High Inflation and Monetary Policy: Where Do We Go from Here

Is the current policy stance of the European Central Bank appropriate to combat inflation? What are the main challenges that the ECB and central banks will face in the short and in the long run, including financial stability? These questions have been addressed in the IGIER policy seminar "Rethinking Monetary Policy?", held at Bocconi University on 17 March 2023. The seminar saw three distinguished speakers: Professors Lucrezia Reichlin (London Business School), Jordi Galì (Centre de Recerca en Economia Internacional, Universitat Pompeu Fabra), and Director General of Monetary Policy Massimo Rostagno (European Central Bank). The discussion was moderated by Professor Tommaso Monacelli (Bocconi University, IGIER).

Panelists started by explaining the causes of growing inflation. Two main drivers were discussed: the surge in energy prices, especially given the geopolitical uncertainty stemmed from the war in Ukraine, and the process of normalisation of the economy after the COVID-19 pandemic, which caused a surge in demand that has not been entirely met by supply. This resulted also in bottlenecks in supply chains and a pass-through of higher energy prices to other inputs in the production of final goods and services. In fact, one of the key takeaways of the event is precisely that, being energy "a pervasive input in all industries", this inflationary episode has manifested in the form of staggered relative price adjustments of sectoral inflation after the initial energy price shock.

The common response given by most central banks, including the European Central Bank and the Federal Reserve, has been - with some differences - to adopt a contractionary monetary policy stance starting from July 2022, implemented through an increase in interest rates and the start of a process of normalisation of monetary policy, that has seen rates move away from the zero lower bound (ZLB) after a decade of low and stable inflation, anchored throughout to the 2% medium-term target.

In the face of rising rates, one of the most complex questions to answer is thus: Is current monetary policy too tight or too loose? The panelists presented different views: on the one hand, Galì argued that tightening monetary policy is essential and should continue if inflation is to be brought back on track around its target, and the risk of a too loose monetary policy would imply suffering the costs of higher inflation for longer. On the other hand, Reichlin pointed out that a too tight monetary policy could generate inefficient recessions and potentially undermine the stability of the banking sector.

Rostagno gave an overview of ECB current policy. In particular, he argued that the 1970s inflationary episode, also caused by an oil price shock, could teach us a valuable lesson. However, we cannot expect the Volcker's disinflation strategy pursued back then to be perfectly replicable today. First of all, both the COVID-19 pandemic and the Ukraine war are unprecedented events, which are difficult to model accurately and quickly be incorporated in the forecasting exercises conducted by central banks and other significant institutions, that are crucial to formulate an effective response. Furthermore, compared to the 1970s episode, the economy is coming from a decade of low and stable inflation, with interest rates remaining for many years close to the ZLB. At the same time, the arsenal of central banks has expanded considerably, combining tools of conventional monetary policy, namely the policy rate corridor system, with more unconventional instruments, such as balance sheet policies and forward guidance. This most likely constitutes an advantage for central banks that can combine different tools to tune in the economy and steer rates in the desired direction in order to rein in inflation and achieve price stability. The challenge for central banks would be, thus, to find some sort of "bliss point" where the combination of instruments will deliver the most desirable outcome, while avoiding the risk of a too deep or prolonged recession.

Another important difference to take into account is that ever since the Great Recession of 2008, central banks have been operating in an environment of ample reserves and intend to keep it that way. Any process of normalisation, including quantitative tightening, cannot be implemented too fast, and liquidity demand by the banking sector shall continue to be met, to dodge the bullet of a liquidity crisis.

Galì added to this that the problem becomes even more multi-faceted if we add the analysis of the underlying structural changes that the economy is undergoing. The slow downward movement of the equilibrium real interest rate over time might call for an upward revision of the inflation target in the medium-long run by central banks, to avoid that the zero lower bound is systematically hit.

All this considered, it is also crucial to understand that central banks might lack room for action, as there are factors not under the direct control of monetary policy; by contrast, a coordinated action between monetary and fiscal policy might have better chances at restoring the status quo ante inflation, despite the fact that on several occasions monetary and fiscal objectives might be going in opposite directions.

Thus, we come to our final consideration: if the debate is not settled, how can we expect that the high inflation episode will run its course? The best recipe for central banks seems to be one that pays close attention to the data, perfecting how economic factors are measured and what assumptions are included in forecasting models, in order to make ever more accurate projections to support the active decision-making process. This, combined with a system of shared responsibilities, appears to be the strategy to win the inflation game.