(AGENPARL) – sab 29 aprile 2023 Monetary policy and the return of
inflation: Questions, charts and tentative
answers
Ignazio Visco
Governor, Bank of Italy
1 INTRODUCTION AND SOME TENTATIVE CONCLUSIONS
After at least three decades of moderate consumer price changes in advanced
countries, ination has returned to levels that are severely aecting the lives of all
citizens (Figure ). A series of key issues that are central to the current macroeconomic
debate will be briey discussed in this note. They are related to the dierent nature of
ination across economies and to the recent conduct, possible errors and perspectives
on monetary policy in the euro area.
Figure 1
The return of inflation
Monthly data; annual percentage changes



Source: Eurostat, Istat, UK Office for National Statistics and US Bureau of Labor Statistics.
Note: EA denotes the euro area (changing composition after 1999 and weighted average of the 11 countries
participating to the start of Third Stage of the Economic and Monetary Union prior to that date).
This Policy Insight is partly based on the lectures given at the University of Warwick on 11 February 2023 (available
here) and at the Frankfurt School of Finance & Management on 1 March 2023 (available here). I wish to thank Alessio
De Vincenzo, Rebecca Kelly, Pietro Rizza, Massimo Sbracia and Alessandro Secchi for their useful contributions
and suggestions. The views expressed in this Policy Insight are those of the author, and do not represent those of the
European Central Bank.
April 2023
CEPR POLICY INSIGHT No. 122
In a nutshell, while demand factors have been the crucial element behind the
acceleration of prices in the United States, the euro area has mostly been hit by a
supply shock, whose eects continue to be the main driver of both headline and core
ination. The very easy monetary and nancial conditions established in the years
preceding the recent surge in prices were necessary to eectively counter severe
deationary risks. They may have made the process of normalisation a little more
laborious, but I believe that, also given the state of extreme uncertainty caused by the
pandemic, the policy response in the euro area has, overall, been suciently cautious.
In any case, those conditions do not seem to have caused particularly strong demand-
related price pressures.
Nevertheless, when discussing the high level of headline ination reached in the euro
area, there has sometimes been a tendency to point the nger at possible delays in
the response of the ECB and sizeable errors in its ination projections are sometimes
emphasised. Forecasting errors, however, are in very large part due to the evolution of
energy prices, and particularly those of natural gas. In this respect, the unpredicted
Russian invasion of Ukraine has been the real watershed, triggering a sharp rise in
volatility, pushing both current and expected gas prices to extremely high levels and
fuelling ination. The claim that the ECB responded too late to the acceleration in
consumer prices, therefore, is disputable. When the invasion of Ukraine transformed
what would likely have been a temporary shock, which had only become visible in
the second half of , into a persistent one, the monetary normalisation process
was already underway (and correctly anticipated by market participants). In addition,
the process accelerated during , notwithstanding the very elevated uncertainty
surrounding both the economic outlook and the medium-term price perspectives
associated with the outbreak of the war.
The eectiveness of the monetary tightening is evident when we consider the marked
increase in nancing costs for households and rms as well as the sharp deceleration
in money and credit. It is well known, and accepted, that monetary policy aects the
real economy and ination with somewhat ‘long’ (and perhaps ‘variable’) lags. Thus,
most of the economic impact of the rate hikes implemented so far is likely to be felt in
the coming months. This may in itself suggest that a degree of prudence is necessary
when determining the future path of monetary policy.
The ECB’s monetary stance must continue to be dened in a way that ensures that
the temporary rise in ination caused by the supply shock does not give rise to a more
persistent phenomenon sustained by demand factors. It is essential that we strike
the right balance between the risk of a too-gradual recalibration, which could cause
ination to become entrenched in expectations and in wage-setting processes, and that
of an excessive tightening, resulting in signicant repercussions for economic activity,
nancial stability and, ultimately, medium-term price developments. In line with our
symmetrical price stability objective, equal weight should be given to both risks. In
this perspective, a data-dependent approach to future policy rate decisions plays a
crucial role, also in light of the elevated level of economic and nancial uncertainty.
Risks to nancial stability, in particular, should not be underestimated. The
unprecedented and simultaneous tightening of monetary conditions across many
countries could create unexpected spillover eects that, although dicult to quantify,
may be non-negligible. Even if the euro area banking system is in better shape today
than it was before the global nancial crisis, there is no reason to be complacent and
close monitoring of the risks of adverse nancial amplication eects is as necessary
as ever.
Central banks have the tools to deal with potential stress in the nancial system
without deviating from the objective of bringing ination back to target; claims that
monetary policy is subject to nancial dominance, therefore, are misplaced. However,
recent economic history shows that nancial tensions can prove to be more frequent,
more sudden and more costly than previously thought, jeopardising macroeconomic
and price stability. In order to avoid them, it is of utmost importance to remain on the
straight and narrow path of the necessary tightening of nancing conditions, keeping
a distance from both an excessively aggressive and an excessively lax one.
The ongoing decline of ination towards its medium-term objective is not without
obstacles. In this process – as well as when risks to price stability were on the downside
– monetary policy should not be the only game in town. Indeed, the return to price
stability and the anchoring of ination expectations will, above all, greatly benet
from scal policies, negotiations between workers and rms, and business pricing
policies operating in the same direction as monetary policy. This would also ensure
lower costs of the supply shock to the real economy.
The energy shock is eectively a tax on the euro area economy. It cannot be
circumvented through a fruitless race between wages and prices, nor through an
excessive and permanent increase in public debts. At the same time, the pricing
strategies of businesses, and in particular rms’ mark-ups reecting the most recent
declines in energy prices, will play a central role in achieving a lasting reduction in
underlying ination.
So far, a strong wage–price spiral in the euro area is not discernible and overall price
expectations appear to be well-anchored. However, in the absence of responsible
behaviour by all economic agents, with the possible triggering of second-round eects,
the achievement of price stability would become more dicult and costly, as it may
require some further tightening of the monetary stance.
2. WHY DID INFLATION TAKE OFF AT THE GLOBAL LEVEL? ARE THE
SOURCES OF INFLATION THE SAME OR ARE THERE DIFFERENCES
BETWEEN THE TWO MAIN ADVANCED ECONOMIES?
Even though ination has recently aected many economies in an apparently similar
manner, its underlying sources are dierent across countries. This is especially true if
we compare the United States, where demand factors have been crucial in triggering
the acceleration of prices, with the euro area, which has been hit mostly by a supply
shock.
First, while scal policies were expansionary everywhere during the acute phase of
the Covid- pandemic, in the United States they were especially bold: the public
debt-to-GDP ratio rose by  percentage points in -, to over %. In the euro
area, instead, the increase was limited to  percentage points, to slightly less than
%, despite a much deeper decline of nominal GDP in  and a slower recovery
in . The exceptional support provided to US households is particularly evident
when comparing the dynamics of GDP and disposable income (Figure ). In ,
just as GDP recorded its sharpest collapse in real terms in the entire post-World War
II period (of about %), real disposable personal income grew by over %, the largest
rise since the mid-s. In the euro area, instead, household real disposable income
did not increase, even in the presence of a much larger reduction of GDP.
A similar view on the dierent sources of ination in the United States and in the euro area is expressed by Blanchard
Figure 2
Disposable income and GDP
Annual data; percentage changes


