Fabio Panetta: The complexity of monetary policy

Keynote speech by Mr Fabio Panetta, Member of the Executive Board of the European Central Bank, at the CEPR-EABCN conference on "Finding the Gap: Output Gap Measurement in the Euro Area", held at the European University Institute, Florence, 14 November 2022.

The views expressed in this speech are those of the speaker and not the view of the BIS.

Accompanying slides of the speech.

The output gap – the difference between actual and potential output – plays an important conceptual role in central banking.

In normal conditions, the output gap represents a gauge of inflationary pressure by signalling the amount of slack in the economy. In turn, this provides a yardstick against which central banks calibrate monetary policy. By steering demand so that actual output matches potential central banks can stabilise inflation around their targets.

From the global financial crisis until the start of the pandemic, variations in the output gap reflected prominently the role played by demand factors.

The implication for monetary policy was relatively straightforward. The shocks to demand pushed output, employment and inflation in the same direction, leading to a positive correlation between output gaps and inflation. Monetary policy could aim to close the inflation gap without facing major trade-offs in terms of the output gap.

Central banks ultimately faced the difficulty, not so much of diagnosing, but of delivering: once inflation fell too low, their conventional instruments were constrained as interest rates approached their lower bound. Central banks had to deploy non-standard policy tools to lift demand.

Today we are in a new environment. The economy is experiencing large, negative supply shocks pushing output and inflation in opposite directions. The correlation between estimated output gaps and inflation has become more blurred and uncertain than in the past. And the trade-offs facing monetary policy have become more complicated.