Speech

I am very happy to see all of you here in Montenegro today. I would like to thank the organizers for their invitation to speak on fiscal consolidation and monetary tightening, and the optimal policy mix. 

Policymakers are currently facing a complex and multifaceted challenge: to defeat inflation, while safeguarding financial stability and sustaining the recovery. Success, as emphasized in our latest Regional Economic Outlook for Europe, will require tighter macroeconomic policies tailored to changing conditions, strong financial supervision and regulation, and bold supply-side reforms. Our message is clear: monetary policy cannot do the job alone and policymakers should work in concert.

Inflation

Inflation in Europe remains well above central bank targets. While declining energy prices are helping to lower headline inflation, this will not be enough to bring inflation back to targets. Headline inflation for 2023 is expected to remain high with 5.6 percent in advanced economies and 11.7 percent in emerging economies.[1] And core inflation remains high and persistent.

Monetary and Financial Policies

With regard to policy action, new IMF research shows that the cost of underestimating the persistence of inflation is higher than the cost of overestimating it. 

We often overestimate the decree of economic slack. With labor markets remaining tight and wage growth picking up, higher policy rates can buy insurance against underestimating inflationary pressures. More generally, whenever there is a clear risk that inflation could be more persistent than assumed, it is better for central banks to assume that inflation is in fact persistent and raise rates accordingly.

Central banks should thus maintain a tight monetary policy until core inflation is unambiguously on a downward path back to central bank inflation targets. This means there is more ground to cover for some in terms of the monetary policy tightening cycle to provide a needed contractionary stance, depressing demand. Failure to do so could entrench high inflation and force central banks to tighten much more forcefully later, pushing the economy likely into a sharp recession. It is this—much worse—outcome which we want to avoid.

For the ECB, this implies that rates still have some way to go. Under our baseline projection of April, which assumes a terminal rate of 3.75%, inflation is projected to converge to target only in mid-2025. That is too long a period for inflation to stay meaningfully above target. Moreover, we see risks to that baseline forecast to be tilted to the upside, in the context of accelerating wages in tight labor markets. A more restrictive stance, maintained over a sustained period, would ensure that inflation expectations stay anchored, and inflation returns to target in a timely manner. Monetary policy of course has to continue to follow a data-dependent approach.

Central banks in emerging market economies in Europe should stand ready to tighten further, where real interest rates are low, labor markets are tight, and underlying inflation is sticky. Policymakers also need to factor in spillovers from further tightening by advanced economy central banks, as this could lead to capital outflows and exchange rate pressures. New IMF research finds that negative spillovers to emerging economies tend to be less severe in those with lower exchange rate misalignment, less fiscal vulnerability, and more transparent and rules-based monetary and fiscal frameworks.

While the concern that higher interest rates come with higher financial stability risks, is legitimate, it would be misguided to pause or reverse tightening prematurely. Elevated financial risks during a tightening cycle require continued monitoring, close supervision, contingency planning, and faithful and timely implementation of Basel III. In the European Union, stability could be bolstered by extending the reach of bank resolution tools, clarifying availability of the Single Resolution Fund’s resources, ratifying the European Stability Mechanism’s amended treaty, and agreeing on a pan-European deposit insurance. In jurisdictions where banks are experiencing temporarily high profits, countercyclical capital buffers could be tightened as a step towards positive neutral rates for these buffers.

Fiscal policy

Let me now turn to fiscal policy. Fiscal policy should be aligned to support central banks in fighting inflation. This calls for many European governments to pursue more ambitious fiscal consolidation than embedded in their current plans.

This is a good time to consolidate. Many advanced European economies are close to full capacity, as indicated by tight labor markets, and inflation, which is ultimately a tax on the poor, is likely to remain too high for too long. For almost half the countries, IMF staff sees scope for stronger fiscal consolidation, especially in some advanced economies. However, many countries will see their deficits widen this year, in part because of continuation of generous cost-of-living support packages.

New IMF research shows that if all countries in the euro area would consolidate by an additional 1 percent of GDP in 2023 and 2024 and ½ percent of GDP in 2025, the ECB’s policy rate could be 30-50 bps lower while achieving the same inflation outcome. 

Thus, tighter fiscal policy would help central banks meet their inflation objectives at lower policy rates. This would also lower public debt service costs and reduce financial stability and fragmentation risks.

This is also a time that provides for fiscal savings opportunities. Recent windfall tax revenue gains, including from inflation, should be saved as they will be at least in part temporary. Also, the recent sharp decline in energy prices provides an opportunity to phase out the broad-based energy relief measures; it is now time to target them narrowly to the most vulnerable households. EU countries, on average, budgeted cost-of-living support of 2.7 percent of GDP for 2022-2023. But this support is not well targeted. If governments were to fully compensate the additional costs for the lower income 40 percent of households only, this would cost just 1.5 percent of GDP. So, savings can and should be made.

One final word on fiscal policy for the medium-term. We need to rebuild the fiscal space that has been depleted by the two back-to-back crises—the pandemic and the energy crisis triggered by Russia’s invasion of Ukraine. This will help governments prepare for future shocks and to address spending pressures from aging, energy security, the green transition, and national defense. And countries that are important recipients of Next Generation EU funding will benefit from the associated boost to aggregate demand, so they have an opportunity to consolidate their budgets without weakening economic activity.

Structural reforms

Finally, structural reforms are essential and they should prioritize areas where actions will help ease the growth-inflation trade-off. With tight labor markets across the continent, reforms that increase the labor supply by enhancing participation and facilitating workers’ job transitions will be helpful in lowering inflationary pressures. Moreover, NGEU reforms will help raise output potential. Finally, improving energy security and energy efficiency will remain a critical priority.

Conclusions

Let me conclude. To address today’s high inflation, we need tighter monetary policy for longer, until inflation is on a firm path toward target. This will help avoid more drastic and costly adjustments later. Governments should take advantage of buoyant tax revenues and falling energy prices to pursue more ambitious fiscal consolidation to support the disinflation effort. This would allow central banks to fight against inflation with lower interest rates, and restore depleted fiscal space. Structural reforms, particularly labor market reforms will also be important.

Monetary, fiscal and structural policies can and should work in concert to defeat inflation at a lower cost.

Thank you.