 Here in the Euro area, inflation has been coming down, but it's still much higher than we want it to be. Supply shocks are fading and energy prices are decreasing, but despite this, our food bills keep going up every month and wages are also pushing inflation higher. That's why the ECB Governing Council just decided to raise interest rates again. It's against this challenging backdrop that central bankers, academics, market actors and journalists will be travelling to Cintra, Portugal for the annual ECB forum on central banking. This year's topic is macroeconomic stabilisation in a volatile inflation environment and I've no doubt that there'll be much for them to discuss when they meet from the 26th to the 28th of June. One of those attending is our chief economist Philip R. Lane, who I'm delighted to have here in the studio today. We're going to be talking about our latest decisions, about what kinds of products are still getting more expensive and what is fueling these price rises, wages or profits. You're listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Katie Ranger. Philip, welcome back to the podcast. It's great to have you here today. It's great to be here. Now, you and your colleagues on the governing council just took the decision to raise interest rates again, this time by 0.25 percentage points. This is the latest action in a series of steps for monetary policy that started actually in December 2021 to fight inflation, which is projected at the moment to stay too high for too long. Philip, can you explain which factors went into that decision? As you say, we've been on this campaign for a year and a half. I think it's very important to recognize that monetary policy plays out over, over quite a long period of time. It's not the case we believe that what we decided last week to add another quarter of a percentage point to the interest rate will have an instant and dramatic effect on the inflation rate. But as we meet every six weeks and essentially what we're doing is we are calculating every time compared to what we're learning about inflation since our main meeting. Should we continue to raise interest rates? It makes sense to go step by step because there's a lot of uncertainty out there. We've already raised interest rates by now by four percentage points compared to where they were. That's quite a lot of monetary tightening, but I think we're always looking to see if it's more needed. While recognizing at any one meeting we don't know everything, we need to keep on learning. Between now and our next meeting in July, let's see how inflation develops in the month of June. Let's see what we learn about how our monetary policy is affecting the economy. These are the factors which do mean it really is a step by step process. The decision last week was it makes sense to take another step and we'll continue this step by step process in July, in September, each time deciding is it sensible to continue to increase interest rates or at some point is it sensible to say we've done a lot and let's see what we've done so far, whether that will be enough. That actually brings me on to the next question because this last hike pushed interest rates to the highest that they've been in over a decade and some are concerned that rates will go too high and they'll cause a prolonged recession in the euro area. How will you know what level to take rates to and maybe how long to keep them there as well? I think it's very important to take a long view on this. We are also this month marking 25 years of the European Central Bank, which started operations in June 1998. In fact, we look back a lot further than just 25 years. We looked at the 1970s, the last time we had high inflation. We look back, in fact, to other episodes of high inflation over the many decades before that. So if you like, I don't particularly view where we are now comparing it to a decade ago because a decade ago we did not have this high inflation. What we have to make sure is the interest rate decision is appropriate to the inflation challenge we face and essentially to go over the framework that we have. We need to look at three factors. One, we need to see where we're going and we call that the inflation outlook. We have technicians here also across Europe at the National Central Banks who are trying to use data techniques to project where inflation will be not just this year, but in 2024, in 2025. So we do try and preview or predict where inflation is going. The second element is we also have to look at what have we just learned about inflation. And so we look at the latest data and in particular, and I'm sure we can talk more about this, we can talk more about this concept of underlying inflation. Where is the dynamic right now? And then the third factor is how powerfully are the interest rate hikes we've already done? Are they cooling down the economy? Are they cooling down credit dynamics? Are they affecting the housing market, the financial market? The ability of firms to raise finance? The ability of households to take a mortgage, take a car loan, and so on. So all of these factors go into our decisions. So that's a lot. Absolutely, yeah. So in the end, there's a simple enough decision. Do we raise interest rates by a quarter of a percentage point or not was the question last week. But let me tell you, behind that is a lot of analysis because these decisions are very important for many people, very important for many firms, very important for many individuals, especially