Isabel Schnabel: The euro area inflation outlook: a scenario analysis
Lecture by Isabel Schnabel, Member of the Executive Board of the ECB,
at the Ragnar Nurkse Lecture Series organised by Eesti Pank in
Tallinn, EstoniaTallinn, 30 August 2024
Disinflation in the
euro area has proceeded rapidly. Headline inflation fell from a peak
of 10. 6% in October 2022 to 2. 6% in July of this year. Data released
yesterday suggest that in August inflation has declined further in
parts of the euro area.
These are welcome developments. They
largely reflect an unwinding of the forces that over the past three
years have led to strong increases in the prices of energy, food and
goods, as well as the impact of our restrictive monetary policy.
However, the current level of headline inflation understates
the challenges monetary policy is still facing. In particular,
domestic inflation remains high at 4. 4%, largely reflecting
persistent price pressures in the services sector, where disinflation
has effectively stalled since last November.
While goods
inflation has fallen back to its pre-pandemic average at a fast pace,
services inflation is still more than twice as high as its average
between 1999 and 2019 (Slide 2, left-hand chart).
As a result,
services have accounted, on average, for 70% of headline inflation
since the start of the year (Slide 2, right-hand chart). Within the
services sector, price pressures are broad-based, with strong wage
growth being just one factor keeping inflation at elevated levels
(Slide 3, left-hand chart).
Stubbornly high price pressures in
the services sector are a global phenomenon. Across many advanced
economies, services inflation remains high, even if there has been, on
average, more progress towards pre-pandemic levels than in the euro
area (Slide 3, right-hand chart).
Continued high inflation
momentum, defined as the annualised three-month-on-three-month change,
suggests that services prices keep rising at an elevated pace of
almost 5% (Slide 4, left-hand side).
Medium-term price
stability does not require services inflation to slow to 2%.
Persistent relative price changes, often reflecting sectoral
differences in productivity growth, are not unusual. In many advanced
economies, the prices of services relative to those of goods have
increased for a long time (Slide 4, right-hand side).
But for
price stability to be restored sustainably, services inflation needs
to return to a level that is consistent with underlying inflation of
2% over the medium term. Uncertainty calls for policy
robustness
To assess whether the current monetary and financial
conditions will secure a timely return of inflation to target,
policymakers need to take a stand on the likely future evolution of
the economy.
Incoming data offer useful clues in this regard.
But since monetary policy affects the economy with long and variable
lags, there is a risk that policy might be adjusted too slowly if too
much weight is given to backward-looking data.
Therefore,
economic projections remain a key input to our decision-making
process.
In the euro area, the latest Eurosystem staff
projections are consistent with a return to price stability. They
predict that inflation will fall to 2. 2% in 2025 and to 1. 9% in
2026, even if the last mile of disinflation is expected to be bumpy,
with inflation likely to fall in the coming months before rising again
towards the end of the year.
Under strict inflation forecast
targeting, policy should be adjusted to validate the financial
conditions on which this outlook relies.
However, inflation
forecast targeting was already a challenge even in more tranquil times
when shocks to inflation and its drivers were less pervasive. [1]
Since 2001, inflation projections from the forecasting
community, including the ECB, have on average had little explanatory
power for realised inflation over horizons beyond the very short term
(Slide 5). [2] In most cases, these forecasts almost mechanically
converge to the 2% target, unless judgement is applied.
Managing inflation is particularly challenging in an era of
transformation. [3]
We are seeing fundamental changes in
labour and energy markets and a reorganisation of global supply
chains. At the same time, due to structural headwinds in some euro
area economies, it is increasingly difficult to identify the impact of
monetary policy on growth and inflation.
These forces make it
inherently more complex to produce accurate projections even over
shorter horizons. While short-term forecast errors for inflation have
generally come down since the start of the year, this masks
differences within the Harmonised Index of Consumer Prices (HICP)
basket.
In particular, recent improved forecast accuracy for
core inflation reflects offsetting forecast errors for goods and
services. Since January, disinflation in services has consistently
been slower than anticipated.
