Stagflation

SPEECH

The price of uncertainty and uncertainty about prices: monetary policy in the post-COVID-19 economy

Keynote speech by Fabio Panetta at a Capital Markets webinar organised by the European Investment Bank and the European Stability Mechanism

• Policymakers need nonetheless to form a view on the balance of risks in the economy.
• This is essential to communicate their reaction function, to decide how to act today and to influence expectations about tomorrow.
• Demonstrating to the public that macroeconomic policies are in control is crucial in conditions of high uncertainty.
• This imperative has guided the ECBs response to the crisis, and Europes response more broadly.

The uncertain economic outlook

• As a result, the euro area has so far weathered the consequences of the shock about as well as could be expected.
• Recent survey data suggest that the economy may have bottomed out and we are already seeing tentative signs of recovery.
• Moreover, recent PMI releases only signal a stabilisation or improvement in the rate of contraction of activity from the very low levels reached in April.
• Our baseline scenario sees the economy broadly returning to its pre-crisis level of output by the end of 2022.
• [2] Likewise, survey data indicate that uncertainty about the outlook for inflation over the medium term remains elevated (Chart 2).
• I see three main risks to growth and inflation that warrant a cautious outlook.
• [6] These second-round domestic risks to the economic outlook could in turn be exacerbated by the third factor, which is heightened uncertainty and its effect on investment and consumption.
• [8] Such effects typically diminish only slowly, because firms and households need to be convinced that the shock was a tail event.
• [9] As a result, the consequences of the COVID-19 crisis will likely be more persistent than those of standard recessions.

Demand- and supply-side forces on inflation

• For monetary policymakers, the key question in this environment is what impact these developments will have on medium-term inflation.
• ECB research finds that in a situation of labour market disruptions, heightened uncertainty and financial amplification, inflation would be 0.8 percentage points lower by 2022 than under the pre-crisis macroeconomic outlook.
• Looking at the fundamental determinants of inflation, the euro area economy entered the crisis with a widening output gap and inflation hovering around 1%; inflation expectations were at historically low levels.
• The correlation between inflation and economic activity had markedly decreased (i.e.
• [15] In other words, faced with a large negative supply shock, the forces that have been holding back inflation over the last decade would likely continue to do so.
• And, in fact, these dampening forces might even be strengthened insofar as COVID-19 triggers feedback loops from supply to demand.
• [18] But inflation can also be affected by one-off structural factors that emerge gradually and therefore have persistent effects on prices.
• [20] And the impact of COVID-19 on digitalisation could contain inflation through several channels.
• This could have a meaningful impact in countries such as Germany, where rents make up close to 15% of core inflation and have added 0.2 percentage points to inflation on average since 1999.
• Financial markets agree with this view: five-year forward five-year ahead inflation swaps are currently trading at around 1.1%.

Policy responses under uncertainty

• To start with, heightened uncertainty increases the likelihood that the economy could shift between multiple equilibria, including a scenario of protracted low growth, low employment and low inflation.
• In these conditions, providing policy certainty through forceful actions becomes critical.
• Likewise with net private and public debt issuance in the euro area expected to increase dramatically in the coming years financial market dynamics rest heavily on confidence in the overall policy mix.
• [27] Yet another important reason for forceful monetary policy measures is the high degree of complementarity among macroeconomic policies today.
• It is clear that monetary policy cannot be the only force countering the shock.
• This is partly due to the asymmetry of monetary tools in dealing with downside risks when policy rates are close to their effective lower bound.
• [28] In this environment, monetary policy needs to act proactively to prevent fragmentation of financing conditions, as in doing so we create the conditions for underpinning aggregate demand.
• By acting vigorously to avert financial fragmentation, the ECB has made its credit support policies more effective, allowing the transmission of monetary policy to regain traction faster.

Conclusion

• London, 27 February 2020 We are currently living through times of tremendous challenges for the conduct of monetary policy.
• Although the actions of major central banks over the past few years have succeeded in easing financial conditions and thereby stabilising growth and inflation, current and expected inflation rates remain stubbornly below target, in spite of years of exceptional monetary policy support.
• Subdued price pressures have given rise to widespread scepticism about the ability of monetary policy to bring inflation back to target.
• Communication on the factors affecting the length of the medium term increases the publics understanding of the ECBs monetary policy, thereby also reducing the risks of a destabilisation of inflation expectations.

