Since the pandemic, monetary policymakers have been facing an exceptionally complex environment. As inflation rose, we were confronted with profound uncertainty about how far it would go and how widely it would spread across the #economy. And even as inflation has eased, uncertainty about its persistence has remained.

The potential costs of mis-calibrating policy have been high, which is why we had to employ a policy framework that minimises the risk of mistakes. And we have done so by building our reaction function around three criteria: the inflation outlook, the dynamics of underlying inflation and the strength of monetary transmission.

Though we conceived these criteria when we had low visibility of future inflation, they have also helped guide our decisions as inflation has fallen and forecasts have become more accurate.

As Marie Curie once said, to thrive through the ups and down of life, "we must have perseverance and above all confidence". And our framework has indeed encouraged us to persevere when necessary and to build up confidence when needed.

It has served as a reliable compass for calibrating policy through three phases of our current policy cycle.

First, it helped create robustness during our tightening phase when we were devising how far we needed to go to rein in #inflation.

Second, it has helped us practice patience during the holding phase until the signals from our inflation projections and underlying inflation are more consistent.

Third, it will support us in building up sufficient confidence to begin the dialling-back phase in which we make policy less restrictive.

The tightening phase.
In the early phase of our tightening cycle, our main priority amid surging inflation #rates was to exit our accommodative policy stance as quickly as possible. While the policy challenge was immense, the policy path was relatively simple to calibrate.

But as rates rose and approached restrictive territory, calibrating our policy stance became more complex. We first had to assess how much rates needed to rise until they were sufficiently restrictive, and then for how long they needed to stay at that level. But our assessment was blurred by much lower than normal visibility of the future.

Our forecasts repeatedly underpredicted inflation by large margins, even at shorter horizons. From 2021 to 2022 for example, the absolute inflation forecast errors in the staff #macroeconomic projections, one quarter ahead, more than doubled, largely owing to volatile energy #prices.1

At the same time, the mix of shocks that emerged from the pandemic and its aftermath – rotations in spending, energy spikes, "bullwhip" cycles in manufacturing, supply bottlenecks, tight labour markets, fiscal expansion and reopening effects – heightened the risk of inflation becoming more persistent.

We faced a highly unusual conjuncture of high inflation and declining real wages, but also rising employment. This combination essentially implied a multi-year catch-up process to make up for real wage losses. In turn, this process could have triggered what I referred to at last year's conference as a "tit-for-tat" inflation dynamic.2

And we faced uncertainty as to how quickly and forcefully our monetary policy response would succeed in bringing down inflation. The ECB had not been through a tightening cycle for more than a decade, and there were reasons to believe that the transmission of monetary policy to firms and households might have changed.3

So, to calibrate policy accurately, we needed a framework for policy decisions that would work when we had low visibility and would mitigate heightened uncertainty. This is why we built our monetary policy response around the three criteria I referred to earlier: the inflation outlook, the dynamics of underlying inflation and the strength of monetary transmission.

This approach made our decisions more robust, as the inflation path we foresaw in our projections had to be validated by data we could observe in real time and extrapolate into the medium term. That, in turn, enabled us to take forward-looking decisions with a higher degree of confidence.

And it served us well in practice.

The three criteria helped us to map out the remaining climb, allowing us to bring rates to sufficiently restrictive levels to break the persistence of inflation.4 But also, by guiding us to carefully evaluate the strength of policy transmission, they acted as a cross-check against overtightening. This helped us reach the decision to stop rate hikes after last September.

The holding phase,
Building sufficient confidence to dial back policy,
Conclusion,