In this environment, policy
should be robust to contingencies causing the economy to evolve
differently from what is implied by the modal outlook. Monetary policy
that would be optimal under strict inflation forecast targeting can be
suboptimal when knowledge is imperfect. [4]Monetary policy to remain
focused on bringing inflation down
Scenario analysis is a
powerful tool for making policy more robust while retaining a forward-
looking perspective. Plausible alternative scenarios that scrutinise
the key assumptions underlying the modal outlook highlight the large
uncertainty surrounding the baseline scenario.
If this
uncertainty is communicated clearly and transparently, the
distribution of future expected policy outcomes may better reflect the
risks to the modal outlook.
Inevitably, policy cannot be
robust to all contingencies. A policy that is robust to downside risks
is unlikely to be equally resilient against upside risks, and vice
versa. Central banks thus need to weigh the risks and focus on those
considered to be the most detrimental to the achievement of their
mandate.
In the current environment, monetary policy should
remain focused on bringing inflation back to our target in a timely
manner, for three main reasons.
First, while risks to growth
have increased, a soft landing still looks more likely than a
recession.
In recent weeks, financial markets have repriced
more fundamentally the expected pace of central bank easing, also in
the euro area. This reflects concerns that global growth is at risk of
a rapid deterioration.
While growth prospects warrant close
scrutiny in the coming weeks, the market repricing reflects, by and
large, spillovers from abroad that were amplified by technical
factors, including reduced liquidity during the summer period and the
unwinding of yen carry trades.
It is therefore unclear to what
extent the repricing reflects a change in macroeconomic fundamentals,
also given the relative stability of growth forecasts for major
economies by market analysts (Slide 6). At the ECB, too, growth
projections for the euro area for 2024 and 2025 have remained broadly
stable since September 2023.
While monetary policy has to
avoid unnecessary pain, it must also avoid overreacting to volatile
financial market expectations. Central banks’ actions should be guided
by their evolving assessment of the inflation and growth outlook.
Second, history shows that central banks were often
unsuccessful in bringing inflation back to target after a long period
of very high inflation. [5]
In their new research, Christina
and David Romer show that perseverance is critical for successfully
restoring price stability after a large inflation shock. [6] They
demonstrate that strong perceived commitment to disinflation has often
not been sufficient to reduce inflation through its impact on expected
inflation.
Rather, successful disinflation was typically the
result of policymakers having persisted in their efforts to fully
extinguish past inflationary shocks. [7] Hence, central banks must not
abandon disinflationary policies too early.
In the euro area,
as we gained confidence in the projected disinflation path, we decided
to start dialling back the degree of policy restraint earlier than
central banks in other advanced economies. But the earlier monetary
policy shifts in response to forward-looking signals, the more
cautious and gradual it can afford to be on the way back to (an
unknown) neutral.
Third, even if inflation is no longer a
primary concern to financial markets, it is still very much on
people’s minds.
Although headline inflation has come down
quickly, inflation perceptions are proving more persistent, and
untypically so from a historical perspective. Today, more than 40% of
people still regard inflation as having risen “a lot” over the past 12
months (Slide 7, left-hand side).
Elevated inflation
perceptions raise inflation persistence and make inflation
expectations more susceptible to new shocks, as memory cues make
people recall past inflation experiences more rapidly. [8]
In a
new study, economists at the Federal Reserve Board quantify these
risks. [9] They show that inflation persistence has increased
measurably across advanced economies, including the euro area.
As a result, if today the euro area were to be hit by a
“normal” supply shock, as opposed to the unusually large shocks of the
past few years, inflation would be higher by almost one percentage
point next year compared with a scenario where inflation persistence
is lower.
This risk is also reflected in the right tail of the
inflation expectations distribution remaining thicker than before the
pandemic, even among professional forecasters (Slide 7, right-hand
side). Incoming data broadly confirm the baseline
scenario
Making policy robust to these risks requires a
thorough review of the main assumptions underlying the baseline
scenario for policy to be adjusted. Such a broad-based review is
carried out every three months when the projections are updated.
In the euro area, the expected decline in headline inflation
to the 2% target by the end of 2025 rests on three critical
assumptions.
One is that the current high growth in unit
labour costs predominantly reflects the lagged effects of past price
shocks related to the pandemic and Russia’s invasion of Ukraine.
