1 Introduction

After a long period in which inflation remained well below the European Central Bank's target,
prices in the Netherlands and the euro area have shot up in recent months. This is partly due
to the reopening of the economy after the COVID-19 crisis, which was accompanied by a sharp
increase in demand that supply has yet to catch up with. The Ukraine crisis has added to this
conundrum, especially as energy prices have risen sharply. Economic growth is losing
momentum due to the war in Ukraine, and this puts the ECB in a difficult position. The central
bank has to balance curbing inflation (by raising interest rates) with stimulating growth (by
keeping interest rates lower). As the ECB's primary mandate is to ensure price stability, it has
started to phase out its support measures. In the longer term, however, high inflation and low
growth are not necessarily incompatible: a recent study by DNB researchers shows that an
inflation level of above ~4% harms long-term growth potential. Reducing very high inflation
therefore can foster economic growth in the long run.

This DNB analysis is a follow-up to a DNB analysis from March 2022, which presented a scenario
in which the Dutch economy is exposed to long-term disruption of the commodity market as a
result of the war in Ukraine.1 That analysis shows that the Dutch economy and that of the euro
area as a whole both suffer considerably from these disruptions. The focus of this analysis is on
the euro area and the implications for monetary policy. The first section describes the economic
outlook, the role of energy prices and the broadening of inflationary pressures. The second
section focuses on the role of monetary policy. In particular by looking at the importance of
demand and supply shocks, the risks of inflation expectations moving away from the 2% target
(de-anchoring) and second-round effects through wage formation. Finally, we discuss the steps
already taken by central banks to curb inflation and possible further steps they can take.

3
2 Economic outlook and drivers of
inflation
2.1 Energy and commodity prices
Dutch inflation started to rise in the second half of 2021, when economic demand picked up
due to the relaxation of coronavirus restrictions. During this period, supply struggled to keep
up with this increasing demand, due to the lingering distortions in production and supply chains
and scarcity in the global markets for energy and other commodities. The Russian invasion of
Ukraine has added to the supply problems, causing commodity prices – and the price of natural
gas in particular – to rise to unprecedented levels. The sharp rise in energy prices is one of the
main driving forces behind the rise in inflation. Since the end of 2021 households and businesses
have been paying significantly more for fuels, especially natural gas and electricity. In April
2022, energy prices in the Netherlands were 83% higher compared to the year before. This
obviously has an impact on inflation. Dutch inflation, calculated according to the harmonised
consumer price index (HICP), was 11.2% in April, of which as much as 7.0 percentage points
were due to energy inflation (Figure 1).

Figure 1 – Dutch inflation and its components Figure 2 – Euro area inflation and its
percentage points and percentage changes (y-o-y) components
percentage contributions resp. annual changes and average
annual estimates
12 8

10
6
8
4
6

4 2

2
0
0
-2
-2 19 20 21 22 23 24
19 20 21 22 Energy Food
Services Ind. goods excl energy Ind. goods excl energy Services
Food Energy total HICP Core inflation
Total Core inflation ECB projection March ECB projection (core)
Sources: DNB HICP estimate, Eurostat and Statistics Sources: Eurostat and Statistics Netherlands.
Netherlands

The same applies to the euro area, although the picture is slightly less extreme (Figure 2).
Year-on-year inflation in the euro area was 7.4% in April. The difference with inflation in the
Netherlands is largely due to the fact that the price movements of natural gas and electricity
are measured differently in the Netherlands than elsewhere in the euro area. In particular,
Statistics Netherlands (CBS) measures the prices that energy companies offer on new contracts
every month. However, a large proportion of consumers have multi-year contracts with a fixed
delivery price. As a result, they are not yet affected by the high energy prices, even though the

4
increase has already been fully incorporated into the inflation rate. Another reason why Dutch
and euro area inflation differ is that compared to the euro area average, the Dutch economy is
more dependent on natural gas consumption. The increase in natural gas prices therefore has
a more significant impact on Dutch inflation than on euro area inflation.