r



Source
: Eurostat and US Bureau of Economic Analysis.
Second, the dierent dynamics of household disposable income across the two
economies translated into dierent eects on demand. In the United States, GDP
returned to its pre-crisis trend at the end of , but aggregate data hid a large
heterogeneity between sectors: while demand in the services sector was restrained by
pandemic-related factors, the goods sector increasingly showed signs of overheating
(Figure ). In the spring of , for example, personal consumption expenditure
in the durable goods sector was already more than % higher than its pre-crisis
level. The fast recovery in US demand, in a phase in which global supply was still
constrained due to the waves of the pandemic, caused bottlenecks in international
value chains, which drove up the prices of intermediate goods everywhere. In the euro
area, instead, in the second half of last year, the demand for both goods and services
was still below the pre-pandemic trends.
Figure 3
Demand in the goods and services sectors
Monthly and quarterly data; indices: Jan. 2020 / 2019 Q4 = 100
Goods sector



Services sector









Source: US Bureau of Economic Analysis and estimates based on Eurostat.
Note: dashed lines show pre-pandemic trends.
Third, the labour market has been much tighter in the United States than in the euro
area. The US unemployment rate still stands at just .%, a value last seen only in the
late s and about half the level of the euro area (.%). The dierence between the
number of vacancies in the US non-farm sector and the number of people who are
unemployed is still around  million today, i.e. there are many more jobs available than
people looking for them, while in the euro area the opposite is true, with the number
of unemployed exceeding job vacancies by over  million. Unsurprisingly, the annual
change of US nominal wages (measured by the employment cost index) surpassed %
as early as in the third quarter of , approached % in early , and still stands
above % today, a level that is dicult to reconcile with an ination target of %
(Figure ). In the euro area, on the other hand, in spite of current requests for sizeable
wage increases in some countries where labour markets are particularly tight, wage
growth has so far remained moderate on average, at around %, and overall there are
no clear signs of a wage–price spiral.
Figure 4
Nominal wage growth
Quarterly data; annual percentage changes

