Monetary autonomy in a globalised world

Welcome address by Fabio Panetta, Member of the Executive Board of the ECB, at the joint BIS, BoE, ECB and IMF conference on “Spillovers in a “post-pandemic, low-for-long” world”

Frankfurt am Main, 26 April 2021

Thank you very much for the opportunity to speak at this conference on spillovers in a “post-pandemic, low-for-long” world.^[1]

Over the last decade, globalisation has called into question central banks’ ability to achieve domestic objectives. According to some^[2], close economic and financial ties across borders make inflation more of a global phenomenon than a domestic one. And spillovers would leave central banks less able to control domestic financing conditions.

Today, these views are being put to the test.

US authorities are engaging in unprecedented fiscal and monetary expansion, which will show whether forceful policy stimulus can still raise inflation. The associated improvement in the US and global economic outlook has generated upward pressures on sovereign bond yields, which central banks whose economies are less advanced in the recovery are striving to resist. Whether they succeed will reveal the scope of monetary autonomy in a globalised world.

What will the outcome be? For smaller and emerging market economies, the constraints on policy may remain significant. But I expect this episode to confirm that globalisation cannot constrain monetary policy in large economies, like the euro area.

How globalisation affects both inflation and financing conditions in the euro area depends on our policy response to it. If globalisation leads to below-target inflation, it is because we are tolerating that undershooting.

The euro area has monetary autonomy – the only question is how to use it wisely.

Faced with uncertainty about the true economic damage caused by the pandemic, we must preserve accommodative financing conditions well into the recovery. Better still, monetary and fiscal policies should work together to deliver a stronger and more inclusive recovery, reducing the risk of inflation undershooting our aim for a prolonged period. This is the best way to avoid lasting scars.

Globalisation and inflation

Let me start by discussing the role of globalisation in inflation outcomes.

Inflation has a common global component, which is largely driven by energy and commodity prices. But the view that globalisation makes inflation a global phenomenon – and a disinflationary one – goes further.^[3]

Trade integration might cause disinflation through lower import prices, lower production costs and the forced exit of less productive domestic producers.^[4] By increasing global labour supply, it might have created “global slack”.^[5] And growing international competition could limit the scope for firms to pass on domestic cost increases to consumers.^[6]

These forces, especially commodity price shocks, can have sizeable effects on price developments. But the evidence suggests that globalisation has only marginal effects on trend inflation.^[7]

While inflation has fallen across advanced economies over recent decades, its correlation with the pace of globalisation is weak. The sharpest reductions took place in the early 1980s, before globalisation took off (Chart 1). Since the 1990s, inflation has fallen fastest in two periods when trade integration was less intense.^[8]

Similarly, global economic slack has little impact on domestic inflation or the slope of the Phillips curve.^[10] And there is little evidence that the role of global factors has increased for core inflation over the last decade.^[11] Consistent with this observation, euro area core inflation since the global financial crisis has been driven mainly by services (Chart 2, left panel), the inflation component that is most sensitive to the domestic output gap (Chart 2, right panel).^[12]

Insofar as globalisation has influenced inflation in the euro area, it may rather be the result of macroeconomic policy choices.

From 1999 onwards, globalisation led to a stronger rise in trade openness in the euro area than in other large economies like the United States (Chart 3, left panel). This, in turn, created more opportunities for euro area economies to “rotate” demand to foreign markets when internal demand stalled. The result, especially in the wake of the global financial crisis, was a shift from domestic to external demand by the euro area as a whole. This led to a large current account surplus (Chart 3, right panel), while the protracted weakness in internal demand weighed down on inflation (Chart 4).^[13]

In fact, underlying inflation^[14] in the period before the financial crisis had approached 2% only because domestic demand in “non-core” countries had pushed it higher, while “core” countries had lower demand and inflation (Chart 4, left panel). But after the crisis, lower domestic demand in “non-core” countries was not offset by higher domestic demand in core countries. Rather, domestic demand fell everywhere, which contributed to underlying inflation being compressed (Chart 4, right panel).

This fall in underlying inflation was not visible to the same extent in the United States, which relied more on internal demand.^[15] In fact, the United States entered the global financial crisis with underlying inflation having averaged 2.2% over the previous decade, and after 2012 it was 0.2 percentage points lower on average. The euro area, meanwhile, entered the crisis with underlying inflation averaging 1.7% and, after the sovereign debt crisis, it was 0.6 percentage points lower on average (Chart 5).

Globalisation and policy autonomy

If globalisation does not directly lead to low inflation in the euro area, can it constrain the ability of monetary policy to influence the inflation process? This could happen through two channels.

First, globalisation could depress the natural rate of interest and make it harder for monetary policy to stoke price pressures, especially at the lower bound. That could happen if trade and financial integration increase global demand for safe assets.^[16] Globalisation might also favour “winner-takes-all” markets that stifle productivity growth and put downward pressure on the natural rate.^[17]

But the evidence about the importance of global factors in explaining the decline of the natural rate is inconclusive at best.^[18] There is a stronger consensus that demographics have been the key common driver.^[19]

Second, globalisation could constrain monetary autonomy by increasing exposure to financial spillovers, making it harder for central banks to set financing conditions at the appropriate level to stabilise domestic inflation. Evidence suggests that a “global financial cycle”^[20] does exist, driven by international risk factors, and that financial spillovers from the United States to the euro area have been increasing since the 1990s.^[21]

In particular, since the mid-2000s euro area term premia have become more responsive to global factors (Chart 6). This matters because central bank asset purchases that aim to lower market yields work mainly by compressing term premia. If those premia are simultaneously rising on account of external spillovers, this could weaken the traction of monetary policy over euro area yields.