2.2 Broadening of inflation

The sharp rise in the energy component of inflation does not tell the whole story, however. We
see clear indications that inflationary pressures have been increasing across the board. In part,
these are higher costs of energy and commodities that companies pass on to consumers.
However, rising demand, especially for goods and to a lesser extent for services, is also driving
price increases. The broadening of inflation has an important consequence. High inflation rates
for non-energy components are more persistent than those for the energy components and
therefore remain high for longer, even when energy inflation falls again. This is one of the
findings of the Inflation Persistence Network (IPN) which examined the dynamics of inflation in
the euro area. A persistently high inflation rate can lead to a de-anchoring of inflation
expectations. To get a feel for the degree of inflation persistence, central banks therefore look
closely at the development of underlying inflation, trying to see through temporary fluctuations.

Figure 3 – Measures of underlying euro area Figure 4 – Euro area services inflation rises
inflation at or near historic highs sharply
*y-o-y changes, box plots *percentage point contribution to headline HICP
8 1,5
7
6
1,0
5
4
3 0,5
2
1
0 0,0
-1
-2
-0,5
HICP HICPX HICPXX PCCI Supercore Trimmed
mean 12 13 14 15 16 17 18 19 20 21 22
(20%) Items with positive inflation
25th-75th percentile Median Items with negative inflation
Max-min 1999-2022 Last known services contribution to HICP inflation
Source: DNB based on ECB/SDW data. The most recent observation is the April inflation rate. The figure on the left
shows, in addition to HICP inflation (left), five measures of underlying inflation: inflation excluding food and energy;
inflation excluding food, energy and other volatile items; the persistent components of inflation; the components
that move with the business cycle; trimmed mean measure leaving out the 10% of items with the highest and 10%
with the lowest inflation, thus leaving out the most volatile items.

Several measures of underlying inflation show an increase. Figure 3 – which shows box plots
for the HICP index and for five measures of underlying inflation – documents how for each of
these measures, recent figures have been at or near the historical maximum. For example, at
5.5% the Persistent and Common Component of Inflation (PCCI)2 inflation rate is higher than

–––––––––––––
2
Persistent and Common Component of Inflation (PCCI) is a measure developed by the ECB to analyse common and
persistent inflation developments. PCCI uses information from 1,000 subcomponents of twelve euro countries in an
econometric analysis.

5
the other underlying measures, whereas in previous months it was mostly between 1.5% and
2.0%. As this measure reflects the development of the persistent components of inflation, it
suggests a risk that inflation will remain high for some time. Service inflation (Figure 4) also
shows that inflationary pressures have broadened. Services account for 42% of the euro area
HICP price index, and they are not directly affected by higher commodity prices or disrupted
production chains. However, we also see a sharp increase in the contribution of services to
inflation from the second half of 2021, with almost no services experiencing a fall in prices.

Box 1 - Euro area and United States inflation comparison

Figure A - Headline inflation – EA versus US Figure B – Core inflation – EA versus US

Seasonally adjusted indices Dec 2019 = 100 Seasonally adjusted indices Dec 2019 = 100, excl. food
and energy
110 US CPI excl 'owner equivalent rent' 110 US CPI core excl 'owner equivalent rent'
EA-19 HICP actual EA-19 HICP core
EA 3-mth delayed EA 3-mth delayed
108 108
EA 6-mth delayed EA 6-mth delayed

106 106

104 104

102 102

100 100

98 98
dec-19 jun-20 dec-20 jun-21 dec-21 dec-19 jun-20 dec-20 jun-21 dec-21
Source: Eurostat, BLS, owner-equivalent rent is the Source: Eurostat, BLS, owner-equivalent rent is the
imputed rent for owner-occupiers imputed rent for owner-occupiers

6
3 The role of monetary policy
The rise in inflation raises the question of the role of central banks and how monetary policy
can be used to curb inflation. Monetary policy does not directly affect all price developments
and has a delayed effect. Central banks therefore focus on price stability over the medium term,
with the ECB aiming for 2% inflation. In the short term, deviations from this target are
inevitable, for example in the case of economic shocks. The Eurosystem prepares quarterly
projections to assist the ECB's Governing Council in gaining an understanding of inflation over
the medium term. The next projections for the euro area will be published on 9 June and take
into account the most recent data on the economy and financial markets. The projections are
important input for further discussions on the design and calibration of monetary policy.

