The return of inflation, higher interest rates, record-high debt levels and geopolitical tensions threaten to expose vulnerabilities within the financial system.

This letter was submitted to G20 Leader ahead of their meeting on 15-16 November.
The letter notes that developments since the Rome Summit have been a stark reminder that global financial stability should not be taken for granted. The return of inflation to levels not seen in decades has resulted in a strong interest rate response and significantly tighter financial conditions. The tightening is occurring amidst record-high levels of debt of non-financial corporates, households and governments globally, and in a global financial system where the provision of finance through non-banks has become as important as bank credit.
The letter notes that during the Indonesian G20 Presidency, the FSB has intensified its monitoring of current vulnerabilities and taken forward work to reinforce the resilience of the financial system. At the same time, the FSB has continued to work to enable the financial system to adapt to secular trends. The FSB has done so in three ways. First, by taking forward the Roadmap for Enhancing Cross-Border Payments, with the focus now being on three  priority areas, cooperating closely with the private sector. Second, by developing a comprehensive framework for the regulation, supervision of oversight of crypto-assets activities and markets. Third, by working to address financial risks from climate change through enhancements to disclosures, data, vulnerabilities assessment and regulatory and supervisory policy. Work in all these areas will continue under the Indian G20 Presidency in 2023.
The letter outlines the reports being submitted to the November Summit, which cover:

Policy proposals to address systemic risk in NBFI
Key performance indicators to achieve targets for enhancing cross-border payments
Scenario analysis of climate-related financial risks to better understand the financial risks associated with transition to net zero

The FSB Chair asks for the G20’s continued and reinforced support for the work of the FSB to strengthen the resilience of the financial system as a whole. The challenges that lie ahead make global cooperation on financial stability matters as important now as it was after the global financial crisis, when the decisions of G20 Leaders triggered reforms that, coordinated through the FSB, have made the global financial system more resilient and growth-enhancing.
Compliments of the Financial Stability Board.
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Today, the EU Commission and the High Representative put forward an Action Plan on Military Mobility 2.0 and a Joint Communication on an EU cyber defence policy to address the deteriorating security environment following Russia’s aggression against Ukraine and to boost the EU’s capacity to protect its citizens and infrastructure.
In particular, the Action Plan on Military Mobility will help European armed forces to respond better, more rapidly and at sufficient scale to crises erupting at the EU’s external borders and beyond. It will bolster the EU’s ability to support Member States and partners as regards transport of troops and their equipment. It works towards better connected and protected infrastructure, while streamlining regulatory issues. It will reinforce cooperation with NATO and promote connectivity and dialogue with key partners.
Building on the achievements of the first Action Plan launched in 2018, the new Military Mobility covers the period 2022-2026 and includes:

Identification of possible gaps in the infrastructure, informing future actions to prioritise improvements and integrate fuel supply chain requirements, to support short-notice large-scale movements of military forces;

Digitalisation of administrative processes related to customs logistics and military mobility systems;
Measures to protect transport infrastructure from cyber-attacks and other hybrid threats;
Promoting access to strategic lift capabilities and maximising synergies with the civilian sector to enhance the mobility of the armed forces, especially by air and sea;
Enhancing the energy efficiency and climate resilience of transport systems;
Reinforcing cooperation with NATO and key strategic partners, such as the US, Canada and Norway, while promoting connectivity and dialogue with regional partners and enlargement countries, such as Ukraine, Moldova and the Western Balkans.

