectations help to contain any second-round effects, so that high inflation does not become more permanent. If expectations become destabilised and feed into wage negotiations, a feedback loop between wages and prices could be triggered, leading in turn to progressively higher inflation, necessitating further tightening of monetary policy.

The monetary policy response to ensure price stability

Against this backdrop of rising prices and significant risks to the inflation outlook, the Governing Council of the ECB took steps to normalise monetary policy. In designing its response, a key question to be answered was what factors are contributing to the very high inflation observed today. Is the rise in inflation coming from the demand side or from the supply side? The required monetary policy response differs depending on the factor causing the inflationary shock.

In contrast to the US, inflation in the euro area is mainly coming from the supply side. In this case, any undue tightening of monetary policy could amplify the negative effects on output of supply shocks. The main challenge for monetary policy is therefore to reduce inflation while limiting as much as possible the impact on output.

Given these concerns, the appropriate monetary policy response is to proceed gradually but decisively, with discretion and flexibility. In this respect, the Eurosystem’s gradual normalisation approach has been successful, as it has been designed to stabilise inflation expectations and ensure smooth transmission to financial markets.

Exactly one year ago, the Governing Council initiated the shift in monetary policy from an accommodative stance to a gradually more restrictive one and has taken a series of decisions since then.

The first step in the process of monetary policy normalisation was the announcement of a gradual reduction in net securities purchases from the first quarter of 2022 onwards. Net purchases of securities under the Pandemic Emergency Purchase Programme (PEPP) ended at the end of March 2022. Net purchases of securities under the Asset Purchase Programme (APP) also ended in July. Securities reinvestments under the PEPP will last at least until the end of 2024. Securities reinvestments under the APP will continue to be implemented in full for as long as necessary to maintain the appropriate stance of monetary policy. In addition, the gradual withdrawal of temporary measures to expand eligible collateral has started and the terms of the third series of targeted longer-term refinancing operations (TLTRO-III) adopted during the pandemic have been adjusted.

The second important step in the process of monetary policy normalization was the increases in the ECB’s key interest rates. In a historic decision in July 2022, the ECB raised interest rates by 50 basis points, ending eight years of negative interest rates. Since then, interest rates have been raised twice more, for a cumulative increase of 150 basis points, in order to reduce inflation in a timely manner to levels consistent with the monetary policy objective of 2% inflation over the medium term, to ensure that inflation expectations remain anchored and to prevent any second-round effects.

Given the extreme uncertainty, the Governing Council decided in the summer to abandon the provision of guidance on the future direction of monetary policy, adopting an approach in which decisions on policy rates will be taken with a view to the next Governing Council meeting. In this light, the path of monetary policy rates will be shaped on the basis of the information currently available on the evolution of the inflation and economic outlook.

I would like to refer here to some very important decisions of the Governing Council that build on the lessons learned from the successive crises: the risks of fragmentation of the financial system may undermine the smooth transmission of the change in monetary policy towards a more restrictive direction to all euro area economies and therefore need to be addressed. Fragmentation refers to episodes of deterioration in financial conditions in some euro area economies that are not consistent with their economic fundamentals. In such cases, these countries face higher interest rates than the rest of the euro area economies, resulting in monetary policy not being transmitted evenly across the area.

Taking into account the above and in order to ensure the smooth transmission of the intended direction of monetary policy, the Governing Council announced last December that the reinvestments of securities under the PEPP program can be flexibly adjusted at any time in terms of time, asset classes and countries. This decision also has important implications for our country, as Greek government bonds can also be purchased through the PEPP, in addition to the value of the bonds reinvested at maturity, in order to ensure the smooth transmission of monetary policy to the Greek economy as it recovers from the pandemic. Given that Greek bonds do not meet the investment grade criterion and therefore do not participate in the APP, the Eurosystem’s main asset purchase programme, this decision was crucial because it demonstrated the ECB’s commitment to continue supporting the Greek economy and ensuring the smooth transmission of monetary policy to all euro area economies without exception.

