Philip R Lane: Underlying inflation

Lecture by Mr Philip R Lane, Member of the Executive Board of the European Central Bank, at Trinity College Dublin, Dublin, 6 March 2023.

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

Introduction

When inflation has been far from target for a sustained period and the process of monetary tightening has been under way for some time, there are three primary inputs into monetary policy decisions. First, in view of the medium-term orientation of monetary policy, the inflation forecast over the next one to three years plays an important role. Second, the incoming information on underlying inflation constitutes an essential additional basis for assessing medium-term inflation dynamics, in view of the conditional nature, the lower frequency of production and the intrinsic uncertainty surrounding macroeconomic forecasts. Third, especially in view of the transmission lags from shifts in the monetary policy stance to the financial system, the economy and inflation dynamics, assessing the incoming information on the transmission of previous monetary policy decisions is also necessary for the appropriate calibration of monetary policy decisions.

My focus today is on the second input: underlying inflation. The assessment of underlying inflation (which should be understood in a broad sense, including the information contained in wage dynamics and inflation expectations) should be viewed as a complementary cross-check to the inflation forecasting process. In one direction, if the signals from underlying inflation at a given point in time support the narrative embedded in the inflation forecast, this boosts confidence levels (among policymakers, market participants, firms and households) in the inflation forecasts. In the other direction, if the signals from underlying inflation at a given point in time are at odds with the inflation forecast, this calls for robust policy decisions that take into account the different signals coming from the forecast and the analysis of underlying inflation.