The ECB is currently facing very high inflation, but economic growth is also under pressure –
which is likely to slow down inflation over time. Both are largely due to the war in Ukraine. If
high inflation starts to affect wages and inflation expectations, the risk increases that inflation
remains high for a long time – which ultimately will have a structurally negative impact on
growth. The role of central banks is therefore not to let high inflation permanently infect the
behaviour of households and businesses. In addition, governments can mitigate the negative
effects of high inflation with targeted compensation measures for vulnerable households.

3.1 Inflation affecting wages and inflation expectations

In the Netherlands, negotiated wage increases have increased in recent months to 2.8% y-o-y
in April, according to Statistics Netherlands. According to the measure used by the Dutch
General Employers’ Association (AWVN), which is based on the unweighted contracts concluded
in May and is more forward-looking, the negotiated wage increase amounts to 3.7%. For the
euro area, wage growth lags further behind inflation, with contract wages 1.8% higher in March
compared to a year earlier (excluding one-off payments)3. The rise in Dutch negotiated wages
is understandable, given current inflation and the very tight labour market. Real wages have
fallen sharply and employees and trade unions are trying to make up for this loss at the
negotiation table. This is a normal economic phenomenon in which imbalances created by high
inflation are corrected. In this process, underlying inflation is usually reflected in negotiated
wages with a lag of a few quarters. The dynamics between wages and prices only become
problematic when a leapfrogging effect between prices and wages occurs: a wage-price spiral.

Persistently high inflation has raised concerns about the anchoring of inflation expectations.
These concerns are reinforced by the continued upward surprises in inflation figures and
indications from sectoral data that high inflation has become more broadly based.
Consequently, the longer-term (5-year) inflation expectations of professional forecasters have
risen above 2% (Figure 5; SPF), and even 2.4% for the most recent 10-year Consensus
forecast. Inflation expectations for 5 to 10 years, which are derived from financial instruments

–––––––––––––
3
Including one-off payments, negotiated wages in the euro area increased by 3.7% in March, mainly due to
coronavirus-related payments in Germany. One-off benefits show an acceleration, but are very volatile.

7
(inflation-linked swaps), rose rapidly to around 2.4% and have fallen back somewhat in recent
weeks to around 2.2%.

A model-based decomposition of the inflation swap curve suggests that the increase is mainly
driven by the inflation risk premium (Figure 6). This is because the observed inflation swap rate
is not a clean measure of inflation expectations and contains an inflation risk premium. The
inflation risk premium is the additional compensation that an investor requires to bear inflation
risk, and is an indication of the risk balance that financial markets attribute to future inflation
developments. The risk balance has shifted towards high inflation. All in all, professional
forecasters and financial markets seem to be assuming as yet that inflation will stabilise at the
upper end of the 2% inflation target, which also takes into account a number of interest rate
hikes by the ECB this year (see Section 4).

Figure 5 – Survey-based and market-based Figure 6 – Increase in inflation swap rates

inflation expectations on the rise appears driven mostly by inflation risk premium
2,8% 5y5y inflation risk premium
SPF Consensus 5y5y swaps
5y5y inflation swaps
3,0%
5y5y inflation expectations component
2,4% 2,5%

2,0%
2,0%
1,5%

1,0%
1,6%
0,5%

0,0%
1,2%
-0,5%

0,8% -1,0%
'04 '06 '08 '10 '12 '14 '16 '18 '20 '22 '12 '13 '14 '15 '16 '17 '18 '19 '20 '21 '22
Sources: SPF, Consensus, Bloomberg. The decomposition of the 5y5y ILS is based on an estimated model that follows
the methodology outlined in Camba-Mendez and Werner (2017). Most recent observation: 25 May 2022.

