Such inflation is consistent with wages rising at a pace that reflects our target and productivity gains, thereby supporting real disposable income. The first is “good” inflation, which comes about when demand is robust, output is at potential, employment is high, inflation is converging towards 2% and inflation expectations are anchored at 2%. Source: ECB Three types of inflation: the good, the bad and the uglyįor illustrative purposes, we can identify three different types of inflation. (month-on-month percentage changes, annualised, seasonally and working-day adjusted) To this end, we should keep using all of our instruments for as long as warranted, with the necessary flexibility to support the transmission of our policy stance throughout the euro area on its uncertain path out of the pandemic. We should remain focused on completing the recovery, returning GDP to its pre-crisis trend, as the condition for achieving self-sustained inflation at our target in the medium term. We should not exacerbate the risk of supply shocks morphing into a demand shock and threatening the recovery by prematurely tightening monetary policy – or by passively tolerating an undesirable tightening in financing conditions. In this context, so long as higher short-run inflation does not feed into inflation expectations and wage and price-setting in a destabilising way, monetary policy should remain patient. This is leading to a temporary spike in the price level, which acts as a “tax” on consumption and a brake on production, over time generating effects akin to an adverse demand shock.
Today, I will argue that globally we are seeing a mix of demand and supply shocks, but in the euro area supply constraints dominate to a much greater degree than in some other major economies. Our focus needs to be on the risk that inflation in the medium term turns out persistently lower or higher than our 2% target, rather than on short-run developments. But in order to design our policy action, we need to gauge their implications for inflation in the medium term. We cannot say exactly when these factors will normalise.
We are facing a unique combination of shocks that reflect the exceptional nature of the recovery from the pandemic: supply bottlenecks, surging energy prices and labour market frictions. This, in turn, requires a clear framework for thinking about inflation developments and what conditions would warrant a monetary policy response. In this environment, central banks must clarify their reaction function, so that market expectations remain aligned with their policy intentions. Markets are indicating increasing uncertainty about the inflation outlook, and investors’ expectations of lift-off dates have become more dispersed. Following years of too-low inflation and policy oriented at addressing deflationary risks, we are now in an environment of two-way inflation risks and heightened short-term volatility (Chart 1). The long and rocky road out of the pandemic is creating challenges for monetary policy.
Speech by Fabio Panetta, Member of the Executive Board of the ECB, at Sciences Po
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