Monetary policy hits harder after big shocks
The ECB Blog finds that interest rate hikes during 2022 and 2023 were particularly effective in curbing inflation. This strong policy transmission occurred in response to supply-driven shocks, resulting in a low "sacrifice ratio".
Expectations anchor disinflation
Recent model-based analysis reveals that the ECB's interest rate increases from July 2022 to September 2023 caused a pronounced strengthening of the inflation response, alongside a lower than usual response in terms of real activity.
This effect is primarily driven by how people's expectations about future inflation behaved.
Even as inflation rose sharply from mid-2021, expectations remained firmly anchored.
As monetary tightening accelerated, analysis shows a substantially stronger reaction in inflation expectations than in earlier periods, reinforcing the disinflationary effects of the policy.
The time-varying framework used in the analysis, applying a structural autoregressive model quarter by quarter over two decades, illustrates this pronounced strengthening of the inflation response to a 25-basis-point interest rate hike, with a relatively small contraction in economic activity.
Supply shocks demand forceful response
The economic responses to monetary policy decisions depend on the state of the economy and the nature of the underlying shock.
Analysis confirms that it makes a significant difference whether a shock is driven by supply or demand forces.
In the post-pandemic period, there was a pronounced shift in the responsiveness of monetary policy to different types of shocks.
Specifically, the ECB reacted more forcefully to supply-driven inflationary pressures during the 2022-23 tightening episode compared to earlier periods, such as 2006-2008.
This decisive reaction reflects a substantial increase in the pass-through from oil price disturbances to headline inflation after 2022, which raised the risk of temporary inflation becoming embedded in expectations, necessitating a more aggressive policy response.
High inflation, lower sacrifice
This analysis provides a crucial insight into the state-dependent effectiveness of monetary policy.
It suggests that the perceived trade-off between inflation reduction and output loss is not static, but significantly more favorable during periods of high inflation.
Policymakers should internalize this non-linearity, as it implies a greater capacity to tame inflation without severe economic costs than traditional models might suggest.
Source: Why monetary policy hits harder after big shocks
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