To ensure a well-connected, capable and secure military mobility network, the European Commission is supporting the Action Plan with funding instruments such as the Connecting Europe Facility (funding dual-use transport infrastructure projects), and the European Defence Fund (supporting the development of interoperable logistical and digital systems).
Background
The first Action Plan on Military Mobility was launched in 2018 to strengthen the EU Common Security and Defence Policy. It aimed to ensure swift and seamless movement of military personnel, materiel and assets – including at short notice and at large scale – within and beyond the EU. It helped to create a well-connected network, with shorter reaction times and capable, secure and resilient transport infrastructure and capabilities.
The new Action Plan on Military Mobility responds to the call in the Strategic Compass to enhance the military mobility of our armed forces within and beyond the Union following Russia’s military aggression against Ukraine. This urgent need was also reflected in the Joint Communication on defence investment gaps adopted in June 2022.
Military Mobility is supported through other defence initiatives, notably through the Permanent Structured Cooperation (PESCO) Military Mobility project and Logistical Hubs project. The European Defence Agency’s programme on “Optimising Cross-Border Movement Permission procedures in Europe” and the Coordinated Annual Review on Defence (CARD) also contribute to the effort.
Together with the Security and Defence package, the Commission is also publishing today the first progress report on the Action Plan on synergies between civil, defence, and space industries, available here.
Compliments of the European Commission.
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Today, the Commission presented a proposal to reduce air pollution from new motor vehicles sold in the EU to meet the European Green Deal’s zero-pollution ambition, while keeping vehicles affordable for consumers and promoting Europe’s competitiveness.  
Road transport is the largest source of air pollution in cities. The new Euro 7 standards will ensure cleaner vehicles on our roads and improved air quality, protecting the health of our citizens and the environment. Euro 7 standards and CO2 emission standards for vehicles work hand-in-hand to deliver air quality for citizens, as notably the increased uptake of electric vehicles also creates certain air quality benefits. The two sets of rules give the automotive supply chain a clear direction for reducing pollutant emissions, including using digital technologies.
The new Euro 7 emission standards will ensure that cars, vans, lorries and buses are much cleaner, in real driving conditions that better reflect the situation in cities where air pollution problems are largest, and for a much longer period than under current rules. The proposal tackles emissions from tailpipes as well as from brakes and tyres. It also contributes to achieving the new stricter air quality standards proposed by the Commission on 26 October 2022.
While CO2 emission rules will drive the deployment of zero-emission vehicles, it is important to ensure that all vehicles on our roads are much cleaner.  In 2035, all cars and vans sold in the EU will have zero CO2-emissions. However, in 2050, more than 20% of cars and vans and more than half of the heavier vehicles in our streets are expected to continue to emit pollutants from the tailpipe. Battery electric vehicles also still cause pollution from brakes and microplastics from tyres.
Euro 7 rules will reduce all these emissions and keep vehicles affordable to consumers.
The new requirements based on the Euro 7 standards:
The proposal replaces and simplifies previously separate emission rules for cars and vans (Euro 6) and lorries and buses (Euro VI). The Euro 7 standards rules bring emission limits for all motor vehicles, i.e., cars, vans, buses and lorries under a single set of rules. The new rules are fuel- and technology-neutral, placing the same limits regardless of whether the vehicle uses petrol, diesel, electric drive-trains or alternative fuels. They will help to:

Better control emissions of air pollutants from all new vehicles: by broadening the range of driving conditions that are covered by the on-road emissions tests. These will now better reflect the range of conditions that vehicles can experience across Europe, including temperatures of up to 45°C or short trips typical of daily commutes.

Update and tighten the limits for pollutant emissions: limits will be tightened for lorries and buses while the lowest existing limits for cars and vans will now apply regardless of the fuel used by the vehicle. The new rules also set emission limits for previously unregulated pollutants, such as nitrous oxide emissions from heavy-duty vehicles.

Regulate emissions from brakes and tyres: the Euro 7 standards rules will be the first worldwide emission standards to move beyond regulating exhaust pipe emissions and set additional limits for particulate emissions from brakes and rules on microplastic emissions from tyres. These rules will apply to all vehicles, including electric ones.

