Monetary Policy Transmission in the Euro Area: Is this Time Different? Chapter I: Lags and Strength

This paper documents the transmission of conventional monetary policy (MP) shocks over the period of two decades of the euro area’s existence. First, we estimate a linear Bayesian structural vector autoregression (SVAR) and show that it takes approximately 12-18 months for the MP shock to fully transmit to both output and headline inflation. However, the transmission lags to the core and services inflation are longer, with full pass-through requiring more than 2 years. This implies that the impact of policy rate hikes implemented in 2022 and 2023 are still unwinding and will further contribute to disinflation of these HICP items. We then extend the SVAR system to allow for time-variation in both the parameter space and shock volatilities to pin down potential changes in the transmission mechanism. Time-varying impulse response functions reveal that the impact on output has been broadly stable over time. However, the reaction of inflation to policy rate hikes has been much stronger and more persistent in the recent tightening cycle, suggesting an exceptionally low sacrifice ratio. Finally, we rationalize those findings in a medium-scale New Keynesian DSGE framework. Model simulations suggest that two factors have contributed to the stabilisation properties of monetary policy: a forceful central bank response to the inflation surge and an increase in the frequency of price changes. While frictions related to wage-setting and real rigidities have likely had only minor implications concerning the effectiveness of monetary policy in the recent tightening cycle.