Fabio Panetta: Mind the gap(s): monetary policy and the way out of the pandemic

Speech by Fabio Panetta, Member of the Executive Board of the ECB, at an online event organised by Bocconi University

• In 2020, with the pandemic raging, the direction of policy support was obvious and the choices facing policymakers were relatively narrow.
• Monetary and fiscal authorities everywhere intervened to support the economy on a massive scale.
• But in 2021, with the progress made on vaccine technology, policy choices have become less clear-cut.
• As such, it might be tempting to conclude that there is less need for monetary policy support.
• We will still face two prominent gaps that we need to close: the output gap and the inflation gap.
• At present, the risks of providing too little policy support still far outweigh the risks of providing too much.

Eliminating downside risks

• There is a good chance that a recovery will take hold in the latter part of this year.
• But that is not a justification for policies to run on neutral.
• First, in a dramatic crisis like this one, macroeconomic policymakers should not bank on the most favourable scenario materialising.
• As I have argued elsewhere, the pandemic has produced an asymmetric balance of risks, which requires an asymmetric reaction function.
• Just as we looked though temporary negative inflation in recent months, we will look through this transitory hump in inflation.
• And this shallow growth path remains vulnerable to a series of downside risks.
• This divergence will bring risks of its own: in fact, we are already seeing undesirable contagion from rising US yields into the euro area yield curve.
• The risks to private consumption growth are therefore substantial.

Chart 1 Household financial situation and savings

(change in percentage balance from January 2020 to January 2021)
• Given the weak financial starting point of many firms, investment is likely to only increase gradually and cautiously.
• [5] A risk management approach would therefore clearly call for policy to eliminate these risks and reinforce the central growth path.
• And, if we were to do too much and push the economy onto a stronger growth path, that would in fact be a welcome result.

Closing the gaps faster

• But the experience of the last cycle suggests that it is hard to lift inflation dynamics without demand testing potential more dynamically.
• Despite several years of robust economic growth, the euro area economy might still have been operating with significant economic slack even on the eve of the pandemic.

Chart 2 Pre-crisis and recent estimates of the output gap in the euro area

(% of potential output) Source: ECB staff calculations.
• In the decade after the Lehman crash, yearly domestic demand growth in the euro area was almost 2 percentage points lower on average than it had been in the previous decade, and it was much lower than that of our main trading partners (Chart 3).
• This contributed to compressing inflation persistently below our aim, leading to a significant price level gap (Chart 4).
• [6] That was not the case in the United States or the United Kingdom, where domestic demand stayed on a stronger trajectory.

Chart 4 Harmonised Index of Consumer Prices (HICP)

(all-items, January 1999=100)
• This clearly called for action, as reflected in the additional support we decided on in December.
• Boosting demand is also necessary to reduce hysteresis risks after the pandemic.
• [8] Policy should not accept hysteresis as a reality which imposes new supply constraints, but rather explicitly set out to test those constraints.
• [9] A tight job market also improves the outlook for future demand, thereby strengthening business investment.

Delivering the necessary policy stance

• So the challenge we face is how to deliver the necessary policy stance.
• Since the start of the pandemic, monetary policy in the euro area has gone through three phases.
• In the first phase the phase of fragmentation the flexibility of our pandemic emergency purchase programme (PEPP)[10] averted an unjustified widening of spreads which would have disrupted monetary policy transmission.
• In the second phase, the PEPP increasingly became a tool for steering the overall monetary policy stance.
• This essentially means more focus on anchoring key financial variables above all, lending rates and the yield curve as key indicators of the monetary policy stance.
• So, that constellation of financing conditions should be seen as the reference point for our policy moving forward.

Chart 5 Euro area real and nominal rates

• In this way, we can prevent a tightening of financing conditions which would otherwise lead to inflation remaining below our aim for longer.
• Eventually, firm commitment to steering the euro area yield curve may allow us to slow the pace of our purchases.
• But in order to reach that point, we must establish the credibility of our strategy by demonstrating that unwarranted tightening will not be tolerated.

From policy fatalism to policy coordination

• But counterfactual analysis shows that after the financial crisis and during the COVID-19 shock the ECBs expansionary policies have been highly effective.
• Without our policies, inflation and GDP growth would have been dramatically lower and many more people would have lost their jobs.
• Preserving favourable financing conditions will have a powerful effect on demand and inflation.
• However, given the fall of the natural rate of interest,[14] monetary policy is more effective if deployed in sync with other policies.
• Monetary, fiscal and structural policies must reinforce each other in order to cut slack and close the gap between saving and investment.
• Fiscal policies continue to be a key channel for transmitting monetary policy to the real economy[15] and they are expected to remain supportive in 2021.

Chart 6 Euro area real and potential GDP

(EUR billions)
• They need to target investment in technology, education and infrastructure, creating an environment that bolsters growth and supports the sustainability of debt.
• We have a joint interest in making the European economy more dynamic.
• [16] NGEU is an important tool precisely because it ensures that common spending triggers growth-enhancing reforms that subsequently benefit all.

Conclusion

• My main message today can be summed up with the title of a song by the electronic music duo Daft Punk[18]: Harder, better, faster, stronger.
• The harder we push to close the output and inflation gaps, the better the outlook for the euro area economy.
• Achieving this will require the right combination of monetary and fiscal support at the EU level, and it will require continued, determined reforms at the national level.