Ensure that new cars stay clean for longer: all vehicles will need to comply with the rules for a longer period than until now. Compliance for cars and vans will be checked until these vehicles reach 200,000 kilometres and 10 years of age. This doubles the durability requirements existing under Euro 6/VI rules (100,000 kilometres and 5 years of age). Similar increases will take place for buses and lorries.

Support the deployment of electric vehicles: the new rules will regulate the durability of batteries installed in cars and vans in order to increase consumer confidence in electric vehicles. This will also reduce the need for replacing batteries early in the life of a vehicle, thus reducing the need for new critical raw materials required to produce batteries.

Make full use of digital possibilities: Euro 7 rules will ensure that vehicles are not tampered with and emissions can be controlled by the authorities in an easy way by using sensors inside the vehicle to measure emissions throughout the lifetime of a vehicle.

Next Steps
The Commission’s proposal will be submitted to the European Parliament and the Council in view of its adoption by the co-legislators.
Background
Road transport is the largest source of air pollution in cities. In 2018, more than 39% of NOx and 10% of primary PM2.5 and PM10 emissions in the EU came from road transport. These percentages are much higher in cities, where transport is regularly the main contributor to air pollution. It is estimated that road transport caused about 70 000 premature deaths in the EU-28 in 2018.
In 2035, Euro 7 will lower total NOx emissions from cars and vans by 35% compared to Euro 6, and by 56% compared to Euro VI from buses and lorries. At the same time, particles from the tailpipe will be lowered by 13% from cars and vans, and 39% from buses and lorries, while particles from the brakes of a car will be lowered by 27%.
Following the Dieselgate scandal, the Commission has introduced new tests to measure emissions on the road (the RDE method) and increased the market surveillance powers of Member States and the Commission, in order to ensure that vehicles are as clean as expected by the Euro 6 norms.
The rules on pollutant emissions are complementary to the rules on CO2 emissions. The agreed target for 100% CO2 reduction by 2035 for cars and vans has been taken into account in this proposal. The Commission will review in the coming months the CO2 standards for lorries and buses.
Compliments of the European Commission.
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We need to intensify the greening of our economies despite the energy crisis. Hastening the process will reduce the costs of transition and help to ensure price stability in the long run. This is the third post in a series of climate-related entries on the occasion of COP27.

The current energy crisis has sent gas and electricity prices skyrocketing and brought the potential challenges and opportunities of the green transition into sharper relief. Does that mean that the green transition must now wait until the current crisis is resolved? The answer is firmly no. Humanity must act today to mitigate the devastating effects of climate change[1] and the earlier the green transition takes place, the lower the ultimate costs will be. For central banks globally, fighting climate change and fighting inflation can go hand in hand. The ECB Blog explains why.
The unexpectedly sharp increase in fossil fuel prices, in particular after the Russian invasion of Ukraine, has generated substantial uncertainty. The high energy prices have eaten into households’ real income and business profitability, which makes investing in low-carbon technologies and activities difficult for now. European governments have provided substantial subsidies to businesses and households to cushion the impact of energy price rises. At the same time, they have scrambled to secure energy supplies, undertaking substantial investment in fossil-fuel infrastructure. That includes re-opening mothballed coal-fired plants and constructing liquefied natural gas terminals.
These actions risk hindering the green transition. New fossil fuel infrastructure can reinforce reliance on, and lock in usage of, carbon-intensive fuels. Broad-based energy price subsidies mask the price signals given by the relatively more expensive fossil fuel prices compared with other products including clean energy. Yet, these relative price changes are needed to incentivise lower consumption of fossil fuels, behavioural changes and greater investment in green technology. Broad-based energy subsidies also risk burdening public finances. Government support instead needs to be made temporary and better targeted towards vulnerable households and small businesses, while preserving relative price signals.
Hastening the shift towards a green economy
The current situation also offers opportunities to hasten the green transition. The shortage of energy has brought home the urgent need to reduce reliance on fossil fuels and to foster energy efficiency. Recently made policy proposals such as RePowerEU, even if not sufficient, point in the right direction.[2] Challenges remain related to their implementation, though.
In the medium term, and once pressure on fossil fuel prices eases, governments should price in the negative effects of carbon more effectively. Already committing today to a gradual and predictable future increase in carbon taxes would allow households and businesses to timely prepare. Besides, pricing carbon would provide an incentive to steer financial flows towards green energy sources and low-carbon production and offers governments revenues to support these investments. The green transition is ultimately a question of structural transformation. It cannot happen without green investment.