if you're at that stage of life where many people are indebted because they're buying their first home, that kind of thing. And then later on in life, people who are saving for retirement also care quite a bit about the level of interest rates. So a lot goes into these decisions. They are not taken lightly. I mean, I want to focus actually on one of the points that you mentioned, which in and of itself is already contains a wealth of data. And that's inflation measurements themselves. And I want to focus in on underlying inflation that you mentioned. But maybe I'll just take a step back first and explain the different kinds of inflation measurements that we have. So economists usually look at two main things, right, when in setting the inflation rate. They have headline inflation, which includes all consumer prices. So services such as how much my visit to the hairdresser costs, commodities like wheat, coffee beans, crude oil, but it also includes goods. So we've got services and then we've also got goods like cars, machines, basically anything that we can buy in the supermarket. Plus, it also covers the energy that we pay to hear our homes and the electricity that we use to watch TV. So that's headline inflation, a huge basket of things. Then there's another one, which is core inflation, which and here's the difference. It does not include food and energy prices. And that's because those are typically volatile and they can move up and down quite wildly. And we've obviously all seen that firsthand in the supermarkets, petrol stations and in our energy bills at the end of the month most recently. And now I want to go back to the one that you mentioned, Philip. And that's underlying inflation. Can you explain what it is and why it matters? Very good question. So in the end, all that we care about, and I think all that people care about, is the overall cost of living. How expensive is it for a typical individual or typical family to basically have their typical monthly activities? Going to the grocery store, fueling the car, paying rent, all of these things. So let's be clear. When we say we want inflation to be at 2%, we mean that that's in relation to the overall cost of living. Now, in order for us to analyze what's going on, as you say, some categories, if we see a price increase in the month of June, for some categories, we think history tells us, well, that price increase is unlikely to last. In fact, that price increase may turn into a price decrease in the coming months. And therefore, that, if you like, washes out in many ways over time. I think in the last 20 years, the price of petrol at the pump is an example. It's one of the few examples where we've seen the price actually fall in recent months. So it's not just that the price stops rising. Sometimes the price of petrol actually falls. So you might say, well, if I'm looking at a kind of horizon of the next year or two, the increase and decreases might cancel out. That might be true also for some types of food purchases. So some, I'd say, the commodity type things, some of that sometimes, the price goes up, the price goes down. So what we focus on with this phrase of underlying inflation is, if we see that kind of inflation pick up, it's likely to remain with us. And that's where we need monetary policy to respond. Because if that inflation remains with us, it will not fall back to 2% on its own. It needs monetary policy to respond. Now, for us these days, the kind of challenges with the pandemic, with the war situation, that is a lot of special factors. We had very unusual price movements over the last couple of years. In the first year of the pandemic, there was a big increase in the price, say, of home gym equipment. So people were at home. They really wanted to buy a stationary bike. They may want to buy a better computer monitor and so on. And so there was a congestion for those prices. We all know with the war that there was a very rapid and spectacular increase in the price of gas. So for firms, if they had a gas-powered factory, that was a very important for electricity generation, or if you had gas heating your home, that very rapidly and in a very severe way raised prices very quickly. What we see now is the price of gas has reversed. And so a lot of the traditional ways of saying, well, is this a price increase that's temporary? Is it going to last longer? I think we've thrown out the traditional, if you like, rulebook on that, and we are taking a fresh look because we do think some of the energy price increases have long-lasting consequences. We do think some of the food increases have long-lasting consequences. On the other hand, with a big reversal in gas prices, we do think that this will help to cool down inflation across the economy. And as you get out of the pandemic, a year ago, tourism was super expensive. People really wanted to go on holiday last summer, but the airlines were not ready, the hotels were not ready, and you had this kind of mismatch between demand and supply and very strong price increases. This year, maybe still pretty strong, but maybe more normal. Next year, maybe more normal again. So after the pandemic, we think the economy is reshaping, and we have to take that into account in, if you like, exploring this mysterious concept of underlying inflation. And this is why this, for me, I always say this, there's no shortcuts, there's no single number out there that say, oh yeah, that's underlying inflation. It requires us to take account of a