A shock-dependant monetary policy

• In calibrating monetary policy, central banks typically distinguish between two broad types of shocks affecting the inflation outlook.
• Such demand shocks typically call for determined policy action.
• To minimise volatility in economic activity, supply shocks therefore usually require a smoother and more protracted policy response.
• In reality, of course, economies are constantly hit by a wide variety of shocks, and central banks often have only a limited understanding of the precise configuration of the forces pushing inflation in either direction, which complicates the conduct of monetary policy.
• Today I will focus on other, more slow-moving structural factors that may influence the transmission of monetary policy to inflation.
• I will start from the question as to why inflation has not seen more persistent upward pressure despite years of exceptional monetary stimulus.
• Chart 1 Unconventional policy instruments had considerable positive impact


A second hypothesis is that economic slack may still be larger than conventional indicators suggest. Estimates by international organisations suggest that slack in the euro area has diminished measurably over the past few years and that, by and large, the output gap in the euro area has closed. Chart 2 a Uncertainty over the remaining degree of economic slack… Euro area output gap (in percent of potential output)
Alternative measures of the output gap paint a different picture, however. Chart 2 b Uncertainty over the remaining degree of economic slack… Euro area output gap (in percent of potential output)

• Clearly, this measure would point to continued substantial slack in the euro area economy.
• The first is that they reverse engineer that is, inflation, or the lack thereof, is always and everywhere attributed to economic slack.
• And the second caveat is that they are difficult to reconcile with both survey-based and hard data-based indicators of slack in the labour market, which even point to growing signs of labour shortages.
• Importantly, improvements in the labour market have not been confined to headline unemployment.
• Over the past few years we have observed a marked decline in the number of discouraged workers and underemployed part-time workers (Slide 3, left panel).
• ECB estimates suggest that current broad labour market conditions do not differ much from those observed just before the outbreak of the global financial crisis.
• At the same time, however, these estimates currently leave a large part of underlying inflation unexplained.
• It is possible that these residuals reflect measurement errors, for example regarding economic slack.
• But they may also reflect, at least in part, other structural factors that are more difficult to identify and quantify.
• Chart 5 a Supply shocks likely contributed to decline in market-based inflation expectations Drivers of developments in the 10-year euro area inflation-linked swap (% p.a., cumulative changes)
• But you can also see that a substantial part of the cumulative decline in inflation expectations may be due to supply-side factors.
• Indeed, in the hypothetical absence of these supply-side shocks, ten-year inflation-linked swaps could currently be trading at levels much closer to 2%.
• Chart 5 b Supply shocks likely contributed to decline in market-based inflation expectations Counterfactual path of the 10-year euro area inflation-linked swap in the absence of supply-side drivers (percentages per annum)
• These shocks are likely to reflect a variety of structural factors which may differ as to how, and to what extent, they affect inflation over time.
• I would like to discuss two such structural factors and their potential implications for the ECBs medium-term horizon.
• And the second factor relates to the pricing behaviour of firms and their ability to buffer cost-push shocks through changes in their profit margins.

The changing role of energy in inflation dynamics

The rise in energy prices was a prime contributor to euro area HICP inflation before the outbreak of the global financial crisis. Chart 6 Marked fall in the contribution of energy to headline inflation Shares of the main HICP aggregates in average HICP inflation (percentage)
• So the measurable and persistent decline in the contribution of energy prices to inflation has been one major source of low inflation in recent years.
• What is less clear, however, are the causes of the fall in the contribution of energy price inflation and whether the effects can be expected to persist in the future.
• Energy inflation has so far been predominantly driven by the price of oil, which fluctuates in line with supply and demand.
• Chart 7 a Overhang in oil inventories weighing on oil prices Oil price decomposition (cumulative contributions to changes in oil price since January 2010; oil price in USD per barrel)


Another way to see this is to consider the strong surge in oil inventories among OECD countries. Chart 7 b Overhang in oil inventories weighing on oil prices OECD oil inventories and oil price (lhs: billion barrels, rhs: USD per barrel, inverted)

• Oil inventories typically correlate closely, and negatively, with oil prices.
• Over this period, the United States has emerged as the largest oil producer in the world, and it now accounts for nearly one-fifth of total global oil output.
• [2] Chart 8 a Shale oil break-even prices may anchor oil price expectations Market share of major oil producers (percent)
• Over recent years, we have observed an interesting correlation between future expected oil prices and the evolution of the break-even price of shale oil producers, i.e.
• the price above which it becomes profitable to exploit new sources of shale oil.
• [3] Chart 8 b Shale oil break-even prices may anchor oil price expectations Oil production break-evens and long-term oil price expectations (USD per barrel)
• Whether or not the oil supply has indeed become more elastic, and may therefore permanently reduce the upside contribution of energy to headline inflation, is, ultimately, an empirical question.
• For example, between 1990 and 2018, global oil intensity total oil consumption per unit of gross domestic product fell by 25%.
• Chart 9 a Global economy more resilient to oil price shocks Oil intensity (oil consumption (mbd) per GDP in constant prices)


ECB staff analysis suggests that, as a result, a supply-induced increase in oil prices today causes global industrial production to contract by only around half as much as it did during the 1990s and 2000s. Chart 9 b Global economy more resilient to oil price shocks Response of global industrial production to oil supply shocks (impulse responses to shock after 48 months; median and 15th and 85th percentiles, percentage points)

• These trends could even intensify in the future in the course of the ongoing energy transition.
• [5] In the European Union, for example, the objective is to further reduce energy consumption by one-third by 2030, and to increase the use of renewable energy sources.
• [6] If successful, this would further mitigate the pass-through of potential oil price fluctuations to production and, hence, underlying inflation.
• [7] Moreover, if more fundamental progress is achieved in terms of energy storage, the marginal cost of producing renewable energy may become considerably lower and more stable compared with the production of fossil fuels.
• This could much more fundamentally transform the role of energy in affecting overall price dynamics.

