Everything everywhere all at once: responding to multiple global shocks

Speech by Fabio Panetta, Member of the Executive Board of the ECB, at a panel on “Global shocks, policy spillovers and geo-strategic risks: how to coordinate policies” at The ECB and its Watchers XXIII Conference

Frankfurt am Main, 22 March 2023

We are still going through a sequence of global shocks that are disrupting economies around the world. In just three years we have seen a pandemic, severe supply chain disruptions, a war, an energy crisis and now tensions in banking markets.

The resulting swings in activity and prices have presented policymakers with the challenge of identifying turning points in their underlying dynamics at a time of disruption in the economy and the financial sector. Inevitably, we need to navigate between the risk of underreacting – which could prolong the inflationary effects of these shocks – and that of overreacting, which could turn volatility into instability.

There are no simple solutions to these complex problems.

We need to adapt our policies to the overlapping effects of the shocks, to geopolitical developments, to the risk of financial amplification and to spillovers from other jurisdictions.

Three principles can help guide our monetary policy decisions in this context.

First, given the prevailing uncertainty and the ground we have already covered in tightening our policy, we must remain fully data-dependent and avoid pre-committing to any specific policy path. We should be guided by our reaction function, taking stock of inflation developments, underlying inflation dynamics and the strength of monetary policy transmission, also given the possible risks for the medium term outlook stemming from both the real economy and the financial sector.^[1] This way we can ensure that we calibrate our measures in the light of the incoming information.^[2]

Second, we need to monitor the effects of our measures and the way our different instruments interact with each other. In particular, we should continuously assess the combined effect of raising rates and reducing the size of our balance sheet.^[3] The experience of other jurisdictions suggests that abrupt adjustments could make it more difficult for investors to adapt to evolving market conditions.

We need to maintain our disinflationary stance until we see convincing signs that inflation is returning to our target, in line with the “separation principle”: delivering the appropriate policy stance should not come at the cost of impairing its transmission.

And third: given the global nature of the shocks we are facing, we need to consider how they are transmitted across markets and economies as well as the potential spillovers from policies adopted abroad. But we should remain focused on our primary mandate of ensuring price stability in the euro area, without being overly conditioned by other jurisdictions.^[4]

I will start by illustrating the global shocks and the uncertainty they create. I will then turn to the policy response to these shocks and their spillovers across jurisdictions. And I will outline what this means for our monetary policy in the current environment.

Global shocks and uncertainty

Over the past three years we have faced considerable uncertainty from both domestic and global shocks, complicating the policy diagnosis and increasing the risks of either underreacting or overreacting.

Global shocks, their pass-through and their unwinding

A major source of uncertainty surrounding both inflation and economic activity relates to the pass-through of global shocks and their unwinding. For example, the unprecedented sequence of domestic and global shocks makes it difficult to distinguish supply-demand imbalances triggered by the pandemic and the energy crisis from persistent, self-sustained inflationary dynamics.

Pandemic-related shocks

The reopening of the economy after the pandemic gave a sudden boost to demand (Chart 1) at a time when supply disruptions had not yet been resolved, leading to persistent bottlenecks. Firms reacted by building up inventories and hoarding labour, fuelling inflationary pressures. As a result, both demand and supply contributed to inflation in 2022.

The boost to activity from the reopening is now fading. Supply bottlenecks have largely faded out^[5] (Chart 2) and firms are starting to run down their inventories (Chart 3). This should dampen price pressures.

Chart 2

Easing of supply chain bottlenecks

(diffusion indices)

The energy crisis

The energy crisis has had similar effects.^[6] The sharp increase in wholesale energy and commodity prices has raised not only energy and food inflation but also – indirectly – core goods and services inflation (Chart 4).

Chart 4

Contributions of energy-sensitive components to goods and services inflation in the euro area

(annual percentage changes and percentage point contributions)

These effects are starting to be reabsorbed. Lower energy and commodity prices have translated into lower energy inflation (Chart 5). And they should eventually pass through to food and core inflation – consistent with the easing in pipeline price pressures (Chart 6). This is compressing medium-term consumer inflation expectations^[7], and might temper catch-up wage demands. But how quickly these effects will be reflected in the inflation data is uncertain. And concerns about inflation persistence^[8] make projecting core inflation particularly challenging.

