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Concluding remarks by Director Ana Paula Serra at "Economia Viva 2022"

Concluding remarks1

 

First of all, I would like to thank the “Nova Economics Club” and “Nova Student’s Union” for inviting me to the closing ceremony of the 2022 edition of Economia Viva.  It is also a pleasure to be back to a much warmer, face-to-face format, in this beautiful campus. 

Economia Viva has set itself as one of the top conference cycles in Portugal fully organized by students. It is a very good example of how universities can promote events that empower the young generations with leadership thought to intervene in central society debates.

Over this week, important topical economic and political issues for our common future as European citizens were discussed, with fruitful and lively debates delivered by notable speakers.

The future of monetary policy, challenges ahead for European integration, education and fight against inequality are undoubtedly concerns, not only for academics and policy makers but also for citizens and companies.

For all that, I want to congratulate the Nova students and all those who made this event possible. 

As a central banker, and not surprisingly, I will focus my brief intervention on “monetary policy”, which was one of the subjects of this conference. 

More specifically, I will very briefly speak about the monetary policy strategy review that Eurosystem concluded in July 2021 and some of the decisions taken afterwards.

 

1. Why was a review of the Eurosystem monetary policy strategy needed in the first place? 

Since 2003, when the last review of the Eurosystem monetary policy strategy was done, the world and the euro area have seen major changes and, and I would dare to say, even disruptive transformation. These changes present numerous new challenges to central banks. These are:

  • Structural developments have lowered the equilibrium real interest  rate in the euro area (and globally). 
  • Declining trend economic growth, due to slowing productivity and an ageing population, as well as persistently higher demand for safe and liquid assets in the wake of the global financial crisis, in mature and emerging markets, have driven the equilibrium real interest rates down;
  • The decline in the equilibrium real interest rate has reduced the scope for the ECB to ease monetary policy by conventional instruments - interest rates - in the face of disinflationary shocks. Thus, addressing low inflation has proved to be very different and challenging from addressing high inflation; 
  • In addition to the decline in the equilibrium real interest rate, the world has changed in other ways that have influenced the euro area economy and the environment in which monetary policy operates; 
  • Globalisation and digitalisation influence the structure of the markets for goods, services and labour and have a direct effect on prices that may affect inflation beyond the short term; the recent pandemic has acelerated these trends.
  • Changing financial market structures. The rise in financial intermediation via the non-bank sector have altered the transmission mechanism of monetary policy;
  • The institutional architecture of the euro area has also undergone substantial reform since 2003, but remains incomplete. Further steps in the banking union, capital markets and fiscal union are still pending. 
  • Climate change – the greatest challenge facing humankind this century – and related mitigation policies, in particular greening and decarbonising policies, alter the structure and dynamics of the economy and the financial system, thus affecting price stability; 
  • The communications landscape has also changed significantly, with rising importance of direct channels of communication such as social media and increasing public demand for scrutiny and transparency.

During approximately 18 months, the strategy review gave rise, allow me say, to a rather stimulating debate among academics, market participants and other observers and within the Eurosystem. Staff members from the ECB and national central banks collaborated closely to jointly produce analysis to support the debates. The general public and civil society organisations have also participated, sharing their views in the listening events hosted by the Eurosystem. 

Banco de Portugal contributed significantly to this exercise. The analytical work developed by the Bank in this context was published in an e-book. We also organised three listening events, with academia, civil society organizations and journalists, to take into account Portuguese citizens opinions and worries in the debate. 

 

2. What have been the main changes of the new strategy? 

  • The new strategy implements the price stability objective in terms of a clear and symmetric target: a 2% inflation target over the medium term. Symmetry means that negative and positive deviations from this target are equally undesirable;
  • The new strategy confirmed that the interest rates remain the primary monetary policy instrument. However, other instruments that over the past decade have been used to mitigate the limitations generated by the lower bound on nominal interest rates, will remain an integral part of the ECB’s toolkit;
  • The new strategy also explicitly takes into account the implications of climate change and the carbon transition. This means that, the Eurosystem will further expand the analytical capacity in macroeconomic modelling and develop statistical indicators and new tools to assess the implications of climate change for monetary policy transmission and price stability. The Eurosystem will also introduce environmental sustainability disclosure requirements for eligibility for collateral and asset purchases; and adapt its risk assessment framework, corporate sector asset purchases and the collateral framework to account for increased risks driven by climate change. 
  • The new strategy will involve a redesign of the communication with the general public to improve understanding and trust on our actions. This means simpler and more accessible messages and increasingly closer communication with stakeholders.