lot of factors, but it's super important for monetary policy that we try to do the best job we can of identifying those elements of inflation that will persist and that require us to respond to monetary policy. And what are you seeing in terms of underlying inflation right now? I mean, you mentioned energy prices, they're going down, so they're pushing headline inflation down. So let me say, I think there's two forces. One, we do expect that the decline in energy prices will help also to moderate inflation across the economy. And so many sectors use energy as an input. If I'm running a restaurant, if I'm running a bus company, if I'm running a hotel, all of these use a lot of energy. So the fact that energy prices are now falling, not just stabilizing, but falling, should put downward pressure across many categories over these months. The price of goods, I talked about how they went up strong in the pandemic, that now seems to be calming down. So those are favorable developments. Let me point out the opposing trend, which is last year prices went up a lot, but wages were slow to respond. This year, we are seeing wages pick up. People need to improve their standard of living after suffering last year. And so even those other factors are declining. The wage element is pushing up inflation now. That's, if you like, a kind of natural phase two of this inflation cycle, if you like. We don't think it lasts forever, but we do think right now that that wage element is playing a role. That brings me very nicely onto the next question, Philip, which is indeed about wages and this thing called the wage price spiral. I mean, as you've said, wages have gone up and prices are also still rising at 6.1%. And this is despite the monetary policy measures and despite the fact that energy prices have fallen and supply chain issues have calmed down. Philip, can you explain briefly what is a wage price spiral? You already mentioned it a little bit and how concerned are you about it? So this is a famous phrase going back to decades, the wage price spiral. So let me start with that, but then let me move on to a different way to think about it. So the wage price spiral, I think captures quite a lot of what has happened historically in basically in episodes where inflation not only rose, but stayed high for a long time. Because essentially what happened was, for some reason prices went up, then wages rose strongly in response to that. High wages in turn caused firms to raise prices yet again. But essentially fundamental to that was essentially people's behavior changed. They believed, well, if inflation is 10% this year, it's gonna be 10% next year or indeed 12 or 14. It was a true spiral. So there was a kind of leapfrogging. Wages would go up, prices would go up more strongly and you leapfrogged to mixed metaphors. Leapfrogging, spiraling, and you had inflation not just going up for a year or two, but moving up for a long time. And we know countries right now around the world and in history where inflation is not in single digits, it goes double digits and beyond. We don't see this. We do not see this and this is so important because what's happening, a big factor for what's happening is what I would call catch up. Last year, inflation took everyone by surprise. Inflation towards late 22 was over 10%. Nowhere were wages growing at that rate or very few places. So what we do think is this year when a worker or union is negotiating with the employer, there's a recognition that there has to be a kind of special wage increase if you like to not fully make up for last year, but to partially make up. And what we have in the forecast we released last week is this year we expect wages on average in Europe to maybe grow at 5.5, let's say. That's a rough number. Next year, we think there's more to go because inflation will be lower, the pressure on wages will be less intense and we think wages in 2024 might grow at 4.0 something. And then in 25, at 3.0 something. These are higher than normal, but if you like it's an inverse spiral. It's not every year getting higher. It's a big adjustment this year, still more to do next year, still more to do in 25. So it is a multi-year dynamic. Labor markets move slowly. People typically negotiate their wage once a year or even in some countries once every two years or even longer. So this is why even though the energy prices are reversing, even though the pandemic bottlenecks are easing, it's not the case we come back to 2% overnight. So what I would say is our analysis strongly indicates that with our monetary policy, with the reversal of these original inflation shocks, we have a high degree of confidence that inflation will fall back towards 2%. But in that transition, there will be a phase like we have right now where if you like, that return to 2% goes more slowly because of the need, the inevitability of wages needing a period to catch up. So again, for me it's kind of an adjustment phase. It's a catch up phase. It is not a spiral. It comes back to the long view that you were talking about earlier, Philip. Right, right. So I think this is definitely, monetary policy is definitely more of a marathon than a sprint in many ways. Now there is another spiral that I want to talk to you about and that's what they call the profit price spiral. So we've got the wage price spiral. Now we're on the profit price spiral. Now companies in some sectors have made surprisingly high profits recently and people are doubting that they are simply covering