In addition, the Transmission Protection Instrument (TPI) was introduced last July to support the effective transmission of monetary policy. The TPI allows the Eurosystem to acquire on secondary markets securities issued by countries experiencing deterioration in their financial conditions not attributable to their fundamentals. The TPI is a powerful tool that allows the Governing Council to better safeguard the monetary policy transmission mechanism and to more effectively fulfil its primary objective of price stability.

Concerns about the conduct of monetary policy in the coming period

I would like to raise some concerns about the conduct of monetary policy in the coming period.

Inflation in the euro area is very high. The Governing Council has demonstrated its commitment to restoring price stability by adopting a series of appropriate policy measures, including three successive bold increases in key interest rates, which entail a front-loaded shift in monetary policy from an extremely accommodative stance to a more restrictive one in order to achieve the objective of price stability in a timely manner.

When taking decisions on the process of normalizing monetary policy, several factors should be taken into account.

• First, the increased risk of the euro area slipping into recession.
• Second, the lags with which decisions already taken are transmitted to inflation and output, as it will take time for the effects of monetary policy normalisation measures to fully manifest themselves in the economy. This means that the impact of measures taken now may only be felt when inflationary pressures have already begun to subside.
• Third, the fact that inflation in the euro area is largely driven by supply-side shocks.
• Fourth, the fact that the current situation is characterised by a synchronised tightening of monetary policy internationally, potentially leading to synergies that reinforce the above-mentioned factors reducing inflation.

In this context, and as long as the available data do not suggest that increases in inflation have been built into inflationary expectations, and second-round effects remain contained, “monetary policy should be accommodative but not overreactive,” as Fabio Panetta,[2] a member of the ECB Executive Board, said.

However, overcoming the challenges posed by excessively high inflation requires the cooperation of other policy actors. Fiscal policy has a very important role to play in protecting the most vulnerable groups from high inflation, but it must act in a way that does not cause further increases in inflationary pressures. Fiscal policy measures, if targeted and temporary, can cushion the impact of rising energy costs without having a more permanent adverse impact on aggregate demand.

In addition, the worsening macroeconomic situation combined with uncertainty about inflation and interest rates poses risks to financial stability. The ECB should stand ready to intervene in the event of fragmentation of financial markets in the euro area, which would undermine the timely return of inflation to the desired level. Such phenomena could lead to a deterioration in financial conditions beyond the extent necessary to contain inflation. At the same time, a sharp tightening of monetary policy, which could lead to a sharp increase in government bond yields and a widening of spreads for vulnerable countries, could have serious implications for financial stability.

The above describes the complex situation facing the Governing Council. I would like to stress once again the importance of taking immediate action to control inflation. However, the pace of monetary policy tightening should be appropriately determined so as not to exacerbate the economic slowdown and not threaten financial stability.

This is a particularly difficult task that requires a careful approach. In the current context, monetary policy should inspire stability and confidence that inflation will return to its target in a timely manner. In this effort, it is important to proceed gradually and prudently. As former ECB President Mario Draghi aptly observed,[3] “in a dark room you move with very small steps. You are not running, but you are moving.”

With these words, I would like to close my speech and wish the conference a productive and constructive work.

Thank you.

[1] Without the monetary policy measures, GDP would have been at least 2.7 percentage points lower by the end of 2018, while the annual inflation rate would have been 1.3 percentage points lower. See Rostagno, M., Altavilla, C., Carboni, G., Lemke, W., Motto, R., Saint-Guilhem, A. and Yiangou, J., “A tale of two decades: The ECB’s monetary policy at 20”, ECB Occasional Paper 2346, December 2019.

[2] See the speech by Fabio Panetta, Member of the Executive Board of the ECB, at the CEPR-EABCN conference entitled “Finding the Gap: Output Gap Measurement in the Euro Area” held at the European University Institute on 14 November 2022.

The complexity of monetary policy (europa.eu)

[3] ECB, Press Conference, 7 March 2019. See

Monetary policy statements (europa.eu)

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