Lagarde: “The European economy today resists shocks better”

Today the European economy has increased ability to resist “shocks”reducing “the need for unconventional or particularly incisive monetary policy responses”. The president of the ECB, Christine Lagarde, said this when opening the Forum in Sintra, Portugal. “The ECB’s tools have reduced the risks of fragmentation, also through the tool for protecting the monetary policy transmission mechanism, making unjustified movements in the yield differentials of government bonds less likely”, added Lagarde for whom, furthermore, “these tools allow us to raise rates to deal with inflation without the fear that the tightening itself will become a source of financial tension”.

“The consolidation of the European institutional architecture has also alleviated fragmentation by addressing the link between banks and sovereigns on both sides. European banking supervision and the European resolution framework have increased the resilience of the banking sector, reducing the possibility that shocks are amplified by the banking system; however, we must remain aware that challenges to financial stability could emerge in non-bank financial intermediation, where supervision has not evolved at the same pace,” Lagarde continued.

“European frameworks for fiscal policies have also developed considerably, from the European Stability Mechanism to Next Generation EU and other common debt instruments, thus loosening the link on the side of sovereign issuers,” continued Lagarde. At the same time, “there are reasons to believe that policy responses in Europe are also reducing the extent to which shocks are passed through to the real economy. Our assessment of the strategy found that the anchoring of inflation expectations has approached 2%reflecting the clear and symmetrical objective pursued by the ECB as well as the results achieved in combating both too low and too high inflation”, explained the President of the ECB for whom “this aspect is fundamental to protect the economy from the unwanted second impact effects deriving from shocks on the side of imported energy goods”.

“The transition to clean energy is also starting to change how such shocks are transmitted to the economy as a whole. In countries with higher shares of low-carbon electricity, such as Portugal and Spain, wholesale electricity prices are increasingly decoupling from gas prices. This resilience has become evident in recent years,” Lagarde further explained. The euro area has also “withstood the largest increase in U.S. tariffs in nearly a centuryas well as what the International Energy Agency called the largest oil supply disruption in history. The costs were huge, but the economy was not compromised. Cyclical oscillations have remained limited, even if some of these shocks pose challenges for Europe’s long-term growth prospects”, underlined Lagarde for whom “the resilience has allowed monetary policy to focus more specifically on its main function: stabilizing prices through interest rates, without the constraints deriving from fragmentation risks, vulnerabilities of the banking sector or the lower limit”.

Monitoring inflation expectations and the issue of rates

“Inflation expectations are and will always remain a key part of the data we monitor. Any signs of an unmooring of longer-term expectations will undoubtedly require a response. In the face of large and persistent shocks, it may be appropriate react incisively even earlier that an unmooring occurs”. This was said by the President of the ECB, Christine Lagarde, opening the Forum in Sintra, Portugal.

“Stable longer-term expectations they can potentially cause policymakers to delay responding to inflation that is already above target and perceived by households and businesses, even when the latest forecasts and data would call for action. Conversely, if policymakers act to prevent a future decoupling, there is no reliable way to assess how far they need to push rate hikes, nor to know in hindsight whether the preventative intervention was excessive or at all necessary,” Lagarde explained.

Advances in data analysis and improved projections

However, “thanks to advances in the data we use and how we use it we now have a clearer and more timely picture of what is happening in the economy and a more solid basis for calibrating our decisions in the current environment. For starters, starting from 2022 the ECB has carried out considerable work to understand how real-time hard data translates into medium-term inflation, in particular by developing a set of underlying inflation indicators. Instruments such as the common and persistent component of inflation have properties considered to be leading indicators”, added the president of the ECB.

Furthermore, “we have significantly invested in improving our projections. Projection errors during the 2022 inflation surge have resulted in a number of improvements including a move to more granular forecasts for oil, gas and electricity. Projection errors since the outbreak of war in the Middle East have been very limited. The current projections give us a more complete medium-term view, not only of the inflation outlook but also of how inflation will react to changes in our monetary policy, helping us to calibrate a very more suitable to the context I have described”, concluded Lagarde.