Inflation and growth forecast errors and the sacrifice ratio of monetary policy in the euro area

This paper investigates the relationship between inflation and GDP growth forecast errors and the expected monetary policy stance in the euro area during the monetary policy cycle of 2022-2024, when inflation was well above the ECB’s target. Under rational expectations, forecasts of monetary contractions should be unrelated to subsequent inflation and growth forecast errors. On the contrary, we find that expected monetary policy tightening has been associated with higher than projected GDP growth, suggesting a lower monetary policy effect than that factored in by (ECB/Eurosystem and IMF) forecasters. In other words, forecasters overestimated the monetary multiplier. At the same time, monetary policy tightening has been associated with lower than expected inflation, suggesting an underestimation of the monetary multiplier on inflation. Putting these two stylized facts together implies that forecasters overestimated the sacrifice ratio during the last monetary policy tightening cycle. Our findings suggest that forecasters may have inaccurately perceived the recent inflationary crisis in the euro area as predominantly supply-driven, underestimating its demand-driven component. This led to the belief that monetary policy in the euro area would be exceedingly costly in terms of output.