The role of profits in the transmission of monetary policy

• The second structural factor that I would like to discuss today relates to the role of profit margins in affecting inflation outcomes and the transmission of monetary policy.
• It is well-known that many firms routinely absorb short-term fluctuations in demand, exchange rates or production costs in their profit margins.
• Chart 10 a Variations in profit margins affect inflation dynamics GDP deflator and components (annual percentage changes, pp contributions)


A model-based assessment by ECB staff shows that demand shocks – both domestic and foreign – and changes in oil prices are prime sources of fluctuations in profit margins. Chart 10 b Variations in profit margins affect inflation dynamics Structural decomposition of unit profits (deviations from mean in y-o-y terms and pp contributions)

• My starting point for answering this question is the evolution of the profit share over time.
• You can see that the profit share has increased substantially, both in the euro area and the United States.
• [9] Chart 11 a Structural rise in profit share and number of highly profitable firms Profit shares in the euro area and the United States (percentages)
• It has rather been a gradual and persistent increase that only came to a halt with the outbreak of the global financial crisis in 2008.
• But microdata corroborate the view that aggregate profitability is likely to have increased structurally over time.
• [10] Chart 11 b Structural rise in profit share and number of highly profitable firms Profitability of firms in the euro area (percentage of firms)
• Two broad competing hypotheses have been proposed in the literature to explain the rise in profits, mainly for the case of the United States.
• One is that growing profits are the result of the rise of highly productive superstar firms.
• The other hypothesis, which is less favourable, is that a gradual decline in competition and increased regulation has protected rent-seeking firms.
• I will rather focus on what the rise in profits may imply for the pass-through of monetary policy to inflation.
• Rising profits imply a lower labour share, so changes in labour costs have less direct impact on inflation than they did two or three decades ago.
• This does not mean that the pass-through of changes in demand and production costs to final consumer prices is generally impaired.
• Rather, it means that the lags with which they are transmitted may be longer and more variable.
• ECB research indeed confirms that the role of profits may have changed more fundamentally over time.
• [14] Chart 13 Changing the role of profits in absorbing wage shocks
• According to this research, profits only started to take on a measurable buffering role over the past 20 years.
• In the 1970s, by contrast, profits even slightly increased in the face of a labour cost-push shock.
• It could thus have contributed to the changing role of margins in the propagation of cost-push shocks.
• For central banks, this means that the effects of monetary policy may, at times, take longer to show through in underlying inflation, in particular in periods of elevated uncertainty.
• It also means that profit margins may currently operate like a benign supply-side shock: they lift output but they suppress inflation.


And this supply-side nature of changes in profit margins implies that the policy-relevant horizon over which policymakers should steer inflation back to their aim is longer than it would have been in the absence of such structural changes, similar to the effects of the shale oil revolution.

Conclusion

• Services price inflation tends to be much higher than non-energy goods price inflation.
• Against this background, this box reviews some of the features and sources of the gap between services price inflation and non-energy industrial goods price inflation in the euro area.
• [1] The gap between services price inflation and goods price inflation has narrowed in the period following the financial crisis.
• Since 1999, HICP services price inflation in the euro area has been, on average, 1.9%, whereas non-energy industrial goods price inflation has been about 0.6%.
• The narrower gap reflects a larger decline in average services price inflation (2.3% to 1.5%) than in average non-energy industrial goods price inflation (0.7% to 0.5%) from the first period to the next.
• It is therefore likely that the larger decline in services price inflation than in non-energy industrial goods price inflation has to some extent reflected the weaker demand conditions in the euro area after the crisis.
• Chart A Services and goods price inflation and the gap between the two (annual percentage changes and percentage points)

• The decline in services and non-energy industrial goods price inflation is fairly broad based in terms of the respective sub-components.
• [2] With the exception of communication services, all sub-components have recorded lower average contributions to services and non-energy industrial goods price inflation in the post-crisis period than previously (see Chart B).
• The less negative average inflation rate for communication services is, to a large extent, accounted for by a less pronounced trend decline in the price of telephone services and equipment.
• Lower rent inflation has been the main driver of the decline in the contribution from housing services inflation.
• The decrease in the contribution from non-durable goods has reflected price developments in different goods, especially those for personal care.
• Chart B Average contributions of the respective sub-components to services and goods price inflation rates (percentage points)

• Wages and productivity are typically seen as some of the main general factors behind the gap between services price inflation and goods price inflation.
• A high wage growth relative to productivity growth in the services sector is in line with the Balassa-Samuelson effect, whereby the relatively high wage growth in the manufacturing and tradable goods sectors spills over to the market services sector with its non-tradable goods.
• The importance of wage growth in determining services price increases is strengthened by the different cost structure of the two sectors.
• [4] Looking at the synthesis of wages and productivity in terms of unit labour cost growth, the decline in the gap between services price inflation and goods price inflation in the post-crisis period has coincided with the corresponding decline in the gap between the unit labour cost growth of the two sectors.