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Executive summary

• Inflation pressures emerged in the United States (US) and the United Kingdom (UK) earlier than in the euro area, while there is hardly any pressure in Japan. Inflation in the euro area mainly results from supply shocks, while in the US and UK there is a strong demand component. The European Central Bank (ECB) raised interest rates some months after the Bank of England and Federal Reserve, which is in line with the macroeconomic differences. Nevertheless, all three central banks have tightened belatedly.
• Even if inflation is primarily supply-driven in the euro area, it might result in persistent medium term inflation. A central bank with a price stability mandate should end its expansionary monetary policy when inflation moves significantly above target. The question is the ultimate value of the central bank interest rate.
• No forecasters predicted a strong and long-lasting increase in euro area inflation in late 2021, nor the energy supply problems resulting from Russia’s invasion of Ukraine. It would be unfair to blame the ECB for not raising rates already in 2021. However, our analysis suggests the ECB made mistakes at its December 2021 monetary policy meeting, which have been corrected only slowly:
  • The claim that monetary accommodation was still needed when inflation was well above target and rising, the growth outlook was strong, and risks were balanced, was not well justified in our view.
  • The forward guidance on the level of interest rates was data-dependent, but another condition for an interest rate increase was the termination of asset purchase programme (APP) net purchases, which was date-dependent. Forward guidance on asset purchases should have been data-dependent as well.
  • The forward guidance on APP net purchases was extended beyond October 2022 at a time of high and rising inflation and strong growth.
  • Interest rate forward guidance put too much emphasis on ECB staff forecasts, even though staff forecasts had a poor track record in the 5-year period prior to the COVID-19 pandemic, when no major shock hit the economy.
  • Even though the July 2021 monetary policy strategy review underlined the importance of owner-occupied housing cost inflation, this was not taken into account in the inflation forecast. Including it could have brought the December 2021 inflation forecast above 2% in 2023 and 2024.
  • Following the planned end of pandemic emergency purchase programme (PEPP) net purchases in March 2022, APP net purchases were to increase from April, suggesting a kind of compensation, even though the two instruments had different goals.
  • Fears of market fragmentation might have partially motivated the extension of APP asset purchases; instead, it would have been preferable to introduce earlier a transmission protection instrument.
• Looking ahead, many factors suggest slowing economic activity, and a recession is likely in case of an eventual complete stop in Russian gas supply. We recommend a gradual pace of interest rate hikes until the economic fallout from the war becomes observable.
• We recommend the ECB to ease the adverse inflationary impact of energy-supply bottlenecks at a time of monetary tightening by designing a special longer-term refinancing operation aimed at providing favourable conditions for investments in energy efficiency improvements and clean energy generation.