their higher costs and some have even called this greed inflation. And the idea is that companies are exploiting the inflation that we're seeing to put up their prices way beyond just covering the extra costs that they've had, for example, linked to higher energy prices and then using that to maximize their profit margins. And that in turn can lead to inflation going up even more a bit like this leapfrog effect as well. Philip, how much are company profits driving inflation in your opinion? So I think the way you describe it, I think captures a lot of what's going on. So let me focus on last year. So the high inflation we had from the start of the war all the way through the rest of it last year. So what we think is essentially, the biggest driver was as you say, the cost of energy. Now then on top of that, you have to ask, well, how did the payments to workers, wages and how did the payments to the owners of firms, the profits move? And we do see not, there was very little contribution in 2022 from wages. There was a significant extra, if you like injection of inflation coming from rising profits of firms. So that is true. What we think this year is different and again for the years to come. Because we do think what's happening now this year is that wages will go up and that will partly be absorbed by firms, which as you say in many sectors made good profits in 2022, recognizing they cannot pass all of the wage increases on to the consumer and they have to accept lower profits. That's going to be one of the major issues we track. How strongly is that happening? Because of course, if the wage increases are fully passed on to price increases, then the level of inflation will remain higher for longer and we would have to respond. But I do think the economic incentives will be that in some sectors firms know very well that they made extraordinary profits last year and know very well that if they tried to repeat that this year, then in the context of higher interest rates, they would lose customers, they would lose revenue over time. They would have to recognize that essentially the open goal if you like they had last year. What I said to you last year, there was such a strong demand for tourism, strong demand for going out. There was an opportunity to raise profits. I think that is less through this year. Let me mention one other factor here. It is of course, in some industries, for example, like agriculture or commodities, there are a lot of global influences and prices. Again, last year in 22 a lot of those global influences were basically in the direction of rising global prices. And if prices are rising around the world, it's easier for European firms to raise prices. What we think now actually is, because it's not just the ECB tightening policy, the Fed is tightening policy, the Bank of England is, there's a lot of tightening in many parts of the world. So we do think global prices are going up more slowly and in turn that will limit the ability of European firms to raise prices as well. Well, Phillip, thank you for this truly fascinating conversation. It was really interesting and lots of insights there for our listeners. Before we wrap up, we always have a question that we ask all our guests on the podcast. You've been on the podcast before, so I'm sure you know it. And that's for a hot tip linked to the topic that we've been discussing today. Have you thought of something for our listeners? So let me advertise the ECB forum next weekend in Cintra and there's a great website and over and above the kind of other contributions from, if you like, senior academics and policymakers. This is very important and actually the most fun part of Cintra for me is to get to know the work of the 10 young economists who've been shortlisted for their work on economics and finance. So these are people who are typically finishing their PhD in some of the world's best programs. And I can tell you by far the best economic research is done by people in their 20s. They're doing their PhDs. They're innovative. They're creative. I learned so much and this new generation of economists typically have amazing contributions. And on the website, you can find their bios. You can find the papers they've written and I believe the final selection there by President Lagar the announcement next Wednesday will be streamed on the internet. Absolutely. That's a brilliant hot tip and indeed you can head to the website listeners and you'll find all that information that Philip has mentioned. Now, also for those of you looking to hear more about some of the topics we discussed today, you will want to follow our ECB forum on central banking. It's taking place from the 26th to the 28th of June in Cintra, Portugal and in addition to the Young Economist Prize Award ceremony that Philip mentioned, there will also be panel discussions and sessions on a wealth of topics. So we've got monetary and fiscal policy in the face of high inflation, supply shocks, changes in energy markets, macroeconomic forecasting and much more. And indeed, all of it will be live streamed. So head to the show notes to get the link to the program. Now, I want to thank our chief economist, Philip Arlene, for joining the conversation today and for giving these valuable insights. Thank you so much, Philip, for joining us. It was my pleasure. You've been listening to the ECB podcast with Katie Ranger. If you like what you've heard, please subscribe and leave us a review. Until next time, thanks for listening.