 The world has faced many challenges recently, a global pandemic, energy shock and the outbreak of war, all of which has affected people, every one of us, and of course our economy too. Inflation started to increase, it peaked in late 2022 at 10.6%. To fight this, we started raising interest rates in July 2022. We did that 10 times. And since September 2023, we have kept them unchanged. And this was also the case in our meeting in March. We have seen strong disinflation. In February this year, inflation declined to 2.6%, but we are not quite at our 2% inflation goal yet. You are listening to the ECB podcast, bringing you insights into the world of economics and central banking. My name is Stefania Secola. With me today is ECB Chief Economist, Philip R. Lane. He'll be updating us on where inflation stands and on the recently announced changes to our operational framework. This is what we use to implement our monetary policy. I think many are interested in understanding what this is about and what it means for interest rates in the years to come. Philip, great to have you back on the podcast. We've got lots to cover today. As we said earlier this month, you and your colleagues on the governing council decided to keep interest rates unchanged. This is part of our fight against the high inflation we've seen. Can you give us some background into that decision? Where does inflation stand right now? So what we have is a situation where compared to the very high peak you mentioned of 10.6% in October 2022, inflation has come down a lot. This is, by the way, what we expected to happen last year. Essentially, the very big price increases in 2022 especially were not repeated in 2023. And with this improvement in the situation, inflation has come down. But we have to make a judgment call. We have to make a judgment call about at some point the improvement in inflation will allow us to roll back some of the rate increases you mentioned. And essentially where we are now in March is we do have a baseline forecast. We look ahead and the baseline forecast says this year inflation will average at 2.3%. So since in February inflation was at 2.6%, we do think there'd be more progress this year. And then we think next year and the year after inflation should stabilize around a 2% target. I think this is a good baseline. And essentially what we decided is in these weeks from that meeting, we need to keep on checking this assessment. And what I would say is if this assessment is confirmed, then we will start looking more closely at reversing some of the rate increases we've made. So what I would say is good progress, there's still some questions to answer, and as the data teaches us about the open questions, then we will move forward. Thank you. Let's talk about wages now. Because along with profits and productivity growth, wages are one of the things you are keeping a close eye on. In a previous episode, and by the way, dear listeners, we will link to that episode in the show notes, you explain how wages and prices are interlinked in what we call the wage price spiral. So prices go up, then wages rise in response to that, firms increase prices to cover the higher wages, and so the spiral continues. You said that rising wages are pushing up inflation. What's going on there? So it's important to emphasize is the very high inflation did not originate with high wages. The very high inflation primarily had to do with very large increases in energy prices, which is mostly for Europe coming from the rest of the world. So high gas prices, high oil prices. But these, of course, raise the cost of living. And then we have, if you like, the second round is people naturally need to see an improvement in their wages to offset, to some extent, that increase in the cost of living. And so the trigger was, if you like, external price increases. So what we have now is those external price increases are coming down or stabilizing. So what we have remaining is this second round dynamic. How big are the, we expect to see bigger wage increases than normal. We had that last year. We expect to have it this year and also, by the way, next year in 25. So it's a multi-year process. So last year, wages grew around 5.3%. We expect wages to go around 4.5 this year, 3.6 in 25. And then, if you like, back to a normal value around 3% in 26. So we expect to see wage increases. But let me encourage you, if you like, in terms of language, we don't think it's a spiral. The spiral suggests the dynamic every year is getting stronger. So to me, that's a spiral. And some historical episodes, we saw a spiral. What I would face this is, it's an adjustment. What's key to the adjustment is every year it's kind of moving closer to normal. So as I mentioned, we had the peak last year of wage increases at 5.3. What we're looking for is evidence of deceleration to mid-force this year. We've seen deceleration in the last months of 23. We've seen deceleration in the opening weeks of 24. But we need to see more evidence of that. So what I would say is that, to repeat, workers were not the origin of the high inflation. It's desirable and inescapable that we do have several years of wage increases above a normal level. But what we need to make sure is it's basically a return to normal. It's a normalization process. And this is where we're looking at this. And I would say we're