But in practice globalisation does not seem to impose an insurmountable constraint on the ECB’s monetary policy. Even when economic conditions in the United States have diverged from those in the euro area, the decisive action we have taken at the ECB has allowed us to deliver financing conditions appropriate for our economic cycle, decoupling from those in the United States.^[22]

Indeed, when the ECB introduced forward guidance and asset purchases between 2013 and 2015, the correlation between US and euro area financing conditions weakened significantly (Chart 7, left panel). And in recent months, euro area yields have decoupled from those in the United States (Chart 7, right panel).^[23] This reflects the ECB’s commitment to preserve favourable financing conditions, which was behind our decision in March to significantly increase the pace of our asset purchases.

Asserting policy autonomy

So we do have policy autonomy in the euro area. In the face of two key facts, we should use it to shelter the domestic recovery from adverse foreign spillovers.

First, the recovery remains dependent on policy support. For example, job retention schemes are playing a major role in cushioning unemployment: the share of workers who are unemployed, discouraged or enrolled in such schemes is around double the headline unemployment rate (Chart 8, left panel). And €420 billion in guaranteed loans are still outstanding in the largest economies (Chart 8, right panel).

This policy dependence masks the true underlying state of the economy – particularly in terms of labour market scarring and corporate vulnerabilities – and therefore its resilience to less expansionary policies. The recovery will need to be well advanced before we can get a clear picture of the underlying damage.

Second, even with the ongoing monetary and fiscal policy support, our recovery is expected to be slow and incomplete in terms of both growth and inflation. In fact, the euro area economy is projected to return to its pre-crisis GDP level only in the middle of 2022 and to remain below its pre-crisis trend (Chart 9, left panel).^[24] GDP in the United States, in contrast, is projected to recover both its pre-crisis level this year and its trend thereafter (Chart 9, right panel). The euro area and Japan are the only major advanced economies where inflation is projected to remain subdued over the medium term.

This evidence suggests that we should avoid withdrawing policy support – either deliberately or by tolerating adverse spillovers – until the output gap is closed and we see inflation sustainably back at 2%.

For the ECB, this implies that we will have to maintain very favourable financing conditions well beyond the end of the pandemic period. The need for very accommodative policy over a longer period should in any case be uncontroversial, given that inflation remains well below our aim in our projection horizon and, according to survey measures of inflation expectations, even beyond it.

Towards more ambitious goals

As I have made clear, Europe has the capacity to overcome the pandemic and its economic consequences. So we face an important decision. We can act as a group of small, open economies, as we did after the global financial crisis, with each country competing to capture external demand. Or we can behave how a large economy would, with European and national policymakers working together to raise internal demand through adequate policy stimulus.

At this point in time, failure to pursue the latter option – reconnecting to the pre-crisis growth path and restoring healthy inflation levels – would increase the danger of the pandemic causing lasting damage to our economy. Three risks stand out.

The first risk relates to the record high levels of public and private debt reached during the pandemic, which make debt dynamics more sensitive to inflation undershooting.

An accounting exercise indicates that if euro area inflation were to undershoot our baseline by 1 percentage point each year for five years, the private debt ratio would increase by around 7 percentage points. This is equivalent to firms and households taking on €900 billion in extra debt at a time when debt needs to be reduced.^[25] That could depress investment and consumption and further reduce inflation.

For governments, a similar exercise implies a 5 percentage point increase in the public debt ratio compared with the baseline over five years, and a 10 percentage point increase over ten years.^[26] And for countries facing debt-to-GDP ratios of around 150%, ten years of inflation undershooting could increase their debt ratio by approximately 15 percentage points. This is the opposite of what we need at a time when interest rates are near the lower bound and fiscal policy is a transmission channel of monetary policy.

The second risk comes from the inequality that will likely result from the outsized impact of the pandemic on less advantaged groups.

These groups typically have a higher propensity to consume, so a fall in their share of labour income would hold back domestic demand and inflation. Moreover, if they cannot reintegrate into the labour market we could see long-lasting effects, including a permanent loss of human capital.^[27] The best way to achieve that reintegration and contain scarring is through faster growth.

Getting back to our pre-crisis growth path would imply a 3% increase in GDP by 2022^[28], which estimates suggest would create millions of new jobs.^[29] That, in turn, would lead more quickly to tightness in the labour market, supporting wage growth and the return of inflation to our aim.

It would also boost the life chances of the poorest members of society. For example, a 1 percentage point narrowing of the overall unemployment gap in the euro area reduces the unemployment rate of ‘low-skilled’ workers by 1.3 percentage points more than the unemployment rate of ‘high-skilled’ workers.^[30] Vibrant labour markets are the most effective way to support those who have lost the most from the pandemic and to reduce inequality.

The third risk is that persistently weak economic activity can reduce productivity.^[31] Long periods of inactivity may hurt labour productivity through the loss of on-the-job knowledge. And weaker sales expectations may lead to firms investing less in capacity.^[32]

With these risks in mind, it makes sense for the euro area to take advantage of the favourable financing conditions created by monetary policy to launch a stronger fiscal stimulus in order to rapidly return growth to its pre-pandemic path. The focus must be on productive investment, so that spending is concentrated on projects with high multipliers.

The additional investment required is well within our reach. According to simple, illustrative estimates, extra spending^[33] on productive investment of around 2.8% of GDP^[34] would be sufficient to reconnect with the pre-crisis growth trend by 2022 (Chart 10).

Conclusion

My main message today is that Europe’s economic trajectory is in our hands. The inflation process is still a domestic phenomenon which forceful monetary policy can control. The ECB has already asserted its monetary autonomy and will continue to use it to bring inflation back to our aim of 2%.

This, in turn, enables fiscal authorities to use the space available to them to bring about a full recovery, which would guarantee higher productivity, more sustainable debt and more inclusive growth.