As many wage contracts are only infrequently negotiated, the
economy can take some time to return to equilibrium. The recent sharp
decline in headline inflation should therefore progressively lead to
lower wage growth, as also suggested by staff analysis (Slide 8, left-
hand side).
Unit labour cost growth is expected to slow
further once the adverse impact of labour hoarding on productivity
growth reverses as demand recovers.
The second assumption is
that firms are absorbing a large part of the current strong increases
in unit labour costs in their profit margins, as the current level of
interest rates is dampening the growth in aggregate demand.
The third assumption is that price pressures outside the
services sector will ease further or evolve in line with historical
regularities.
Over recent weeks, incoming data have lent
support to these assumptions.
Negotiated wage growth slowed
visibly in the second quarter. Although part of this development is
driven by volatile one-off payments, with wage growth expected to
reaccelerate in the third quarter, surveys and private sector
forecasts suggest that expected wage increases will moderate
measurably in 2025 and beyond (Slide 8, right-hand side).
Firms also expect that increases in their selling prices will
decline as growth in input costs slows.
According to the most
recent Survey on Access to Finance of Enterprises (SAFE), selling
prices are expected to increase by 3% on average over the next 12
months, down from 4. 5% at the end of last year (Slide 9, left-hand
chart). While firms in the services sector still expect a larger
increase in their selling prices compared with other sectors, the size
of intended price increases is declining there too.
Firms have
also started to use their margins to absorb the increases in labour
costs. In the first quarter of this year, unit profits no longer
contributed to inflation in a meaningful way (Slide 9, right-hand
chart). This is a significant change from last year.
Monetary
policy is actively supporting this rebalancing process. By
constraining growth in aggregate demand, it makes it more difficult
for firms to pass on higher costs to consumers. Surveys suggest that
the current level of interest rates is incentivising people to save
more and spend less.
Notably, savings intentions for the
coming year have never been higher than they are today, with
households actively shifting their savings into time deposits offering
higher returns (Slide 10). As consumer confidence is recovering and
households’ unemployment expectations remain subdued, it is likely
that the desire to save is not driven by precautionary motives only.
Finally, energy and food inflation have recently surprised to
the downside, while a stronger euro, coupled with the recent fall in
oil prices, can ease headline inflation further, at least over the
near term.
All in all, recent data remain consistent with the
baseline scenario that foresees that inflation will sustainably fall
back to our 2% target by the end of 2025. Along with signs of a
potential decline in economic momentum in other parts of the world,
there is less risk that a further moderate and gradual dialling back
of policy restraint could derail the path back to price stability. An
alternative scenario: scrutinising the key assumptions
It is
conceivable, however, that the conditions on which the modal outlook
rests do not materialise. Scenario analysis can reveal the reasoning
behind these risks and evaluate their consequences for the inflation
outlook. Unit labour cost growth could remain high for longer
In the alternative scenario, growth in unit labour costs would
not come down as quickly as projected. In the June Eurosystem staff
projections, annual growth in unit labour costs is expected to fall to
2. 5% in 2025, from 4. 7% this year.
This is a sharp decline,
especially as unit labour costs were still growing at an annual rate
of 5. 3% in the first quarter, with momentum remaining high. By way of
comparison, annual unit labour cost growth in the United States was
only 0. 9% in the second quarter.
Growth in unit labour costs
could disappoint expectations because of stronger wage growth.
Although surveys suggest weaker wage growth ahead, the staggered
nature of wage negotiations implies that workers may take longer than
projected to recoup their purchasing power.
While in some
countries, such as Portugal and Spain, workers have, on average,
recouped the losses incurred in their real wages since before the
pandemic, there is still a considerable share of workers in Italy,
Germany, Finland and other countries whose real wages remain well
below pre-pandemic levels (Slide 11). This also reflects differences
in the duration of collective wage agreements.
Wages could
also expand more strongly if labour market conditions remain tight. A
protracted imbalance between labour supply and demand could more
fundamentally challenge the assumption underlying the Eurosystem staff
projections that wage growth merely reflects past price shocks and the
resulting catch-up process.
While labour demand is slowing, it
remains high in an environment in which unemployment is historically
low and where a significant share of firms, especially in the services
sector, still regards labour as a factor limiting business (Slide 12).