Chart 5

Headline inflation and components in the euro area and the United States

(annual percentage changes and percentage point contributions)

Chart 6

Pipeline pressures and input/output prices

(panel a): annual percentage changes; panel b): diffusion index)

The risk of inflation becoming entrenched

The unwinding of inflationary pressures has triggered concerns about the risk of second-round effects in the form of a de-anchoring of inflation expectations or a wage-price spiral, especially in view of the tight labour market conditions in advanced economies (Chart 7).^[9]

Chart 7

Labour markets are still tight

(panel a): percent; panel b): annual percentage changes)

In the euro area, medium-term inflation expectations remain anchored at our target. This reflects the ECB’s clear commitment to stamp out inflation. As President Lagarde stated this morning, “the public can be certain about one thing: we will deliver price stability, and bringing inflation back to 2% over the medium term is non-negotiable.”^[10]

Robust wage growth over the next three years is also consistent with our projections, which indicate that inflation will gradually fall to around 3% by the end of 2023 and around 2% by the middle of 2025.

The risk is rather that wage and price-setting dynamics could make high inflation stickier and eventually feed into inflation expectations. Wages are still accelerating, and we cannot rule out a scenario in which stronger and persistent wage increases take hold. This risk needs to be closely monitored.

Opportunistic behaviour by firms could also delay the fall in core inflation. In fact, unit profits contributed to more than half of domestic price pressures in the last quarter of 2022 (Chart 8).^[11] In some industries, profits are increasing strongly (Chart 9) and retail prices are rising rapidly, in spite of the fact that wholesale prices have been decreasing for some time. This suggests that some producers have been exploiting the uncertainty created by high and volatile inflation^[12] and supply-demand mismatches^[13] to increase their margins, raising prices beyond what was necessary to absorb cost increases. We should monitor the risk that a profit-price spiral could make core inflation stickier.

Chart 8

GDP deflator at market prices

(annual percentage changes; percentage point contributions)

Chart 9

Sectoral wage and profit developments

(left-hand panel: percentage change from Q4 2019 to Q4 2022; right-hand panel: gross operating surplus over real value added, level)

Looking ahead, a normalisation of profits would help bring down core inflation and reduce the risk of second-round effects, as wage demands could be accommodated without leading to an increase in prices in response.

Global supply-demand mismatches

Uncertainty about global supply and demand conditions is still high – and is now exacerbated by the financial tensions that have recently emerged.

Demand is showing signs of weakness in both the United States and the euro area.^[14]

In China, the end of zero-COVID policies has been followed by a downturn and then a rebound, which could still be slowed down by headwinds emanating from the property market. The reopening will have an ambiguous overall effect on global inflation: it could dampen prices in sectors where China is a net exporter – such as goods – and increase prices in sectors where it is a net importer, such as commodities.^[15]

The global policy response and its spillovers

A second source of uncertainty relates to the global policy responses to the shocks, and the spillovers from these responses.

We have already seen clear examples of these spillovers. For instance, the outsized fiscal stimulus implemented in the United States in response to the pandemic boosted the demand for durable goods (Chart 10) but led to a negative supply shock in other countries.^[16] In the euro area, this supply shock contributed to pushing up inflation and hit the economy at an early stage of its recovery.^[17]

Chart 10

Individual consumption – durables and services

(panel a): index: Q1 2018 = 100; panel b): January 2018 = 100)

We are now facing a simultaneous and rapid global tightening of financing conditions (Charts 11), which is creating financial and policy spillovers (Chart 12). For example, monetary tightening in the United States is also resulting in tighter financing conditions^[18] in other jurisdictions, including the euro area.^[19] This adds to the risk of overtightening if central banks do not factor in the feedback loops they create.^[20]

Chart 11

Global tightening of financing conditions

(panel a): standardised indices; panel b): percentages of countries)