Source: ECB and US Bureau of Labor Statistics.
Fourth, the energy shock played a very dierent role on the two sides of the Atlantic.
Since the second half of , oil prices rose gradually in both the United States and the
euro area. The price of the natural gas delivered in the United States increased much
more markedly, rising from around $ per megawatt hour before the pandemic to a
peak of over $ last summer, before sliding back below $ (Figure ). However, it was
the price of the natural gas delivered in Europe that recorded the most extraordinary
dynamics, dwarng even the  four-fold oil price increase: from slightly above €
per megawatt hour in early , it rocketed to € before the war, soaring to a peak
of € last summer and then falling sharply, hovering around € in the last weeks.
This extreme volatility of gas prices was also the result of a ‘bullwhip eect’, which is
the response of demand to uncertain supply, consisting of ordering more, ordering
earlier and replenishing gas stocks.
Figure 5
Natural gas prices
Daily data

nrn
nrnn
Source: Refinitiv.
Note: Title Transfer Facility (TTF) quotations for European gas and Henry Hub for US gas.
3. WHAT IS THE CURRENT SITUATION? ARE DEMAND PRESSURES ALSO
MOUNTING IN THE EURO AREA?
After peaking towards the end of last year, euro area headline ination started to
decline, reecting the sharp drop in the energy component: still at around % in
mid-, it reached a peak of .% in October , before falling to less than %
in March . By contrast, core ination (i.e. net of energy and food products) has
continued to climb since mid-, reaching an all-time high of .% in March 
(Figure ). US consumer price ination instead increased from below % in February
 to a peak of over % last June, before declining to .% in March . Core
ination took the lion’s share of the rise, with a peak of .% last September, and in
March was higher than headline ination, at .%.
Several factors lie behind the dynamics of euro area prices. Some of these are still
related to supply-side disturbances, such as bottlenecks and the gradual pass-through
of the exceptional past surge in energy prices; others originate on the demand side,
fuelled by household savings accumulated during the pandemic and by the scal
impulse. Assessing the relative importance of supply as opposed to demand shocks
is crucial to gauge the risks for price stability and, in turn, dene the appropriate
monetary policy stance.
Figure 6
Headline and core inflation
Monthly data; percentage changes



n




r

Source
: Eurostat and US Bureau of Labor Statistics.
While the post-pandemic expansion has weakened, the euro area economy is proving
more resilient than expected. This resilience is leading to a certain degree of over-
emphasising, including in policy debates, the role of demand factors as drivers of the
current ination cycle. However, overall there is still scant evidence of excess demand.
A closer look reveals, in fact, that despite the pandemic-related monetary support
and the scal impulse, which have helped to absorb the distributional eects of the
sequence of adverse shocks, euro area GDP still stands below pre-Covid trends.
Private consumption has also remained below trend and has even weakened recently,
due in good part to the limited pass-through of ination to wages. Indeed, in both the
third and fourth quarters of , euro area contractual earnings increased by .%
on an annual basis and the renewals signed at the beginning of  are still well
below price developments. However, in some countries increasing wage trends have
been somewhat more accentuated since late last year, also reecting some wage drift.
In Germany and the Netherlands, minimum wages were increased, while in France
they rose due to their automatic indexation to prices, a mechanism that is also still
applied in Belgium to all wages. So far, however, the risks of a wage–price spiral have
been averted in the euro area as a whole.
A variety of empirical approaches points to a more prominent role of supply-side
shocks in steering ination dynamics. In particular, increases in energy prices have
been and still are having relevant eects on the underlying price dynamics (e.g. Neri et
al. ). Similarly, out of the .% core ination in the euro area in March, the energy
component alone accounted for . percentage points (Corsello and Tagliabracci ).
A plurality of factors, driven by both demand and non-energy supply shocks, accounts
for the remaining . percentage points. The latter most likely originate from supply
bottlenecks, increases in the prices of non-energy raw materials and changes in labour
supply. The relative contribution of these drivers is dicult to quantify; however, in
line with the persistent weakness in consumption, excess demand is unlikely to prove
to have played a predominant role.
The impact of energy shocks on core ination has gradually been increasing since
the rst quarter of . The transmission of rising production costs along the price
formation chain takes time, depending on how long price setters expect the shock
to endure. Until late , the price of natural gas futures suggested that the energy
shock was expected to be temporary, lasting only until the end of the cold season; its
perceived persistence, however, increased in . It is therefore hardly surprising
that, while the direct contribution of energy to headline ination is waning as
the energy shock peters out, its indirect impact via the core and food components
continues to grow.
A disaggregated analysis of the recent price dynamics suggests that high core
ination could last for some time. The core items in the consumption basket that
have registered the largest price growth increases since , and contributed to
around half of the core ination recorded in , are, in fact, also characterised by a
relatively higher degree of persistence. These components are related, in particular, to
the automotive sector, the goods and services associated with housing, and the sectors
mostly connected with leisure, such as restaurants and personal care. The historically
high persistence of price dynamics in these sectors suggests that the future decline
of core ination may be rather gradual. Historical regularities, however, could break
down and favour a faster fall of core ination, as the drop in energy prices, especially
the quotations of natural gas, has been unprecedented, just as its previous rise was.
A faster-than-expected drop may also be led by the items that usually have a larger
elasticity to higher interest rates; there are, indeed, early signs that the ination rate
of these items, in particular durable goods, might have peaked.
Supply factors also continue to exert a dominant role in the expected dynamics
of consumer prices in the euro area, even if the contribution of demand factors is
gaining weight. This is conrmed by a quantication of the structural drivers of
ination expectations, as measured by ination-linked swap (ILS) rates, obtained by
breaking down their daily uctuations into domestic and global shocks.
Results show
that, since the start of the war in Ukraine, the ination rate predicted over a ve-
year horizon has increased mostly in response to supply shocks (Figure ). The much
smaller contribution of demand shocks rose progressively over the course of ,
reecting improved business cycle conditions. Over the last year, expectations seem to
have been contained mostly by the spillover eects of US monetary policy on euro area
ination expectations. Since the second half of , however, the ECB’s monetary
policy tightening is having the desired eects.
Figure 7
Drivers of inflation expectations
Daily data; percentage changes and per cent


















































