The Importance of Understanding Underlying Inflation in Setting Monetary Policy

Introduction

As the world recovers from the disruption caused by recent events such as the pandemic, energy shocks, and wars, governments and central banks grapple with inflation rates and managing monetary policy. In this lecture, Philip Lane, a Member of the Executive Board of the European Central Bank, discusses the importance of understanding underlying inflation in the setting of monetary policy.

Conceptual Issues of Underlying Inflation

According to Lane, underlying inflation refers to the medium-term estimate of where headline inflation will settle after temporary factors have vanished. It is essential to distinguish this signal from the noise produced by temporary or idiosyncratic factors that may affect inflation rates. To ensure robust policy decisions, policymakers must understand and monitor the signals from underlying inflation.

Recent Data Flows Relevant to Assessing Underlying Inflation

Lane notes that the current data flows from the euro area offer insight into the assessment of underlying inflation. Inflation forecasting and the analysis of underlying inflation are complementary cross-checks. Policymakers must consider the signals from both areas when making monetary policy decisions.

Related Facts

– Central banks have set inflation targets to ensure price stability and maintain macroeconomic stability.
– Fluctuations in inflation rates can occur due to internal and external factors such as supply-and-demand factors, geopolitical events, and natural disasters.
– The Covid-19 pandemic has caused significant disruption and increased some consumer prices and declined in others.
– Inflation expectations and wage dynamics are essential inputs in determining underlying inflation.

Key Takeaways

– Distinguishing between signal and noise is crucial in understanding underlying inflation rates.
– Policymakers must consider both inflation forecasting and analysis of underlying inflation when making monetary policy decisions.
– A medium-term estimate of where headline inflation will settle after temporary factors vanishes is necessary to ensure robust policy decisions.

Conclusion

The assessment of underlying inflation plays a vital role in the setting of monetary policy. Policymakers must understand and monitor the signals from both inflation forecasting and analysis of underlying inflation to ensure robust policy decisions. Moreover, as economies recover from disruptive events, policymakers must pay close attention to underlying inflation and its signals to maintain macroeconomic stability.