Chart 12

Global component in yields

(correlation coefficients)

In the euro area, the effects of monetary tightening are already visible, although they are only expected to fully materialise in the coming months due to the usual lag in the transmission of monetary policy. The monetary aggregates M1 and M3 are slowing down rapidly. In real terms their growth rates are in negative territory and at historic lows, below the levels of 2008 and 2011 (Chart 13).^[21] Bank credit is also decelerating rapidly (Chart 14). As a result, it is declining as a share of GDP – faster, in fact, than in previous tightening episodes – and markets expect it to decline significantly further this year (Chart 15). These developments are largely related to our policy normalisation. But the size and the speed of the adjustment indicate that the transmission of our monetary policy to the economy may have become stronger.

Chart 13

Growth of monetary aggregates M1 and M3 in the euro area and the United States

(annual growth rates, percentages)

Chart 14

Credit growth in the euro area

(three-month annualised percentage changes, seasonally adjusted)

Chart 15

Bank loans to the non-financial private sector in the euro area

(percentages of GDP)

The global tightening may also be amplified by the recent financial tensions in global banking markets. Aside from their impact on confidence, these tensions will make banks more sensitive to deposit outflows, inducing them to transfer the rate hikes more rapidly – and to a greater extent – to their customers on both sides of the balance sheet. For a while, banks may also become more prudent about lending and decide to retain cash as a precautionary measure. In the euro area, our bank lending survey^[22] was already pointing to a tightening of lending standards for firms and households before the recent tensions, and this tightening may aggravate the drop in credit growth in the coming months.

In addition, major central banks have been simultaneously raising rates and reducing the supply of liquidity through quantitative tightening policies. This could make the policy adjustment bumpier. There is no reliable experience we can draw on to examine the combined effects of rate hikes and quantitative tightening. It is hard to assess how a contraction of the balance sheet of the central bank affects financial markets – especially if it happens in conjunction with an abrupt increase in interest rates.^[23] The liability-driven investment crisis in the United Kingdom and the crisis of Silicon Valley Bank in the United States suggest that sudden adjustments may have an impact on the transmission of monetary policy and even give rise to severe financial tensions.^[24]

In the current context, weakening growth prospects and heightened uncertainty may lead investors to move from risky assets to risk-free assets. And when the supply of liquidity is contracting quickly, this may spur a “dash for cash”, reinforcing the effects of the sharp increase in policy rates and exacerbating financial vulnerabilities. In fact, in the United States, high quality liquid assets are unusually offering higher returns than risky assets (Chart 16) at a time when liquidity is being withdrawn from the system.

Chart 16

Inverse price/earnings ratio, six-month risk-free rate and excess reserves in the euro area and the United States

(left-hand scale: percentage points, right-hand scale: EUR trillions)

As available liquidity shrinks, both in aggregate and for most banks, the supply of lending could also contract rapidly. Estimates by ECB staff suggest that banks with lower excess liquidity are more likely to reduce their supply of credit in response to policy rate hikes, and the increase in their lending rates is likely to be larger (Chart 17).

Chart 17

Response of loan supply and lending rates to a policy rate hike by level of excess liquidity

(percentage points of supply-driven loan growth (panel a) and change in lending rates (panel b) over three months for each percentage point increase in the deposit facility rate; size of bubbles equal to volumes of loans to firms)

Implications for the ECB’s monetary policy

So how should monetary policy operate in an environment characterised by high uncertainty, strong spillovers and financial vulnerabilities?

Adapting to the current environment

First, monetary policy must remain fully adaptable to changing developments, given the prevailing uncertainty, the lags with which it operates and the risk of sudden financial tensions. This requires a data-dependent approach that does not prejudge future policy decisions and that reflects the risks on both sides.

Second, our tightening must be calibrated prudently. This is because it is already having a strong impact on financing conditions and because we want to avoid undesirable financial volatility. And this prudent approach holds truer still as our policy rates move more firmly into restrictive territory, inflationary forces ease and the risks to the inflation outlook become balanced. At times like this, abrupt policy moves are not necessary.^[25]

Third, in order to avoid financial tensions which could hamper our disinflationary policies, we should rely on our policy rate as the key instrument to steer our stance and we should be measured and predictable in the normalisation of our balance sheet. We should continuously monitor investors’ exposure to interest rate risk and liquidity risk and carefully analyse the impact that the decline in liquidity may have on the supply of credit.