If a shortage of labour prevents firms from increasing production,
rising demand results in higher inflation rather than higher output.
Another reason why unit labour cost growth could remain higher
than projected is a weaker recovery in productivity growth. In the
Eurosystem projections, annual productivity growth is forecast to
recover to 1% in 2025 and 1. 1% in 2026, nearly double the historical
average.
The pick-up in productivity growth may be weaker if
part of the current weakness is not cyclical but more persistent,
reflecting the structural challenges facing the euro area economy.
[10] In fact, over the past year, the recovery in productivity growth
has repeatedly been slower than expected.
Increasing trade
tensions, environmental policies or higher energy prices could all
weigh on productivity growth over the coming years, reinforcing upward
pressure on the growth of unit labour costs and thus inflation. Wage
pass-through may be stronger
In addition, under the alternative
scenario, firms may decide to pass on a higher-than-expected share of
rising labour costs to consumers.
The Eurosystem staff
projections expect unit profits to stagnate this year as firms use
their margins to absorb strong growth in input costs. The buffer
provided by profit margins is particularly important in the services
sector, which is more labour-intensive and where inflation is still
high.
New evidence for the euro area suggests, however, that
the pass-through of higher wages into producer prices is typically
very strong in the services sector. [11] After two and a half years,
the estimated pass-through is 86%, twice as high as in the
manufacturing sector (Slide 13). [12]
In other words, if the
pass-through in earlier stages of the pricing chain remains as in the
past, there needs to be a strong decline in profit margins for the
baseline to materialise.
Softening demand for services as part
of a rotation back to goods could be one such factor. So far, however,
demand for services has remained relatively resilient, even if there
are signs of a weakening (Slide 14).
Looking ahead, it will be
critical to observe how the interplay of rising real wages, a
resilient labour market and the fading impact of monetary policy
tightening will contribute to aggregate demand.
In particular,
the most recent bank lending survey suggests that the economy is
starting to adapt to higher interest rates, as banks reported a first
increase in loan demand by households in two years, while loan demand
by firms is still contracting, but at a more moderate pace (Slide 15).
Geopolitical uncertainty and protectionism pose risks to
baseline
Finally, price pressures outside the services sector
may reappear.
Goods inflation is a case in point. Under the
baseline scenario, it is expected to remain close to current levels as
the disinflationary effect of the easing in supply chain disruptions
fades.
At the same time, protectionism and geopolitical
uncertainty are rising. According to the Peace Research Institute
Oslo, the number of state-based conflicts is the highest since 1946.
[13]
Geopolitical uncertainty is a key risk for the stability
of global supply chains and commodity prices. Recently, for example,
container freight rates have increased measurably, in part reflecting
disruptions in the Suez Canal (Slide 16). A further escalation in the
Middle East could disrupt energy markets and supply chains more
fundamentally.
Global trade measures are increasing in
parallel, especially for critical raw materials – the production of
which is often concentrated in just a few countries (Slide 17).
Together with the growing impact of climate change on food
prices, these are important forces that could challenge the
assumptions underlying the baseline scenario. Conclusion
I
would like to conclude with three implications for monetary policy.
First, incoming data have broadly confirmed the baseline
outlook, bolstering our confidence that conditions remain in place for
inflation to fall back to our 2% target by the end of 2025.
Second, confidence is not knowledge. History will not judge
our intentions but our success in delivering on our mandate. Given
that the path back to price stability hinges on a set of critical
assumptions, policy should proceed gradually and cautiously.
In particular, the closer policy rates get to the upper band
of estimates of the neutral rate of interest – that is, the less
certain we are how restrictive our policy is –, the more cautious we
should be to avoid that policy itself becomes a factor slowing down
disinflation.
In other words, the pace of policy easing cannot
be mechanical. It needs to rest on data and analysis.
Third,
the world around us is changing rapidly. When the future is as
uncertain as it is today, the modal outlook provides a false sense of
comfort. Scenario analysis can protect us from falling victim to model
uncertainty and overconfidence.
Being transparent about what
could go wrong, and factoring this into the decision-making process,
can help make policy more robust to contingencies that threaten the
achievement of our primary mandate.
Thank you.