Source: Hoynck and Rossi (2023).
Note: 5-year ILS rates; changes in the contribution of the drivers with respect to 3 January 2022 (left axis)
and ILS levels (right axis).
4. DID THE ECB MAKE POLICY MISTAKES OR FORECASTING ERRORS? AND
IF SO, WHY?
When discussing the high level of headline ination reached in the euro area, some
commentators have paid less attention to the sudden occurrence of the energy shock,
its size and its persistence, pointing the nger instead at the delays of the central
bank in initiating its monetary tightening.
Critics citing this hypothetical mistake
have also highlighted the large errors in the ination projections made by the ECB/
Eurosystem sta since early  (Figure ).
See Hoynck and Rossi (2023), who decompose the uctuations of ILS rates for both the euro area and the United
States by means of two Bayesian VAR models disentangling the eects of six shocks in each economy: domestic
demand and supply, domestic and foreign monetary policy, a foreign macroeconomic shock and a global risk shock.
An important example, which focuses not only on the ECB but, especially, on the Federal Reserve, is Reis (2022).
Figure 8
ECB/Eurosystem projections errors for euro area headline
inflation
Quarterly data; percentage points
One quarter ahead projection errors
Four quarters ahead projection errors
Source: Bank of Italy and ECB.
Note: dashed lines denote an interval around zero of plus/minus two standard deviations of projection
errors realized in 2003-2020; data for 2023 Q1 are preliminary.
The forecast errors in predicting consumer price changes over the last year were
indeed sizeable and much larger than in the past. Some have even argued that these
substantial errors call into question the very credibility of the ECB, although other
international institutions and private forecasters have made similarly large mistakes.
While the observed size of the errors may understandably cast doubt on the reliability
of the models used for the projections, in the case of Italy the eects of energy prices
– the most important exogenous variables in the forecasting model, whose changes
are usually inferred from the market price of futures contracts – appear to explain,
directly and indirectly (i.e. via their eects on production costs), % of the overall
error made in forecasting ination in  (Delle Monache and Pacella ). This
share rises to % when the eects of food prices, the other volatile component of the
consumer price index, are also taken into account. Similar results are found in the
analysis conducted by the ECB on the forecasts for the euro area as a whole (Chahad
et al. ).
This suggests that, although all models should be (and are) subject to continuous checks
and improvements, the functioning of the economy has not changed dramatically over
the last year. The large forecast errors do draw our attention, however, to the quality
of some of the assumptions for the inputs in the projections.
It must be recognised that the eects of global supply bottlenecks were underestimated,
although demand in the euro area did not contribute greatly to them in any case. The
key problem, however, was the generalised underestimation of the consequences of the
increasing geopolitical tensions. The sharp drop in gas supplies from Russia observed
since early  was in fact (probably mistakenly) attributed at rst to the eects of a
particularly cold winter in Russia and subsequently to the political pressure from the
Russian government to accelerate the opening of the Nord Stream  gas pipeline. The
new shock caused by the Russian invasion of Ukraine in February  dramatically
changed this picture, triggering a sharp rise in volatility and pushing both current and
expected gas prices to extremely high levels, fuelling ination.
It may indeed be argued that an earlier rise in key interest rates might have reduced the
uncertainty regarding ination dynamics and might have more eectively managed
the initial rise in ination expectations. On one hand, this claim is debatable, since it
fails to consider the negative consequences for the economic outlook and, in turn, for
the medium-term ination perspectives of the uncertainty generated by the Russian
invasion, which also needed to be properly evaluated and addressed. On the other, even
assuming that tighter monetary conditions could have reduced the uncertainty around
ination dynamics, it remains highly questionable that a few months’ anticipation in
the actual implementation of the decision to halt asset purchases and start raising
ocial interest rates would have had substantial consequences on the evolution of
consumer prices in the euro area. Indeed, as mentioned, they mostly reected the
increased costs of energy and food.
5. DID THE ECB RESPOND TOO LATE TO THE ACCELERATION IN
CONSUMER PRICES?
The Governing Council of the ECB began the process of monetary ‘normalisation’ at
the end of , when it judged that the progress in economic recovery and towards
the medium-term ination target was sucient to allow for the start of a step-by-step
reduction in the pace of asset purchases. Why did we not start earlier? And why did
we not begin to raise ocial rates before July ?
To answer these questions, it is useful to recall what the ination situation was in June
, when we were about to conclude the ECB strategy review. While in the United
States headline ination was already above % and core ination was .%, pushed
by the demand factors discussed above, in the euro area, despite already higher gas
prices, headline ination was still below % and core ination was less than %. High
ination, therefore, seemed to be a phenomenon mostly concentrated in the United
States. The main problem the Governing Council was facing in that period was still
how to increase the dynamics of consumer prices durably and sustain a rapid re-
anchoring of ination expectations from excessively low levels.
The situation began changing in September , when gas prices went from the
already high level of € per megawatt hour to about € (a ‘supply shock’). At that
time, however, futures quotes predicted gas prices would remain at around that level
during the winter season and then decline very sharply, to well below € by June
. The prediction of declining gas prices implicit in futures contracts remained
more or less unchanged until late December  (Figure ). With such a steep fall
in gas prices in sight, ination could not stay at high levels for long and indeed was
projected to return swiftly to % and below, also in line with the results of the ECB
Survey of Monetary Analysts (Figure ).
Figure 9
Market expectations of natural gas price developments