Price stability and the green transition
Advancing the green transition is not necessarily at odds with price stability. Gradual relative price changes caused by carbon taxes do not inevitably result in higher headline inflation. This is especially true when accompanied by green technological advances and higher energy efficiency.[3] That said, the overall impact of the green transition on inflation is highly uncertain and depends on many factors, including the climate actions taken and the policy responses made.
Increasing the share of renewables can reduce total energy prices in the long run, while also supporting energy security. The price of wind and solar power has plummeted in the past decade due to technological improvements and economies of scale and is now substantially cheaper than fossil fuels. The EU aims to increase the share of renewables. For example, renewables are supposed to account for 45% of gross final energy consumption by 2030 according to REPowerEU.[4] This will help to unwind the recent spike in energy prices and reduce the malign influence of fossil fuels on inflation volatility in the long run.[5]

Chart 1
Fossil fuel prices drive inflation

Annual percentage changes and percentage point contributions

Sources: Eurostat and ECB calculations.
Latest observation: September 2022. The series “other” includes heat energy and solid fuel. and notes

Likewise, an environment of price stability is important for the green transition. Anchoring longer-term inflation expectations at the central bank’s target helps contain long-run financing costs and is conducive to investment in green technologies in the long run.
By contrast, failure to advance the green transition poses risks for price stability. Climate extremes such as droughts or floods can damage infrastructure, ravage harvests, and disrupt supply chains. This can affect the prices of key products and drive inflation volatility.[6] These impacts will only be magnified if we fail to achieve the objectives of the Paris Climate Agreement of limiting global warming to 2°C and making efforts to keep it below 1.5°C.
Government must drive the green transition
The principal responsibility for driving the green transition lies with governments, particularly through properly pricing the negative effects of carbon. But they also have the tools to dismantle the regulatory barriers that currently impede the uptake of renewable energy and to catalyse innovation and investment in green technology.

Now is the time to redouble our collective efforts and hasten along the path of decarbonisation.

The ECB is committed within its mandate to account for climate change. In doing so, it supports the green transition, which will reduce risks to price stability in the long run. We have already made significant progress in implementing our climate change action plan and we will continue to do so.[7]
A well-planned green transition goes hand in hand with energy security and can also contribute to price stability in Europe. Now is the time to redouble our collective efforts and hasten along the path of decarbonisation.
Authors:

Irene Heemskerk
Carolin Nerlich
Miles Parker

Compliments of the European Central Bank.
1. Intergovernmental Panel on Climate Change (2022), Climate Change 2022: Impacts, Adaptation and Vulnerability, contribution to IPCC Sixth Assessment Report.
2. See the European Commission proposal on the REPowerEU Plan.
3. Ferrari, A. and V. Nispi Landi (2022), “Will the green transition be inflationary? Expectations matter”, ECB Working Papers, No. 2726, European Central Bank. Ferdinandusse, M., Kuik, F., Müller G. and C. Nerlich (2022), “Model-based analysis of the short-term impact of increasing the effective carbon tax on euro area output and inflation”, ECB Economic Bulletin, Box 2, Issue 6; Konradt, M. & B. Weder di Mauro (2021), “Carbon Taxation and Greenflation: Evidence from Europe and Canada”, CEPR Discussion Papers, No. 16396, Centre for Economic Policy Research.
4. Discussions are still on-going between the Commission, the Council and the European Parliament.
5. Oil and energy prices have historically played an outsized role in driving global inflation volatility, see, for example, Choi, S. et al. (2018), “Oil prices and inflation dynamics: Evidence from advanced and developing economies”, Journal of International Money and Finance, Vol. 82, Issue C, pp: 71-96; Parker, M. (2016), “How global is ‘global inflation’?”, Journal of Macroeconomics, Vol. 58, pp: 174-197.
6. Parker, M. (2018), “The impact of disasters on inflation”, Economics of Disasters and Climate Change, Vol. 2, Issue 1, pp. 21-48; Faccia, D., Parker, M. & L. Stracca (2021), “Feeling the heat: extreme temperatures and price stability”, Working Paper Series, No. 2626, European Central Bank; Feng, A. & H. Li (2021), “We are all in the same boat: cross-border spillovers of climate risk through international trade and supply chain”, IMF Working Papers, No. 2021/013, International Monetary Fund.
7. See press release on the action plan on 8 July 2021 and the press release on further steps to incorporate climate change into its monetary policy operations on 4 July 2022.

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The global energy crisis highlights the need for a massive surge in clean energy investment