confident that it's on track. But of course, it's always good to double check with the incoming data. And is the situation the same across all euro area countries? I'm thinking, for example, about how countries have very different ways of negotiating pay rises. So let me mention, and I think there's a number of factors here. One is the increase in the cost of living has been very different across Europe. Partly, the energy mix is different. Countries have a different exposure to gas and to oil. And other countries, renewables are important or nuclear power. That's one element. A second element is we've seen very big increases in food prices. And again, parts of Europe are different in how they expose the art to that. So one basic issue is the cost of living pressure is different. Yes. And that source of wage pressure is different. But then also on top of that, we have to recognize in some countries, the labor market is tighter than others. Unemployment is lower, firms report that they have shortages of workers. And so the environment, how quickly workers can raise their wages, differs across the area. So of course, we have 20 member countries, we look at this. But what I would say is by and large, and it's the nature of Europe, I think it is a very strong focus in Europe on essentially having a fair process. So for example, one way the wage increases are happening is through public policy. So minimum wage legislation. So we saw last year, on average across Europe, minimum wages go up by about 10%. So in other words, it's clear that the people who are hurt most by the cost of living increase are those on low incomes. So raising the minimum wage has been a big part of how Europe adjusts. And more generally, unions are stronger in Europe than in some other parts of the world. So there's a lot of emphasis on negotiation. So famously, the ECB has been tracking wages. And we're essentially looking at the negotiations between unions and employers. And that kind of centralized or coordinated way to set wages is maybe contributing to an orderly process. But again, we need to keep an eye on this in the coming years. So let's stay in the realm of jobs. Unemployment is still at historically low levels. That's good news. Of course, many people are still in work despite of tough times we've experienced. At the same time, though, 2023 wasn't a great year for growth. And our last projections expect growth to be at 0.6% in 2024. Just to compare, in 2022, it was at 3.4% in the euro area. So despite the low growth or low growth, the labor market is strong. Why is that? So let me say that the pandemic has been very unusual in many ways and around the world. So let me focus on the fact that we welcome. It is very good news. Unemployment is so low. But when we think about the overall strength of the labor market, that's not all we look at. So compared to 2022, for example, the amount of vacancies has come down. So if you are looking for a job, you've just graduated from college or school or you're re-entering the workforce after taking time out and so on, the opportunities are less. The amount of jobs created last year was lower than the year before. So it's not a very strong labor market. But it is an interesting question about, normally, you would expect to see if there's a big slowdown in the economy to have a kind of pickup and unemployment. And this is going to be one of the very big questions we face. Essentially what we think is happening is many firms agree with us that there is a recovery coming. We have a recovery in the economy coming from the middle of this year onwards. So rather than go through the very expensive process of, if you like, kind of downsizing your workforce and then rehiring them six months later, firms, in many sectors, I think I'm making the calculation, we will hold onto these workers. We will need them when the recovery comes. Let me mention top of that two other factors is that throughout the pandemic and also in relation to the energy crisis, in many European countries, the government, the public sector has been hiring. And so there's been a lot of labor demand from non-market sources like the health system and so on. And maybe the other factor is the mix of activity has changed. What we see is manufacturing and construction has been subdued, whereas the service sector, especially what we call contact-intensive services like tourism, hospitality, entertainment, these hire a lot of people, especially in terms of more kind of entry-level positions and so on. So that is keeping unemployment low. But what we need to see over time is the economy to kind of rebalance, to see a recovery if like in high-value added sectors like manufacturing, to see a recovery in construction. And so it's a complicated picture, but I think a lot comes back to, let's not forget the really, really huge shock of the pandemic and how destructive that's been around the world. And so we do have this unusual configuration right now. We think we understand it and as I say, ultimately our assessment that the recovery is coming will basically rationalize the decision of many firms to hold on to workers. Yeah, thanks for breaking this down for us, Philippe. I'd like to discuss something else now. As I said before, our governing council just decided to make changes to our operational framework. But let's briefly explain what