Article by Governor Boštjan Vasle in Eurofi magazine

Published: Eurofi magazine, February 2022

Transition from crisis mode to a gradual normalisation of monetary policy

by Boštjan Vasle, Governor of Banka Slovenije

Key sentence: We need to start rebuilding the monetary policy space to be ready for the next business cycle.

Less than two years into the pandemic, the euro area economy has returned to the pre-crisis level of activity, though the recovery has been incomplete in some sectors and countries. With a rapid and comprehensive response of monetary, fiscal and other policies to a once-in-a-lifetime shock, we prevented the free fall of the economy and helped to preserve financial stability and protect productive potential. As our interest rates were near the effective lower bound, the Eurosystem has resorted to unconventional monetary measures, launching tailor-made instruments to leave no one behind.

With the roughly simultaneous reopening of economies and relatively robust household incomes, backed by fiscal and other measures, regional and global demand rebounded strongly. This led to supply-chain bottlenecks and shortages of different goods, ranging from energy and construction materials to computer chips, and brought about soaring prices. The pick-up of inflation in the euro area and elsewhere was not unexpected, considering the low reference base in 2020 and the impact of pandemic-driven one-offs and other presumably short-term factors. In an effort to secure the uncertain recovery, we last year had good reasons to tolerate supply-driven spike of inflation - after a decade of it falling short of the target set.

However, Eurozone inflation prints kept surpassing our projections in recent months. Energy inflation and consequently headline inflation exceeded their highest levels since the introduction of the euro. Global supply chain disruptions have proven more sustained, while Europe also grapples with the energy supply crunch, aggravated by geopolitical developments and the EU’s own climate-related policies. With the persistence of these factors, price growth has been gradually spilling over into a wider range of products, bringing core inflation rate on par with its previous 20-year peak.

Elevated inflation is set to persist well into 2022, longer than previously expected. The development of the pandemic and thus the duration of disruptions in supply chains are still uncertain. At the same time, various structural policies and geopolitical disputes indicate no immediate relief in energy prices. Longer spell of higher inflation increases the danger of it becoming more entrenched and broad-based. Studies show that euro area economies tend to be at risk of price hikes leading to increased wage pressures. In addition, expectations of future inflation, an important determinant of inflation, are highly state dependent and tend to react strongly to current inflation. Higher inflation, even if caused by external factors, could therefore result in a feed-back loop through higher wages and increased inflation expectations. Our monetary policy focus should therefore be on identifying early signs of increased wage pressures or the de-anchoring of inflation expectations above our target.

In addition to the surge in consumer prices, some of the unintended consequences of our policies are also weighing heavily on our decisions. In a low-yield environment investors are seeking yields in risker segments of the markets, or are pushing the prices of some investment possibilities, like housing, into levels where abrupt repricing could pose a threat to the macroeconomic environment. Furthermore, our maintaining of favourable financing conditions across all sectors and jurisdictions during the pandemic has contributed to increased debt levels in these sectors, hence inducing refinancing risk. Macroprudential policies with capital- and borrower-based tools are an important line of defence, but they focus primarily on the banking sector and are not all powerful. The longer the highly accommodative policy is maintained, the more pronounced these risks become, and the more painful the normalisation process may have to be.

Given these considerations, the time seems right for our monetary policy to move out of crisis mode and start the process of gradual normalisation. With the return of economic activity to the pre-crisis level, looming labour shortages and in part structural pressures on energy prices, our monetary policy needs to start rebuilding its space to be ready to respond to the next business cycle. However, this has to be a gradual and predictable path, in order not to pull the rug from underneath a more complete recovery in the context of an enduring pandemic. The decisions at our previous monetary policy meetings have laid the necessary groundwork to implement such an approach.

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