We must stand ready to intervene in a timely manner to counter possible market dysfunctions. We have the instruments to adjust the provision of liquidity and ease collateral conditions as necessary, in line with what we have done during the pandemic. And we need to remain committed to our three lines of defence against financial fragmentation within the euro area.^[26]

Finally, all policymakers should be tackling inflation on all fronts. It is not a task for central bankers alone. Thanks to public intervention, we had an unusual recession – one with high profits. This means that firms have the buffers to absorb a catch-up in labour costs without increasing prices in response, also in view of the fall in the cost of other inputs, like energy.

Persistently opportunistic profits should not put a dampener on disinflation. Profiteering strategies that increase inflation and the risk of second-round effects would trigger a monetary policy reaction. But other authorities should also intervene. The appropriate response to excess corporate profits is not more fiscal support to compensate consumers for high prices of goods and services. Rather, it is to intervene to prevent any abuse of market power.

Addressing spillovers

Let me now turn to how monetary policy should address spillovers.

We must take into account all the relevant information when taking decisions, and that includes developments outside the euro area. Given the global nature of the shocks we are facing, we need to consider how they are transmitted across markets and economies, alongside the potential spillovers from the policy response to those shocks. This is what we have done. And in response to tensions in international funding markets, we have worked with other major central banks to enhance the provision of US dollar liquidity via our standing liquidity swap line arrangements.^[27]

At the same time, we need to tailor our policy response to the outlook for the euro area and avoid passively importing financing conditions from abroad through policy spillovers to interest rate expectations and long-term interest rates. We have the necessary autonomy to steer financing conditions in a way that reflects the differences between the euro area and other jurisdictions.^[28]

We can reconcile these two objectives – factoring in spillovers but tailoring our policy to domestic conditions – if we calibrate our policy appropriately and communicate our reaction function clearly.

Our measures need to be calibrated in such a way that they achieve the appropriate domestic stance. To use a metaphor – if outside temperatures start falling after a period of hot weather, we have less need for air conditioning because temperatures inside will gradually cool, too. If we then apply this approach to our current situation, when calibrating our measures we should consider the restrictive impulse coming from the global tightening and from the vulnerabilities that are emerging in the financial sector abroad.

The clarity of our communication is also crucial, especially in view of the current financial tensions. In order to communicate our policy intentions clearly and consistently at a time when we must remain data-dependent and adapt to new developments, we need to set out a clear reaction function and stick to it.^[29] Accordingly, in our latest monetary policy statement we emphasised that “The elevated level of uncertainty reinforces the importance of a data-dependent approach to our policy rate decisions, which will be determined by our assessment of the inflation outlook in light of the incoming economic and financial data, the dynamics of underlying inflation, and the strength of monetary policy transmission.”^[30]

Conclusion

Let me conclude.

A string of shocks has created uncertainty for economies around the world. While the effects of some of these shocks are starting to unwind, it may be some time yet before we see volatility in activity and prices subside, and a new equilibrium settle in.

Notably, my remarks today have focused on the current economic situation. But we may well see longer-lasting changes to economic structures as supply chains are reconfigured to increase resilience to global shocks and align with shifting geopolitical strategies.

In the meantime, monetary policy must perform a difficult balancing act.

Faced with an exceptionally complex environment, we need to acknowledge the uncertainty prevailing in the economy. And we need to continuously assess the combined effect of our different policy instruments, the risks of non-linear effects and the spillovers from policies adopted elsewhere. This means our monetary policy should be data-dependent and adaptable. And it requires us to shape our communication on the basis of our monetary policy reaction function.

In a speech last month I summarised my thinking by saying that we do not want “to drive like crazy at night with our headlights turned off”.^[31] The recent financial tensions have made this conviction even stronger.