that is. As a central bank, we influence the economy and ultimately prices by steering the price and the amount of credit available to people and businesses. Commercial banks are the ones providing credit, but the conditions for doing so are steered by the central bank. This interaction is governed by a set of tools and procedures which we like to call our operational framework. Philippe, why did we decide to review our framework now? What I would say is that the fundamental basis of money is controlled by us. So among the listeners today, I think when people think of money to think of what any bank notes they may have, but they primarily think of the money in their bank account. So then the question is what determines those monetary dynamics? And what I would say is in the end, the decisions of the banking system in terms of how much they lend, how they invest and so on, turns on how they interact with us as a central bank. And essentially, the relationship we have with banks turns on basically three key interest rates. One is at what rate can they borrow from us in a regular operation? So we have what's called as the main refinancing operation, which is every week. So that's basically a very important number. A second number is at what interest rate can they deposit money with us, and that's called a deposit facility rate. And then we have a third interest rate called a Marta lending facility, which is basically for maybe unusual circumstances for individual banks. So we have created a lot of money since 2015 through asset purchasing, through lending operations, and this is true around the world. But what's happened in the last couple of years is now a lot of that is in reverse. We've stopped QE, our stock of bonds is coming down, and the very large lending operation, the TELTRA program is coming to an end. So as the amount of money shrinks, if you like, then it's important that we updated our operational framework. And essentially, in broad terms, we have, I think, a system that will suit your area, which basically has a narrow differential between the rate at which we lend in our main refinancing operation to banks and the rate at which they can deposit money with us. And we think this will create a lot of stability. So let me just emphasize, is in the end, and I think it's the main basis of this, is that we want our operational framework to deliver the commercial environment in the money market needed to bring the economy where we wanted to go in terms of inflation. And we think this system, this operational framework will do that. It's a system that relies less on a very large balance sheet. And so it's suited to this new world in which we no longer need to do QE. We no longer need to have a very large targeted lending operation. And so it's really, I think, good practice to anticipate the fact that in the coming years, let me emphasize, this is about the coming years. It's not about next week or the rest of this year. This is just helping the banking system prepare for the future. And some people might wonder how the review of the operational framework fits with the ECB's decision to raise, hold, or cut rates every six weeks. Could you explain that? So I think it's very important maybe to say this is just how we implement. So the decision about where interest rates should be, we take on the basis of where we think inflation is going. Then at the second stage of, okay, how do we implement that decision? So I would say there's no implications for the interest rates that you listeners care about. And it's an implementation mechanism. But from the point of view, unless you work in the money market section of a bank, this is not something that's super visible to you. So I would say it's very important from a technical point of view. It's very important for the money specialists in the banking system. But again, when you read your headline in the newspaper, when the ECB raises the cuts rates, that's what matters. Thank you so much, Philip. As you know, we always have a question for our guests. And that's for a hot tip. Link to the topic we've been discussing. Philip, what do you have for our listeners today? So this may surprise you, or maybe not, since you know me a little bit. I'm going to, my hot tip is the new occasional paper 344, which is called ECB macro econometric models for forecasting and policy analysis. So I think this is a fascinating read. It's basically our group of economists who run the models, the famous models here at ECB, explaining what's inside these models, how we use them. I think there's a lot of mystique about this phrase about the ECB models, and this will demystify, I think, this topic for many people. So I welcome that this new report is available. I think you need to sit down and take your time in reading it. So it's not the easiest read, but it's definitely my hot tip. Thank you so much, Philip. This brings us to the end of this episode. I want to thank ECB chief economist Philip Arlene for this very interesting conversation. Thank you, Philip. You're welcome. Dear listeners, check out the show notes for more on this topic. You've been listening to the ECB podcast with Stefania Serkola. If you like what you've heard, please subscribe and leave us a review. And in the spirit of Europe, I'd like to end in Irish today and say slán. Until next time, thanks for listening.