A monthly representative survey of about 2,400 Dutch households also shows that inflation
expectations among households have become less anchored since mid-2021 (see Galati et al.
2022). In this survey, half of the respondents are given information on the ECB inflation target
and actual inflation. Short-term expectations refer to a horizon of one year, long-term
expectations to a horizon of ten years. The median short- and long-term household expectations
of euro area inflation have risen sharply since last summer (Figure 7). Moreover, households'
expectations of the likelihood of high inflation – i.e. 4% or higher – have increased during the
recent period of high inflation realisations, both for the short and long term (Figure 8). This
pattern of long-term household expectations suggests that they are at risk of de-anchoring in
the euro area, as inflation has risen well above target in the aftermath of the pandemic. This
pattern is even stronger for the long-term expectations of households that were not given
information in the survey. These results suggest that inflation expectations may respond to
realised inflation, and households' expectations are therefore to a large extent backward-
looking. This is detrimental to the effectiveness of monetary policy and increases the likelihood
that inflation will remain high for an extended period.

8
 Figure 7 – Median household expectations of Figure 8 – Distribution of household long-term
inflation inflation expectations
7% 50 jun-21 mrt-22
ST EA LT EA
45
6%
40
5% 35
30
4%
25
3% 20
15
2%
10
1%
5

0% 0
dec-19 jun-20 dec-20 jun-21 dec-21 <0 [0,1[ [1,2[ [2,3[ [3,4[ >4

3.2 Both supply and demand factors drive inflation

Another relevant question for determining the orientation of monetary policy is to what extent
inflation is driven by demand shocks, which a central bank can stabilise, or by supply-side
developments, which a central bank cannot directly influence, such as high energy prices. For
example, higher than expected inflation can be caused by both adverse supply shocks and
positive demand shocks. The broadening of inflation (see Section 2) suggests that demand
shocks play a role, since the more goods in the inflation basket show an increase in price, the
more likely it is that this is driven by increased demand rather than supply problems for specific
goods. Intuitively, the fact that both economic growth and inflation went up unexpectedly in
the second half of 2021 also seems to indicate that demand shocks play a role (Figure 9).
Supply shocks, for example, are more likely to be associated with disappointing growth
forecasts and higher inflation.
Figure 9 – 2021 euro area inflation and growth Figure 10 – Decomposition of inflation forecast
higher than expected errors also shows role of positive demand shocks
6 5,0 supply demand
June projection 2021 Realisation 2021
4,5
5 4,0
3,5
4
3,0

3 2,5
2,0
2 1,5
1,0
1
0,5

0 0,0
Inflation Core inflation GDP growth 2021Q3 2022Q1 2022Q3 2023Q1 2023Q3

Source: DNB based on ECB/SDW. The figure on the right is based on a VAR analysis for inflation, the energy
component of inflation, the industrial production index and the nominal interest rate. The y-axis shows the quarterly
forecast errors of the June 2021 estimate for inflation in the euro area, distinguishing between the roles of demand
and supply shocks. From 2022Q2 onwards, inflation forecast adjustments are used instead of forecast errors. Supply
and demand shocks are identified through 'sign restrictions': for supply shocks, inflation and industrial production

9
4 What is the monetary policy stance?
Against the background of high inflation, which, as mentioned, is not driven by a supply shock
only, the ECB Governing Council decided in December 2021 to gradually normalise monetary
policy. Central banks typically steer inflation by changing policy interest rates. In recent years,
however, they have also used other instruments to influence prices, as interest rates were
already very low. Specifically, the ECB has provided long-term loans to banks (longer-term
refinancing operations – TLTROs4) and purchased bonds under specific programmes such as the
Asset Purchase Programme (APP) and the Pandemic Emergency Purchase Programme (PEPP).
As a result, the ECB’s balance sheet has grown strongly in recent years (see Figure 11) to
stimulate the economy, push up inflation – which was well below the ECB’s target for a long
time – and prevent permanent damage from financial market turmoil following the outbreak of
the COVID-19 pandemic. Accordingly, normalising monetary policy involves various
instruments, and these are discussed in this section.

