Panayiotis Rougalas
The European Central Bank (ECB) says monetary policy in the euro area was highly effective during the tightening cycle of 2022 to 2023. This comes at a time when concerns about inflation are resurfacing because of the war in the Middle East and expectations are building around possible new rate hikes.
In a report by ECB economists Alina Bobasu, Matteo Ciccarelli, Alex Grimaud, Martin Mandler, and Andrejs Zlobins, the bank notes that rate increases brought inflation down quickly while keeping the impact on economic output relatively limited. According to the report, this reflects a stronger effect of policy on inflation than in the past, a more decisive response to supply shocks, and continued stability in inflation expectations.
The analysis, published on the ECB’s website, emphasizes that the effectiveness of monetary policy depends heavily on the inflation environment. When inflation is high, prices and wages tend to adjust more easily. This makes it possible to bring inflation down without causing major losses in overall output. The findings emphasize the need to consider timing, nonlinear relationships, and the specific dynamics of each shock when evaluating policy in high inflation conditions.
The report also notes that the effects of monetary policy vary across countries, sectors, and time periods. These differences depend on current economic conditions and especially on the type of shocks affecting the economy.
Policy transmission
The way monetary policy affects the euro area economy has changed significantly over time. Model-based analysis shows that while inflation declined, the rate hikes between July 2022 and September 2023 led to only a modest contraction in economic activity. The estimates point to a stronger reaction of inflation to rate increases during this period, along with a weaker than usual response in real economic activity.
One key reason is how the public views future inflation. Even when inflation rose sharply starting in mid-2021, expectations remained well anchored. As tightening accelerated in mid-2022, the response of inflation expectations became noticeably stronger than in earlier periods. This helped reinforce the disinflationary impact of policy.
Does the type of shock matter?
How the economy responds to monetary policy depends on its overall condition and on the type of shock driving changes. The analysis confirms that the nature of the shock plays a major role. There is a clear difference between shocks driven by supply factors and those driven by demand.
The findings suggest a meaningful shift in how monetary policy responded during the post-pandemic period. In particular, the ECB reacted more strongly to supply-driven inflation pressures than it did in earlier tightening cycles such as 2006 to 2008.
Movements in the three-month Euribor show that during the 2022 to 2023 tightening period, policy responded more aggressively to supply shocks like rising energy and oil prices. This reflects the stronger pass-through of oil price increases to overall inflation after 2022 compared with earlier years. As a result, there was a greater risk that temporary price increases could become embedded in expectations, which called for a more forceful policy response than in past energy price spikes.
Significant changes
The results show that both the strength of policy transmission and the policy response itself have changed significantly over time, especially during the high inflation period of 2022 to 2023.
Recent research suggests that pricing and wage-setting behavior shifts depending on the inflation environment. When inflation is low and stable, businesses and workers adjust prices and wages less often, and inflation responds gradually to changes in the economy. When inflation is high, adjustments happen more frequently, making inflation more sensitive to both shocks and policy actions.
The analysis concludes that monetary policy is more effective at reducing inflation when inflation pressures are elevated. Under the assumption that expectations remain stable, the model indicates that in 2022 the sacrifice ratio was nearly twelve times lower than in 2012. This points to greater flexibility in prices and wages during the most recent period of monetary tightening.