Source: Refinitiv.
Note: Profiles of Title Transfer Facility (TTF) futures quotations.
Figure 10
Inflation: Eurosystem projections and analysts expectations in
December 2021
Quarterly data; per cent
rf
ttb
tt
Source: ECB and ECB Survey of Monetary Analysts (ECB-SMA).
Note: median expectations in ECB-SMA and central values in Eurosystem staff macroeconomic projections
for the euro area.
As it turned out, instead of declining by more than % as expected at the end of
September , gas prices increased by almost %, averaging an unprecedented
level of € during the summer of  and leading also to a sharp upward revision
in the prices implicit in future contracts. The Russian invasion of Ukraine had
transformed a temporary shock into a persistent one, warranting an acceleration of
the monetary normalisation.
In the early part of , in fact, the process gained speed. However, we managed
to avoid the potentially dangerous cli eects of too sharp a swing in our stance, not
least in view of the major uncertainty caused by the conict in Ukraine. The end of our
purchases was anticipated to  July  and, shortly after, we started raising our key
ocial interest rates by a signicant size, with the aim of frontloading the exit from
their highly accommodative, indeed still negative, levels.
6. HAS THE ECB’S MONETARY POLICY BEEN INEFFECTIVE SO FAR?
It has been argued that, other than responding too late, the ECB’s monetary policy has
not been suciently eective. According to a survey conducted by Bloomberg among
monetary experts in mid-October , the ECB was believed to be ‘behind the curve’
by % of the participants. In March , the same quota was signicantly reduced,
but still remained around %.
However, it is widely agreed that monetary policy aects the real economy, and
ination, with ‘long’ and possibly ‘variable’ lags. While monetary actions and
communications tend to aect nancial markets’ interest rates and asset prices
almost immediately, their transmission to the nancing conditions of households and
businesses and, subsequently, to consumer prices tends to be much more gradual as
economic agents revise their decisions to consume and to invest slowly and, in some
cases, infrequently. The initial conditions of the economy – including the level of debt,
the degree of economic uncertainty and many other domestic and global factors – also
have important consequences for the distribution over time of the eects of a change
in the monetary stance on ination and growth.
Empirical evidence for the euro area shows that, on average, a change in key rates
exerts its largest impact on GDP growth after about  months and its maximum
eect on ination after one to two years.
Therefore, most of the economic impact
of the rate hikes that have been implemented so far is yet to be felt, suggesting that a
degree of prudence is warranted, as their full results are about to be seen.
In fact, the initial eects of our policy measures are already discernible. Following
the March  monetary policy decision, the overall increase of ocial rates since
July  has reached  basis points and has been transmitted fully and smoothly
to market interest rates. From the start of the reduction of monetary accommodation
at the beginning of  until mid-April , one-year risk-free rates (measured by
overnight index swaps) have picked up from negative levels to .%, while ten-year
rates have increased from barely positive values to .%. In real terms, using the rate
of ination implicit in the ILS contracts as a deator, they currently stand at about
.% and .%, respectively, from around -% and -% at the end of  (Figure ).
Figure 11
Real interest rates in the euro area
Per cent
Term structure, spot rates
fr
ntb
Term structure, 1-year forward rates
tb
rb
Source: Bloomberg and Refinitiv.
Note: nominal OIS interest rates deflated by the corresponding ILS rates.
Long-term interest rates started increasing well before our rst key rate hike. This
should not come as a surprise as it is indeed proof of the credibility of our actions and
our commitment to guaranteeing price stability. This evidence also supports my claim
as to the possibly limited eects of initiating the rise in interest rates a few months
earlier, notwithstanding the uncertainties linked to the war.
Further signs of the eectiveness of the Governing Council’s actions are visible in the
evolution of ination expectations, whose levels are an important anchor for wage
dynamics and actual ination. In the euro area, short-term ination expectations
derived from nancial market prices are falling sharply. ILS rates indicate that in
mid-April  the expected ination rate  months ahead stood at .%, down from
a peak of almost % recorded in late August  (Figure ). The initial signs of a
decline in ination expectations are also broadly conrmed by surveys of rms and
households.
For a discussion of the uncertainty surrounding model-based quantication of the impact of interest rate policy in the
euro area, see Lane (2022).
On the role and evolution of ination expectations, see also Visco (2023).
Figure 12
Market-based inflation expectations
Per cent
Inflation-linked swaps, spot rates
(daily data)