3. Monetary policy decisions taken after the new strategy was announced

  • To support the symmetric inflation target of 2% over the medium term agreed in the strategy review, the Governing Council adapted its forward guidance on interest rates. According to the new guidance announced in July 2021, the ECB will consider raising interest rates only when three conditions are met:
  • First, if inflation reaches 2% well ahead of the end of its projection horizon; 
  • Second, if inflation is projected to remain around 2% durably for the rest of that horizon; 
  • Third, if the realised progress in underlying inflation is consistent with inflation stabilising at 2% over the medium term.
  • At the same time, the euro area economy continues to recover, but growth has slowed down. Economic growth weakened in the last quarter of 2021 and will likely remain muted in the early part of 2022 due to pandemic containment measures, high energy costs and shortages of equipment and labour. These factors are restraining the economic activity. But they should ease during 2022 and prospects are good that activity will bounce back, driven by robust domestic demand. 
  • Inflation has risen sharply in recent months and it has further surprised to the upside in January. Energy prices continue to be the main reason for the elevated rate of inflation but price rises have become more widespread across the economy (like food prices). So, inflation is likely to remain elevated for longer than previously expected. The outlook for inflation is uncertain but it is still expected to decline in the course of this year.

In any case, the pressure on prices is upsetting markets and investors and there is a huge debate on whether the ECB should be moving faster.

As mentioned, ECB stance is to start raising rates, in certain conditions, only after stopping asset purchases. Last week the President Christine Large said the ECB will assess in March, on the basis of the data available, the pace, the speed and the amounts of the net asset purchase programme for the rest of 2022.

In my view, all in all, the President recent statements seem to suggest that the ECB is open minded, just in case inflation overshoots unexpectedly and inflation remains above 2% longer than expected, beyond 2022. The ECB is monitoring closely inflation developments and will be ready to act promptly, if required. 

Some think that the ECB should act sooner raising rates, to avoid that inflation market-based expectations become unanchored on higher inflation figures above ECB target level – this assuming that market expectations are still anchored on ECB projections given there is a large number of people that trust the central bank is in control and are confident on its models and projections. 

Key to the decision is to understand how much inflation comes from excess demand due to ECB monetary policy and how much is coming from supply shocks, green transition and other disruptions including the present geopolitical conjuncture. 

Some of these probably will ease this year but some may not. 

If we look at past episodes of high inflation, we conclude that central banks could not always easily handle unique events such as those driven by geopolitical tensions. 

And central bankers know that there is a limit on what they can do and that there events beyond their control.

The new policy framework allows, as I mentioned earlier, that inflation is moderately above target in a transitory period as long as it stabilizes at 2%. But these are the difficult questions. Will inflation fall back below the ECB’s 2% inflation target before year-end? Will it stabilize at 2%?  

In any case, the decision of the ECB will always have to balance the costs of raising interest rates prematurely, risking stopping the healthy recovery from the pandemic crisis, and those that result if the ECB fails to raise interest rates early enough, having to raise them later, even further, to sustain the overshooting.

So finding the perfect timing and the pace of unwinding the easing is the magic formula to a successful policy. 

Overall, the progress on inflation towards the target and the economic recovery suggests that is still possible to have a step-by-step reduction – and not a sudden reversal in easing -  in the pace of asset purchases over the coming quarters

Yet, in light of current uncertainty, I would say that in 2022 it is more important than ever to maintain flexibility and optionality in the conduct of monetary policy to make sure inflation stabilises at 2% over the medium term. 

Before concluding, I want to draw your attention to a very important issue that came out from the strategy review: the need for the Eurosystem to engage more with the general public and local audiences. It is clear for us that the strategy review has greatly benefited from the input received via the Eurosystem’s “listening” activities. Drawing on this successful experience, outreach events with both a “listening” and an “explaining” dimension are intended to become a structural part of the Eurosystem’s interaction with the public.

This is also acknowledged in the Banco de Portugal Strategic Plan for 2021-25, which prioritizes “promoting a greater proximity with our stakeholders and strengthening trust in our institution”. 

In this sense, Banco de Portugal will in the next four years privilege direct and close contacts with society, reinforce simplified communication aimed at a wider audience and favour forms of communication with which citizens feel engaged. Additionally, the Bank will reinforce its role in the promotion of the economic literacy of the Portuguese citizens. 

Our participation in events, such as this conference, is a good example of that. Young people as you are a promising audience. 

So let me thank again for the opportunity to be here and present our views.

I stop here.


[1] As prepared for delivery