Figure 11 – ECB balance sheet increase mainly Figure 12 – Purchase programmes sharply
caused by COVID-19 crisis reduced after peak of COVID-19 crisis
Special loans to banks (e.g. TLTROs) 180
Pandemic emergency purchase programme (PEPP) APP PEPP
Regular asset purchase programme (APP) 160
Total balance sheet
10000 Total balance 140
sheet
120
8000
Long-term 100
loans to
6000 banks 80

60
4000
40
Purchase
2000 programme 20

0
0
jan-20 jul-20 jan-21 jul-21 jan-22
10 11 12 13 14 15 16 17 18 19 20 21 22
Source: DNB based on ECB data. The difference between the balance sheet total and the remaining items includes
foreign currency, regular monetary operations (MRO, MLF), gold reserves, and covered bond purchase programmes
(CBPP1 and 2). Balance sheet data until 13 May 2022. Right-hand figure: PEPP and APP figures also include other
purchases, including of corporate bonds.

4.1 Purchase programmes

In December 2021, the ECB decided to terminate the pandemic emergency purchase
programme (PEPP) on 31 March 2022, which happened without much friction.5 Purchases under
the regular purchase programme (APP) are currently being phased out and are expected to end
at the beginning of the third quarter (see also the recent blog by ECB President Christine
Lagarde). All in all, this will put a fairly rapid end to the monthly purchases, which peaked at
€160 billion during the height of the COVID-19 crisis (Figure 12). This phasing out of the
–––––––––––––
4 The third TLTRO will end in June 2023. During the COVID-19 crisis, the ECB temporarily eased the TLTRO
conditions, as well as the rates that banks pay on the amounts they borrow under the programme. These special
conditions end in June 2022.
5 Monetary policy decisions, 16 December 2021

11
purchase programmes is taking place much faster than the ECB had anticipated in December
2021. At the time, the Governing Council expected to return to pre-pandemic purchase volumes
by the fourth quarter of 2022, and it had not yet announced their termination. 6 For the time
being, however, the ECB is maintaining a presence in the market through reinvestments. It
intends to continue reinvesting, in full, the principal payments from maturing bonds purchased
under the APP for an extended period of time past the date when it starts raising the key interest
rates. Maturing bonds under the PEPP will be reinvested until at least the end of 2024. This is
relevant because it can contribute to the normalisation of monetary policy, as the ECB’s market
presence ensures a smoother transition, allowing financial markets to better absorb higher
interest rates.

Box 2 – Financial markets' expectations of interest rate path

The €STR forward curve provides an indication Figure C - Markets price in more aggressive
of the development of policy interest rates as policy rate path
expected by financial markets. A forward ESTR Current
curve shows forward rate agreements for April GovC March GovC
February GovC December GovC
different maturities. Market participants use 2,0%
these to hedge against expected changes in
policy rates. By providing forward guidance, 1,5%
central banks attempt to influence the priced-
1,0%
in interest rate path, as it affects broader
financial conditions. The €STR forward curve 0,5%
Sep-22
has recently moved sharply forward (see
Figure c), implying that markets expect a 0,0%

faster rise in policy rates. Currently, a first rate -0,5%

hike is being partly priced in for July, and
markets expect to see a policy rate increase to -1,0%
Jan-22 Jan-23 Jan-24 Jan-25
0% in September (see Figure c). This shows Source: Bloomberg. The Governing Council meetings
that markets are pricing in a more aggressive were held on 16 December 2021, 3 February 2022, 10
March 2022 and 14 April 2022. We plotted this curve on
policy rate path than in December, clearly
29 May 2022.
moving with incoming data.

4.2 Policy interest rates

Bringing forward the APP’s intended expiry date allows for a first interest rate hike in July 2022.
This is because the ECB has so far communicated that a first interest rate increase will take
place ‘some time’ after the end of net purchases and that three conditions must first be met. 7
In particular, inflation must reach 2% well ahead of the end of the projection horizon and

–––––––––––––
6 The ECB intended to continue the APP for as long as the inflation outlook warranted this, which is why the APP was
open-ended. Purchases will be terminated just before the first interest rate increase.
7 The fact that termination of net purchases precedes a rate hike is not a hard and fast economic rule. The ECB opted
for this to avoid shocks to the economy in the absorption of a rate hike and because it has chosen to phase out the
most unconventional monetary policy measures first before raising interest rates.

