Issue link: https://maltatoday.uberflip.com/i/1493445
23.2.2023 11 ANALYSIS the country still experiencing a small- er impact on all counts, while Italy is experiencing a somewhat more signif- icant impact. Overall though, there is no shock happening in the system for any coun- try measured, and monetary transmis- sion is therefore not causing problems. So far, there is no reason to use the ECB's new Transmission Protection Instrument (TPI) as fragmentation of monetary transmission in the euro- zone is not happening at the moment. Most of the impact on inflation and growth still has to feed through While the initial boxes of monetary transmission have clearly been ticked, the timing of the actual impact of monetary policy on the real economy has always been difficult. In theory or in large macro models, it is assumed that it takes 9 to 12 months before monetary policy affects the real economy most. Recently, there have been central bankers (Fed members) suggesting that the lag could currently be shorter than in the past. In any case, the transmission of mon- etary policy can often be blurred by other factors. At the current juncture, the energy crisis is playing a large role in slowing down the economy and has also helped to ease inflation as recent developments have caused gas and electricity prices to come off their peaks. Supply chain problems have been fading recently and demand for goods has weakened, which has helped supply and demand in goods markets become better balanced again. How does this stack up to previous hiking cycles? It is difficult to compare current de- velopments to previous tightening cy- cles by the ECB. e ECB has only en- gaged in three previous hiking cycles, of which the 2011 one only lasted for two meetings. e thing that stands out is that the underlying conditions of the economy matter a lot when looking at the pace of transmission. e 2005 hiking cy- cle happened when the economy was performing quite well, the 2000 cycle started in a strong economy, while 2011 was a famous example of hiking into a recession. at difference shows when looking at the response. In 2005, bank lend- ing growth to businesses continued to accelerate despite rate hikes and only slowed when the 2008 recession start- ed. Asset prices are now also turning down much faster than in 2005 as this only happened years after the start of the tightening cycle in 2008, while we are already seeing the negative effects now. is also holds true for money growth. So it does become evident that the key channels of monetary trans- mission are seeing faster downturns now than in the previous long tighten- ing cycle of 2005. But it's too early to declare victory for the ECB yet While inflation is falling, core infla- tion is still trending up and is far above target at 5.2%. It is therefore too early to declare victory on price developments. Wage growth is also still moving up cau- tiously. While not nearly enough to raise concerns about a wage-price spiral, the labour market remains red hot and negotiated wage growth has moved from the 1.5% to 3% range in 2022. So supply and demand in labour markets have yet to adjust. Wage growth has started to trend up, causing upside risk to the inflation outlook And expectations have started to feed through the monetary transmis- sion system in the wrong way recent- ly. As investors worry about recession and are optimistic about inflation re- turning to benign levels, financial con- ditions are loosening again. is could work against tightening efforts from the ECB and we have seen ECB speakers speak out quite vocally against the premature easing of finan- cial conditions. A lot is now moving in the right direc- tion for the ECB to get inflation back to target, but uncertainty remains. No one really knows how persistent core inflation will be after this series of sup- ply shocks that the eurozone has faced. ere is also uncertainty over how long it will take for GDP and infla- tion to be impacted by the aggressive rate hikes from the ECB so far. Having moved to a restrictive level of policy recently and with more hikes in the pipeline, this uncertainty makes poli- cy-making very difficult right now. Restrictive policy will have a significant downside impact on the economy this year While we are not seeing the full im- pact of monetary policy on prices yet, we do see transmission in full force, which will eventually have a larger im- pact on output and prices. With uncertain delays on economic activity and prices at work, the ques- tion is how hawkish the ECB will re- main over the course of the year, given the tightening of monetary policy so far. At the March meeting, another 50bp hike is all but a done deal. Beyond the March meeting, however, the ECB will likely be entering a new phase in which further rate hikes will not necessarily get the same support from the Governing Council, as hiking deep into restrictive territory increas- es the risk of adverse effects on the economy. e main question beyond the March meeting will be whether the ECB will wait to see the impact of its tightening on the economy or whether it will con- tinue hiking until core inflation starts to substantially come down. In the former case, the ECB could consider a pause in its tightening cy- cle and hike again at the June meet- ing. e latter would see continuous meeting-by-meeting hikes, possibly in smaller increments of 25bp. For our economic outlook, we think that restrictive monetary policy in 2023 will be a key factor preventing the economy from bouncing back from its current weak spell. While all eyes are on the energy crisis at the moment, higher rates will also be an important factor in dampening any meaningful recovery. While the bulk of the impact yet is not evident yet, expect a eurozone economy that flirts with zero growth for most of the year as higher rates complete the transmission to de- mand. Last summer, when the ECB started hiking interest rates, the immediate question for financial markets was how far the Bank would dare to go. Ending an era of negative interest rates and unconventional monetary policy when inflation is approaching double-digit levels is one thing, actively breaking down the economy is, however, another. This is why the eurozone's nominal neutral interest rate – which was pegged at between 1.5% and 2% by almost everyone – suddenly became the focus of attention. Even ECB President Christine Lagarde referred to this illustrious neutral rate (the rate at which monetary policy neither stimulates nor restricts the economy), suggesting that the central bank use this as a rough anchor for when policy could start to become restrictive. When policy is restrictive, this leads to weakening economic activity and ultimately to lower inflation. The rate, however, is a very theoretical concept, impossible to measure and rather an ex-post instrument to describe a monetary policy stance rather than providing guidance for actually conducting monetary policy. This is why the ECB quickly, at least publicly, debunked the idea that it would follow this neutral interest rate concept. Wherever a neutral interest rate in the eurozone might be, hiking interest rates by 300bp, as the ECB has done so far, and with more hikes to come, the question is not whether the ECB's hiking cycle will slow the eurozone economy but rather when. ECB President Christine Lagarde through to the eurozone economy The much feared fragmentation of monetary transmission has not happened so far (Note: red indicates more tightening impact than eurozone average, green indicates less tightening than average)