Inflation-linked swaps, 1-year forward
rates
tbn
bn
Source: Bloomberg.
At the same time, longer-term expectations, net of risk premia, remain at levels
consistent with our % price stability target, and tail-risks of excessive ination have
receded from the peaks of mid- (Figure ). The anchoring of long-term ination
expectations is also supported by the results of the March ECB Survey of Monetary
Analysts.
Figure 13
Inflation tail risks in the euro area
Daily data; per cent
�p
�p


Source: Bloomberg.
Note: probabilities inferred from inflation options;
1) is the probability of inflation being smaller than
0 (1) on average in the next 5 years;
�3 (
�4) is the probability of inflation being larger than 3 (4) on average
in the next 5 years; 50-days moving averages.
The eectiveness of the monetary tightening is also visible by looking at the impact
on credit and money dynamics (Figure ). On the one hand, the three-month
(annualised) growth of loans to rms in the euro area became negative in January
 (-.% in February), from a peak of almost % in August , while loans to
households also continued to decelerate. On the other hand, M is slowing down
markedly (.% in February  on an annual basis, from .% in September )
and the rate of change of M turned negative in January  (-.% in February, a
historical minimum). When assessed in real terms, the dynamics of both aggregates
are in deeply negative territory and at unprecedented lows.
Figure 14
Credit and money growth in the euro area
Monthly data
Credit to firms
(3-month annualised percentage changes)
M1 and M3
(12-month percentage changes)

Source: ECB.
Overall, this evidence suggests that monetary policy has already started to exert
its impact. In the absence of further shocks, the progressive unfolding of its lagged
eects will further contribute to bringing ination back in line with the medium-term
denition of price stability.
7. SHOULD THE ECB OPT FOR RUNNING THE RISK OF DOING TOO MUCH
RATHER THAN DOING TOO LITTLE?
There is no question that the ECB’s monetary stance must continue to be dened so as
to ensure that a temporary rise in ination caused by a supply shock does not become a
more persistent phenomenon sustained by demand factors. We must observe, however,
that, with risks to medium-term price stability increasing sharply in , the pace
and scale of the adjustment of the ocial interest rates has been unprecedented.
The pace of any further rate hike will continue to be decided on the basis of incoming
data and their impact on the ination outlook. The ECB Governing Council will then
need to nd the right balance between two risks: that of a too-gradual recalibration
doing
too little
), which could cause ination to become entrenched in expectations and
in wage-setting processes, and that of an excessive tightening (
doing
too much
), which
would result in signicant repercussions for economic activity, nancial stability and,
ultimately, medium-term price developments. Consistently with our symmetrical
price stability objective, equal weight should be given to both risks.
On the one hand, ‘doing too little’ would come at a cost for the economy if this were
to lead to the need for a stronger and more prolonged restriction of monetary policy
in the future. On the other hand, the costs associated to the opposite risk may be
relevant if ‘doing too much’ were to determine an undershooting of the target and
possibly even lead to serious debt-deation phenomena, triggering nonlinear perilous
amplications. In the face of both of these risks, the central bank decisions should
continue to be characterised by wisdom and guided by careful quantitative evaluations
of incoming data. As testimony to its belief in this view, the Governing Council at its
March meeting reiterated the importance of a data-dependent approach to future
policy rate decisions, taking into account the elevated level of economic uncertainty,
recently heightened by nancial market tensions.
High uncertainty further strengthens the case for conducting monetary policy
cautiously. Indeed, the time-honoured Brainard principle states that when the central
bank is uncertain about the eects of its actions, it should move conservatively (Brainard
). An exception to this principle is the case of uncertainty around the persistence
of ination. When persistence is high, in fact, a strong monetary reaction may be
required to avoid high ination becoming entrenched in agents’ mindsets (Ferrero et
al. ). While this possibility should be carefully monitored, data on market- and
survey-based ination expectations – including their recent decline at short horizons
and their decreasing prole
call into question the persistence of ination at high
levels in the euro area, reinforcing the arguments in favour of gradual monetary
tightening (and here I would like to emphasise the dierence between a gradual and
patient tightening of the monetary policy stance to full the price stability mandate
and a complacent approach with respect to the risk of second-round eects that may
follow a prolonged supply shock).
Similar indications come from the considerable,
albeit volatile, deceleration of prices on a three-month annualised basis with respect
to early  (Figure ).
Going forward, a gradual fading away of the eects of the past shocks as well as of
the measures of underlying ination will be crucial. In any case, when tackling high
ination, a recession is not always inevitable. Communicating a strong commitment
to bringing ination down to target in a speedy manner is fundamental, but doing so
minimising the costs for the real economy is no less important.
Figure 15
Inflation (three-month annualised percentage changes)
Monthly data; 3-month annualised percentage changes


