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Frankfurt am Main, 06.02.2025 12:00:00

The Frankfurt School Centre for Central Banking, together with Bankenverband Mitte, invited to a guest lecture by Pablo Hernández de Cos, former Governor of the Banco de España and incoming General Manager of the Bank for International Settlements (BIS) on 27 January in the Frankfurt School Audimax. Jens Weidmann, Professor of Practice in Central Banking at Frankfurt School, and Sarah Schmidtke, Managing Director Bankenverband Mitte, opened the event and welcomed Pablo Hernández de Cos.

In his speech, the former governor reflected on the recent inflationary episode and its implications for monetary policy. He discussed various reasons for why inflation was so high and persistent and why central banks had initially underestimated it.

In the aftermath of the COVID-19 pandemic and at the onset of the Russian war on Ukraine, Inflation had risen sharply in the Euro area, reaching almost 11% before decreasing to 6% by October 2022. This was driven initially by supply chain disruptions and then exacerbated by energy price increases. Central banks, as many other economists, underestimated this extraordinary surge in inflation, especially after the war in Ukraine. A significant portion of the large forecast errors came from inaccurate technical assumptions, particularly concerning energy prices. Models struggled to capture the large shocks and their transmission to inflation. Nonlinearities in price adjustments by firms further complicated forecasting.

Euro area inflation – supply side shocks as main driver

He also emphasised that supply-side shocks were the main driver of inflation in the Euro area, unlike in the US, where demand-side forces were more dominant. The response to supply shocks should depend on their persistence. Governor Hernández de Cos emphasised that Central banks must be pre-emptive and forward-looking and rely on a risk management approach. Clear communication about uncertainty is also crucial. He advocated for a well-defined 2% inflation target with a mid-term orientation, focusing on underlying inflation trends rather than short-term fluctuations. He further pointed out that central banks should avoid unconditional commitments but instead provide state-contingent guidance.

The lecture also highlighted the low sacrifice ratio – the low output cost of reducing inflation – in the euro area during this inflationary period. The governor argued that this was partly due to well-anchored inflation expectations and faster repricing by firms. He noted the uncertainty surrounding the natural rate of interest (r-star), emphasising that monetary policy should be robust to different scenarios. He also argued that the transmission of monetary policy to prices may have been stronger in the recent episode, while labour markets were resilient. Interest rates should remain the primary monetary policy instrument. Finally, he argued that Quantitative tightening (QT) has had a smaller effect than quantitative easing (QE) and should be implemented gradually and predictably.

During the Q&A session, which was moderated by Frankfurt School Professor Emanuel Mönch, topics like central bank coordination, structural reforms, and the inclusion of Bitcoin in reserves were also discussed, and the attendees continued their discussions at a reception with snacks and drinks.