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Monetary policy and the disinflation process

Speech by Philip R. Lane, Member of the Executive Board of the ECB, at the National Banking Conference of the Banking and Payments Federation of Ireland (BPFI)

Dublin, June 11, 2024

Let me begin by offering some comments on the economic outlook, before discussing our decision last week to cut the ECB’s official interest rates by 25 basis points.(1) The latest macroeconomic projections from the Eurosystem staff forecast economic growth of 0.9 percent in 2024, 1.4 percent in 2025 and 1.6 percent in 2026, while inflation is expected to average 2 .5 percent in 2024, 2.2 percent in 2025 and 1.9 percent in 2026. Relative to average annual inflation rates in 2022 and 2023 of 8.4 percent and 5.4 percent respectively, considerable disinflation has already occurred, with the latest inflation figure of 2.6 percent in May. For inflation excluding energy and food (often called core inflation), the staff projects an average of 2.8 percent in 2024, 2.2 percent in 2025, and 2.0 percent in 2026. With core inflation standing at 3.9 percent and 4.9 percent in 2022 and 2023 respectively, the outlook for 2024-2026 also indicates that considerable core disinflation is underway. The current task of monetary policy is to ensure that full disinflation is achieved, that inflation returns to our 2 percent target in a timely manner and settles at this level on a sustainable basis.

Instead of offering a complete analysis of all the factors that determine the dynamics of inflation, let me briefly analyze the dynamics of wages, which play a particularly important role in the final stages of the disinflation process.(2) Wage growth remains high, driven primarily by the ongoing adjustment to past increases in inflation. The growth rate of compensation per employee increased from 4.9 percent in the fourth quarter of 2023 to 5.0 percent in the first quarter, largely reflecting an increase in negotiated wage growth of 4.5 percent to 4.7 percent. This stronger growth in the first quarter includes very large extraordinary payments in the German public sector.(3) More generally, the design of some multi-year wage agreements specifies large increases in 2024 (to compensate for the lack of wage adjustments prior to rising inflation), but much smaller increases in 2025. The set of forward-looking wage trackers also notes that wage dynamics will remain elevated in 2024, but will slow in 2025. Indeed’s salary tracker decreased to 3.4 percent in April; Similarly, companies participating in the Corporate Telephone Survey expect wages to increase at a rate of 4.3 percent in 2024, compared to 5.4 percent in 2023.

This downward-sloping profile of wage growth helps underpin the projected decline in inflation in 2025, with less pressure from labor costs next year. Over time, disinflation will also continue to be supported by the tightening stance of monetary policy and the fading impact of past inflation on current price pressures, while the offsetting impact of the rollback of fiscal support measures will fade. inflation data.

While wage growth will be the main driver of inflation in 2024, the net impact of labor cost increases on prices is being cushioned by a lower contribution from profits. In particular, by curbing demand and containing inflation expectations, our restrictive monetary stance is limiting businesses’ ability to pass on cost increases to consumer prices. This is evident in the first quarter data, which shows unit profit growth turning negative. In turn, this contributed to the decline in the inflation rate of the “GDP deflator” (which reflects the prices of goods and services produced in the euro area economy, net of the value of intermediate inputs) from 5 .1 percent in the fourth quarter of 2023 to 3.6 percent. percent in the first quarter of 2024. The ongoing compression of unit earnings will play an important role in keeping the disinflation process on track, even as the final stages of convergence dynamics mean wage growth remains high this year.

Let me now address last week’s monetary policy decision. After nine months of holding the deposit facility rate (the primary policy rate that governs money market conditions) at 4.0 percent, we cut it to 3.75 percent.(4) In the interim since our September 2023 policy meeting, the timely return of inflation to our target has been reconfirmed in the December, March and June projection rounds.(5) For example, over the past four forecast rounds, the projected fourth-quarter to fourth-quarter HICP inflation rate for 2025 has ranged within the very narrow range of 1.9 percent to 2.0 percent. As the year 2025 approaches, the opportunity for the projected return to goal becomes more visible on the horizon. Furthermore, in terms of the sustainability of keeping inflation on target, the inflation outlook for 2026 has been reconfirmed in the last three rounds of projections.

Furthermore, the overall speed of disinflation has been faster than expected. During this period, inflation has decreased by 2.6 percentage points. While at the beginning of the retention phase, staff saw average inflation of 5.6 percent in 2023 and 3.2 percent in 2024, inflation turned out to be 5.4 percent in 2023 and, by 2024 , it is expected to be 2.5 percent in recent times. projection exercise (0.7 percentage points less than what was projected last September). The set of core inflation indicators also shows considerable progress compared to the start of the holding period, with most indicators falling towards two percent.

This improvement in the inflation profile has reduced the risk to the stability of inflation expectations posed by inflation “too high for too long”, including through its impact on future price and wage adjustments. Compared to last September, measures of short-term inflation expectations have declined, while measures of longer-term inflation expectations have remained broadly stable, with most hovering around 2 percent.

At the same time, the evidence indicates that our monetary stance has been clearly restrictive. Mortgage rates are considerably lower compared to their autumn peak, but mortgage affordability indices still point to tight conditions. In particular, compared to the start of the holding period, real lending rates to businesses and households have increased markedly and are expected to remain significantly higher than projected in the September 2023 projections, suppressing demand. of external financing. Activity is recovering, although not enough, in those segments of demand that are most sensitive to interest rates, such as construction – beyond the temporary factors that support construction activity in Germany and Italy – and business investment. Furthermore, consumer confidence, although gradually recovering, remains weak. Overall, the available data on financing conditions indicate that the monetary stance remains restrictive, which will help maintain the disinflation process.

An interest rate decision should be sound in a wide range of scenarios. The baseline projections reflect the market yield curve, which foresees a series of rate cuts in 2024 and 2025. However, at a still clearly restrictive level of 3.75 percent for the deposit facility rate, the Realization of even a substantial margin of upward shocks to inflation could be addressed by a slower pace of rate cuts compared to the benchmark rate path included in the projections.(6) At the same time, a policy rate level of 3.75 percent also offers more protection against negative shocks compared to staying at 4.0 percent.

It should be clear that the high level of uncertainty and still elevated price pressures evident in indicators of domestic inflation, services inflation and wage growth mean that we will have to maintain a restrictive monetary stance, following a policy dependent on data and approach meeting by meeting to determine the appropriate level and duration of restriction. Over time, incoming data should be informative about the balance between the dynamics of retrospective price level adjustment (which should gradually disappear) and the more problematic and persistent underlying component of inflation. By connecting inflation data and broader economic and financial data, the evolution of cost dynamics and domestic pricing power will depend on the strength and composition of the cyclical recovery.(7)

That is, our data-dependent approach requires us to carefully analyze and interpret incoming information in the context of our three-part assessment framework to assess the implications for the inflation outlook (both in terms of the base case and the risk scenario). ). ), the dynamics of underlying inflation and the state of monetary policy transmission.

We are determined to ensure that inflation returns to our medium-term target of two per cent in a timely manner, and we will keep interest rates sufficiently restrictive for as long as necessary to achieve this objective. We are not pre-committing to a particular rate path and will continue to take a meeting-by-meeting approach to determine the appropriate level and duration of the restriction.

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