12
durably for the rest of the projection horizon, and the ECB Governing Council must judge that
realised progress in underlying inflation (adjusted for more volatile inflation components, see
Section 2) is sufficiently advanced to be consistent with inflation stabilising at 2% over the
medium term. Given the current outlook and inflationary developments, it is likely that these
conditions will be met in the short term and that key policy rates will indeed be raised for the
first time in July (see also the recent blog by ECB President Christine Lagarde).

The imminent policy normalisation is already reflected in market interest rates and will therefore
already have an impact on the economy in the coming quarters. The central bank influences
the economy not only by raising policy rates or phasing out purchase programmes, but also
through communication (i.e. forward guidance) on future changes in bond purchases and policy
rates. Such communication helps central banks manage expectations about the use of the
various policy instruments, which in turn affects the shape of the interest rate curve, and thus
financing costs of households and businesses. Since inflation prospects shifted sharply upwards
compared to the pre-COVID-19 period, it is only natural for nominal variables, including capital
market yields, to move with them, as the latter also represent remuneration for holding assets
that harbour inflation risks.

Figure 13 – Sovereign bond yields in the euro Figure 14 – Financing rates for businesses and
area rise in both nominal and real terms households also go up sharply
Nominal 10yr GDP-weighted government bond yield EA 10-year mortgage rate (with NHG)
Interest on corporate bond with average maturity of 5 years
Real 10yr GDP-weighted government bond yield EA
Interest on 10-year government bond
2,0 3,0
1,5
1,0
2,0
0,5
0,0
1,0
-0,5
-1,0
-1,5 0,0

-2,0
-2,5 -1,0
Jan-20 Jul-20 Jan-21 Jul-21 Jan-22 jan-20 jul-20 jan-21 jul-21 jan-22
Sources: DNB based on ECB data, Bloomberg, actuelerentestanden.nl and SDW - real interest rates have been
adjusted on the basis of 10-year inflation swaps. Most recent observation: 25 May 2022

Capital market yields, even when adjusted for expected inflation (i.e. in real terms), are
currently still low, but an upward movement is discernible (see Figure 13). This suggests
monetary policy in the euro area is still accommodative, but tightening has started. This can be
seen even more clearly in Figure 14, in which the rise in interest rates on financing instruments
for businesses (corporate bonds) and households (mortgage rates) is evident. Arguably, this is
partly the result of the ECB’s communication about the accelerated phasing out of its purchase
programmes. Related to this, markets have brought forward expectations of the lift-off (see
Box 2), and they expect a higher number of rate hikes overall. The total priced-in path, and
estimates where monetary normalisation would be approximately neutral during the current
economic cycle, are also relevant for financial conditions (see Box 3). The pricing-in of ECB rate

13
hikes, together with rising real interest rates at the long end of the curve, shows that markets
are taking the ECB's policy intentions into account. This implies that the ECB has actually already
embarked on the course of normalisation, although this is not yet directly reflected in its policy
rates.

Box 3 – The "neutral" monetary stance

14
5 Final remarks
In late 2021, the ECB entered a new environment of high inflation. Inflation is becoming more
widespread, which implies that prices of more and more goods are rising. This changed
environment, after a long period of below-target inflation, calls for an adjustment of monetary
policy. With accommodative policy no longer being appropriate, the ECB is already moving
towards a neutral policy. The pace of this normalisation, however, will continue to depend on
incoming data and insights into the development of inflation and the broader economy. This
data dependence also applies to the end point of the normalisation. Initially, net asset purchases
will be phased out, and a rise in policy interest rates from negative to positive territory will be
initiated. How far interest rates will need to rise to stabilise inflation will depend on the economic
situation and the extent to which inflation expectations remain anchored.

15