Source: ECB and US Bureau of Labor Statistics.
Note: EA denotes the euro area; seasonally adjusted data.
8. SHOULD THE ECB BE PARTICULARLY CONCERNED ABOUT RISKS
TO FINANCIAL STABILITY? ARE THERE RISKS OF AN EXCESSIVE
CONTRACTION OF CREDIT TO THE NON-FINANCIAL SECTOR?
The crisis episodes of the last two decades have clearly conrmed that macroeconomic
and nancial stability are closely intertwined. On the one hand, nancial imbalances,
if not identied and curbed in a timely manner, can end up jeopardising economic
growth and price stability; on the other hand, macroeconomic stability is a necessary
condition for the smooth functioning of the nancial system.
For these reasons, although monetary authorities are usually assigned the sole objective
of ensuring monetary and macroeconomic stability, when dening the boundaries
of their activities they must also take account of the risk that large and persistent
nancial disruptions may endanger the achievement of their main objective. This is
not nancial dominance, but the awareness of the impact that nancial stability may
have on price stability.
For what may be seen as a somewhat dierent view, see Brunnermeier (2023).
See also Visco (2014).
Particularly at the current juncture, risks to nancial stability are not negligible and
require a good dose of caution. Indeed, the unprecedented and simultaneous hikes of
ocial rates in many countries could create unexpected spillover eects that, although
dicult to quantify, may not be insignicant.
The cases of Silicon Valley Bank and Credit Suisse are clearly rooted in the poor
management of the respective businesses; they show how important sound regulation
and close monitoring of exposures are, especially when it comes to interest rates
and liquidity risks. That said, the high tensions raised by the failure of these two
banks are yet another conrmation of how quickly condence in nancial markets
can weaken and, if not countered appropriately, how easily localised phenomena
of nancial instability can assume a global dimension. Blows to condence may, in
turn, be exacerbated by the high speed with which news, and not always trustworthy
news, is spread, enabled by modern technology and social media. Importantly, these
considerations apply not only to the banking system but also to non-bank nancial
institutions, which, compared to banks, are subject to less stringent regulatory and
supervisory requirements and do not have access to central bank emergency liquidity
assistance.
In the euro area, the banking system today is in better shape than it was before the
global nancial crisis. The reforms that have been introduced since then have been
eective in strengthening their balance sheets and their ability to provide credit, even
in a challenging macroeconomic environment. These considerations notwithstanding,
a close monitoring of the risks of nancial amplication eects is warranted.
As I already mentioned, credit and money dynamics have signicantly weakened
in the recent months. Although this is the natural (and desired) consequence of
monetary normalisation, both the size and speed of these trends suggest we must move
with caution. This observation is all the more relevant if we consider the lags of the
monetary policy transmission process and take account of the signicant tightening
in credit supply conditions heralded by the last Bank Lending Survey (Figure ).
Figure 16
Credit supply conditions in the euro area (Bank Lending Survey)
Quarterly data; percentage balance
Source: ECB Bank Lending Survey.
Note: net percentages of euro-area banks reporting a tightening of credit standards.
Against this background, a full-blown credit crunch
which, while originating outside
the euro area, could be amplied by an increase in banks’ funding costs as well as
by fears about the sustainability of debt by households and businesses in the face of
rising rates
should be avoided by any means. This concern is particularly relevant
in the Economic and Monetary Union, whose incomplete architecture – especially
its decentralised scal policy and the delays in completing the banking and capital
markets unions – exposes it to a possible fragmentation of nancial markets along
national borders.
Central banks have tools at their disposal to deal with potential stress in the nancial
system without substantially deviating from the objective of bringing ination back
to target. However, nancial tensions always have unpredictable consequences. In
order to prevent them, it is important to adopt a cautious approach, closely monitoring
nancial conditions and ne-tuning them to the needs of the economy, being careful
to prevent both an excessive monetary tightening as well as an excessive loosening.
9. LOOKING FORWARD, WHAT COULD BE THE MAIN OBSTACLES
TO ACHIEVING THE RETURN OF INFLATION TO ITS MEDIUM-TERM
OBJECTIVE? WHAT VARIABLES COULD BE ESPECIALLY SIGNIFICANT?
So far, ination expectations are well-anchored and the ECB forecasts point to a
substantial achievement of the ination target over the medium term. While the
ECB Governing Council’s commitment to bringing ination back to its medium-term
objective is unquestionable, it should also be recalled that the ght against ination
does not rely solely upon the implementation of appropriate monetary policies. In fact,
monetary policy should not be, and nor should it be perceived as being, the only game
in town. The return to price stability will, in particular, be swifter and less costly
if scal policies, wage requests and rms’ pricing strategies all operate in the same
direction as monetary policy.
Looking forward, the main obstacles to ination-reducing action in the euro area
may derive from inappropriate behaviour of other actors involved, which could lead
to second-round eects. From this perspective, wage negotiations should not go
back in time to when they were purely backward-looking; any attempt to make wage
dynamics catch up with those of consumer prices induced by higher energy costs will
only result in a price–wage spiral. Making up for the loss of purchasing power must
instead rely on achieving sustained productivity growth. As I pointed out earlier, in
spite of requests for sizeable wage increases in some countries, so far wage growth
remains, on average, relatively moderate.
At the same time, the pricing strategies of businesses will play a central role. In
particular, we have to closely monitor whether the pass-through of the higher energy
costs observed in  will work in reverse, with producer prices reecting the
most recent cost declines, a key step to achieving a durable reduction of underlying
ination. This involves estimating rms’ mark-ups, an extremely dicult task due to
measurement problems. Many national statistical oces, for example, do not provide
these variables at macro level, while timely and representative data on rm balance
sheets are not usually available. These methodological limitations reinforce the need
for a cautious approach.
Preliminary evidence for Italy indicates that, after some adjustment due to the
pandemic, in the last quarter of  prot margins had returned to their pre-
pandemic levels in almost all sectors (Figure ), suggesting that no particular price
pressures should be expected from rms. Data from Germany, instead, show that
prot margins in , while remaining constant in manufacturing and in other
industries, increased considerably in constructions and in some services (such as
retail, accommodation, and transport). While these sectors account for a limited
share of Germany’s GDP (around % in total in ), this evidence may signal that
price pressures may be building in non-tradeable sectors, which are mostly sheltered
from international competition.
Figure 17
Estimates of mark-ups for Germany and Italy
Annual and quarterly data; 2018 and 2018Q4 = 1
Germany
rfn
tbfb
f
Italy



