Thread by @Isabel_Schnabel

In my speech @Ambrosetti_ on “Managing policy trade-offs”, I discuss the response of monetary policy to the contractionary supply shock caused by Russia’s invasion of Ukraine, and what role fiscal policy can play in macroeconomic stabilisation. #Finance2022 1/16

https://twitter.com/ecb/status/1510173468154806273

Thanks to the response of fiscal and monetary policy during the pandemic, the euro area was on track for one of the fastest recoveries in history before the invasion: from trough to peak, euro area real GDP expanded by 17.5% until year-end 2021. 2/16

In terms of the level of GDP, the euro area is still lagging behind the US due to the much stronger hit to activity in the pandemic. The war will measurably slow the pace of the recovery and lift inflation further away from our target, and for a longer period. 3/16

The appropriate policy response depends on the persistence of the shock. While part of current inflation will vanish over time, a considerable part is likely to prove more persistent, for three reasons: pipeline pressures, structural shocks and wage catch-up. 4/16

First, producer prices in the euro area are increasing at an unprecedented pace, much stronger than elsewhere, affecting consumer prices over a long time. An IMF analysis finds that pipeline pressures are driven by both aggregate demand and supply. 5/16

Second, structural shocks are turning inflationary. The war and the pandemic are accelerating reshoring, thereby loosening the previous brake that globalisation had put on wages and inflation. The energy transition will add to upward price pressures over the medium term. 6/16

Third, job retention schemes are delaying wage adjustments by reducing labour market churn. High inflation and an increasingly tight labour market will likely lead to a staggered and possibly longer-lasting increase in wages, even if the recovery slows. 7/16

The question is whether the impact of the war on demand is sufficiently strong and long-lasting to offset these forces. Expected output remains robust, while surveys paint a mixed picture: large uncertainty over the medium run and a more modest impact in the near term. 8/16

Financial markets remain sanguine about the economy’s capacity to generate inflation in line with our target. Inflation risk premia are even rising, and actual inflation is increasingly influencing forecasters’ beliefs about future inflation. 9/16

By showing resolve, monetary policy can break this dynamic and reduce the trade-off between stabilising output and inflation. Credibility is vital for monetary policy. Therefore, we will continue the path of policy normalisation, subject to optionality and data dependency. 10/16

As monetary policy is focused on preserving price stability and anchoring inflation expectations, the headwinds to growth can be buffered by fiscal policy. Unless the economic situation deteriorates markedly, current circumstances call for targeted support, for two reasons. 11/16

First, monetary policy remains highly accommodative. The real interest rate in three years’ time, which matters for consumption and investment, remains in deep negative territory, with monetary policy far from becoming restrictive for growth and employment. 12/16

Second, euro area governments face a trade-off themselves: between business cycle stabilisation and debt sustainability. Debt has increased materially as a result of the pandemic and fiscal deficits remain sizeable. 13/16

Fiscal policy should prioritise spending on investments that will raise productivity and potential output, especially in the area of the energy transition. Moreover, governments should provide targeted support to the most vulnerable groups. 14/16

Fiscal measures will compensate for a part of the estimated impact of the war on aggregate demand. Coordinated action at European level could complement national initiatives, jointly shouldering the costs from protecting our fundamental values. 15/16

An appropriate policy mix, with monetary policy countering the rise in inflation and fiscal policy countering the drop in aggregate demand in a targeted manner, will be decisive for fostering social cohesion, protecting people’s purchasing power and sustaining the recovery. 16/16

A warm thank you to @ValerioDeMolli and his team for a fantastic conference with stimulating discussions at a beautiful location! Thanks also to my excellent co-panelists and moderator! @COdendahl @PaoloGentiloni @pierremoscovici @guerreraf72