rfrnt
bn
n
Source: Destatis and Istat.
Note: industry includes energy; services include retail, accommodation and transportation.
Finally, although targeted and temporary scal measures to alleviate the burden on
more severely hit households and rms should obviously continue if necessary, their
nancing should not put the progressive reduction of public debt at risk and should
therefore avoid further increasing its burden on the future generations. This is crucial
not only to restore the necessary conditions for robust and lasting growth, but also to
guarantee a timely return to the price stability target, an outcome that would be more
dicult and costly to achieve in the event of excessive government transfers.
With the appropriate contributions from workers, rms and national governments,
monetary policy will succeed in bringing ination down to the ECB’s medium-
term target, as currently envisaged. However, we must continue to closely monitor
developments in all the variables that may trigger second-round eects. A meeting-by-
meeting, data-dependent and cautious approach remains the best strategy.
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ABOUT THE AUTHOR
IGNAZIO VISCO
, Governor of the Bank of Italy since 2011, started his career at
the Bank in 1972 and was appointed Head of the Research Department in 1990.
From 1997 to 2002 he was Chief Economist and Director of the Economic
Department of the Organisation for Economic Co-operation and Development.
He has a Ph.D. in Economics from the University of Pennsylvania and is the
author of various articles and books including:
Price Expectations in Rising
Inflation
, North Holland, 1984;
Saving and the Accumulation of Wealth
(ed. with
A. Ando and L. Guiso), Cambridge University Press, 1994;
L’economia italiana
(with L. F. Signorini), il Mulino, 2002;
Investire in conoscenza
, il Mulino, 2014;
Perché i tempi stanno cambiando
, il Mulino, 2015;
Anni difficili
, il Mulino, 2018;
Inflazione e politica monetaria
, Laterza, forthcoming.
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CEPR POLICY INSIGHT No. 122
April 2023
CEPR POLICY INSIGHT No. 122
April 2023