The global energy crisis is fueling fierce debate around the world over which new energy projects should or shouldn’t go ahead.
Conversations about energy and investment often fail to take into account the considerable lag between investment decisions and when projects actually go live. At the International Energy Agency (IEA), we warned years ago that global investment in clean energy and energy efficiency was not sufficient to put us on a path to reach our climate goals. Without a surge in clean energy spending, the amounts invested in conventional energy projects also risked falling short of what would be needed to meet potential increases in demand.
Even though the current energy crisis was triggered by Russia’s invasion of Ukraine, we must still pay close attention to these underlying investment imbalances as we emerge from the crisis, or we risk more volatility ahead. Are today’s sky-high fossil fuel prices a signal to invest in additional supply or further reason to invest in alternatives?
Energy investment decisions are being clouded by the fog of war. Russia’s invasion has thrown investment plans across all energy sectors into turmoil and exacerbated strains in global commodity markets that were already visible. Energy importing countries are now scrambling to replace disrupted supplies of fuels, and soaring costs have wreaked havoc in many economies and forced millions of people back into poverty and energy insecurity.
Of course, countries need to find immediate substitutes for the fuel imports that were suddenly cut off. If not, factories will close, jobs will be lost, and people will struggle to heat or cool their homes. But today’s energy crisis—the first truly global energy crisis—has given rise to a false narrative that now is not the moment to invest in clean energy.
This could not be further from the truth. We do not have to choose between responding to today’s energy crisis and tackling the climate crisis. Not only can we do both, we must do both because they are intimately linked. Massive investment in clean energy—including energy efficiency, renewables, electrification, and a range of clean fuels—is the best guarantee of energy security in the future and will also drive down harmful greenhouse gas emissions.
A worrying divide
Global energy-related CO2 emissions rose by a record amount in 2021, and investment in clean energy technologies is still well below what it will take to bring emissions down to net zero by mid-century or soon thereafter. The $1.4 trillion we expect the world to spend on energy transitions in 2022 would have to rise to well over $4 trillion by 2030 to get us on track to limit global warming to 1.5 degrees while also ensuring sufficient energy supply.
At the same time, lower investment in recent years has left some oil and gas producers unable to quickly ramp up production to meet today’s demand, even with the incentive of record high prices. We risk seeing the worst of both worlds: the inability to provide for current energy needs and falling woefully short of what is needed to meet international climate goals.
Published earlier this year, the World Energy Investment 2022 report shows some encouraging trends—but also plenty of cause for concern.
The good news is that investment in clean energy transitions is finally picking up. In the five years following the 2015 Paris Agreement, clean energy investment grew only 2 percent a year. However, since 2020, this rate has risen to 12 percent a year, led by increased spending on solar and wind power, including a record year for offshore wind power in 2021.
There is strong momentum in other new areas like low-emissions hydrogen; new battery technologies; and carbon capture, utilization, and storage (CCUS), even if this impressive growth is coming from a small base. For example, in 2021 plans for about 130 commercial-scale carbon capture projects in 20 countries were announced, and six CCUS projects were approved for final investment. Meanwhile, Russia’s war against Ukraine has bolstered policy support for low-emission hydrogen, especially in Europe. And investment in battery energy storage is hitting new highs and is expected to double in 2022.
But this investment is concentrated in advanced economies and China, leaving many emerging market and developing economies, particularly in Africa, unable to attract the clean energy investments and financing they need, widening an already troubling divide. Except in China, clean energy spending in emerging market and developing economies is stuck at 2015 levels, which means it hasn’t increased since the Paris Agreement was reached. Falling clean technology costs mean that this money goes further, but the overall amount—about $150 billion a year—is far short of what is needed to meet rising energy demand in developing economies in a sustainable way.
In these economies, public funds for sustainable energy projects were already scarce and have become scarcer still since the COVID-19 pandemic. Policy frameworks are often weak, the economic outlook is uncertain, and borrowing costs are rising. After the pandemic hit, the number of Africans without access to electricity rose, wiping out years of progress on that crucial front.
No shortage of capital
This is where international financial organizations and development institutions have a major role to play. They can work with local governments to develop policies to improve the investment environment, and their financing can help de-risk private sector involvement.
There is no shortage of capital globally. The amount of sustainable financing available worldwide has surged in recent years and is a strong tailwind for solar and wind projects in particular. But far more needs to go to emerging market and developing economies. For example, sustainable debt issuance in 2021 hit a record $1.6 trillion, but more than 80 percent was in advanced economies.
Sustainable finance, and the wider world of Environmental Social and Governance (ESG) investing, would greatly benefit from clearer standards, definitions, and reporting obligations, and there has been progress. For example, the EU has introduced risk management and reporting requirements for financial market participants regarding climate risks and sustainability practices. Clearer guidelines and opportunities to finance credible transition plans in carbon-intensive sectors would ensure that ESG requirements do not prevent financing for essential-but-emitting energy sectors. Finally, the entire ESG ecosystem must engage more with emerging market and developing economies and take account of their needs and circumstances. Institutions such as the IMF have a major role to play.
In the IEA’s landmark Roadmap to Net Zero Emissions by 2050, we said a massive surge in investment in clean energy technologies and energy efficiency could cut global demand for fossil fuels so much that there would be no need for investment in new oil and gas fields. At the same time, continued spending on existing assets—including investments to reduce upstream emissions—remains essential in this pathway. Moreover, Russia’s war against Ukraine has brought major disruptions to the global energy system. Immediate shortfalls in fossil fuel production from Russia obviously must be replaced by production elsewhere—even in a world working toward net-zero emissions by 2050.
Balancing these demands requires judicious investment, and the IEA is helping decision-makers around the world with data, analysis, and policy advice. The key is to avoid spending on infrastructure that would either lock in heavy emissions for years to come or quickly turn into stranded assets. Suitable options include extending production from existing fields and making better use of natural gas that is currently flared or vented. Some new infrastructure may be needed, especially liquefied natural gas import terminals in Europe, to diversify supply away from Russia. But with careful investment and planning, these terminals could facilitate future imports of low-emission hydrogen or ammonia. In countries open to it, nuclear power has a role to play, especially the promising new small modular reactors that are in development.
A historic turning point
The current situation offers a crucial opportunity for the oil and gas sector to show it is serious about the transition to clean energy. The run-up in prices is set to generate an unprecedented $2 trillion windfall for oil and gas producers this year, bringing their total income to a record $4 trillion in 2022. Yet the oil and gas industry is still spending only modestly on energy transitions: on average, clean energy spending accounts for about 5 percent of total oil and gas company capital expenditure. That is up from 1 percent in 2019, but still far too little. Today’s windfall gains are a once-in-a-generation opportunity for oil- and gas-producing countries to diversify their economies and prepare for a world of lower fossil fuel demand – and for major oil and gas companies to seize leadership roles in some of the clean energy sources that the world will rely on for decades to come.
Let’s not forget that energy security is not just about increasing the supply of power and fuels. It is also about efficient use of energy—especially given today’s array of technologies that can help. The IEA’s 10-Point Plan to Reduce the European Union’s Reliance on Russian Natural Gas, published in March—one week after Russia’s invasion—includes steps to replace Russian gas but also calls for major push on renovating building stock to reduce demand. Better materials and insulation, newer technologies, and more efficient appliances greatly reduce the energy needed to heat, cool, and light our homes and workplaces. Smart electrical grids will better manage and reduce power demand. Consumers can take immediate and simple steps such as adjusting the thermostat to avoid overheating or overcooling, which can collectively add up to massive savings.
The current global energy crisis presents huge challenges, especially for the coming winters. But after the winter comes spring—and the right investment decisions can transform this crisis into a historic turning point toward a cleaner and more secure energy future. We are already seeing encouraging steps in this direction—such as the Inflation Reduction Act in the United States; the REPowerEU package in the European Union; Japan’s Green Transformation plan; and the growth of renewables in China, India, and beyond. A new global energy economy is emerging, and the governments and businesses that invest early and wisely stand to reap the benefits.
Author:

FATIH BIROL is executive director of the International Energy Agency

Compliments of the IMF.
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On November 3rd, the European Commission is launching the third call for large-scale projects under the EU Innovation Fund. With a budget doubled to €3 billion thanks to increased revenue from the auctioning of EU Emissions Trading System (ETS) allowances, this 2022 call for large-scale projects will boost the deployment of industrial solutions to decarbonise Europe. With a special focus on the priorities of the REPowerEU Plan, the call will provide additional support towards ending the EU’s dependence on Russian fossil fuels.
The call will fund projects covering the following topics:

General decarbonisation (budget: €1 billion) seeking innovative projects in renewable energy, energy-intensive industries, energy storage or carbon capture, use, and storage, as well as products substituting carbon-intensive ones (notably low-carbon transport fuels, including for maritime and aviation);

Innovative electrification in industry and hydrogen (budget: €1 billion) seeking innovative projects in electrification methods to replace fossil fuel use in industry as well as renewable hydrogen production or hydrogen uptake in industry;

Clean tech manufacturing (budget: €0.7 billion) seeking innovative projects in manufacturing of components as well as final equipment for electrolysers and fuel cells, renewable energy, energy storage and heat pumps;

Mid-sized pilots (budget: €0.3 billion) seeking highly innovative projects in disruptive or breakthrough technologies in deep decarbonisation in all eligible sectors of the Fund. Projects should prove the innovation in an operational environment but would not be expected to reach large-scale demonstration or commercial production.

Projects will be assessed by independent evaluators according to their level of innovation, potential to avoid greenhouse gas emissions, operational, financial and technical maturity, scaling up potential and cost efficiency. The call is open for projects located in EU Member States, Iceland and Norway until 16 March 2023.
Promising projects that are not sufficiently mature for a grant may benefit from project development assistance by the European Investment Bank.
Next steps
Projects can apply via the EU Funding and Tenders portal where information on the overall procedure is available. Applicants will be informed about the results of the evaluation in the second quarter of 2023. The grant awards and signature of projects will take place in the fourth quarter of 2023.
A webinar on lessons learned from the previous call and an Info Day will be organised on 29 and 30 November 2022 respectively to give prospective applicants the opportunity to get information and ask questions on the new call.
Background
The Innovation Fund is one of the world’s largest funding programmes for the demonstration and commercialisation of innovative low-carbon technologies. Financed by revenues from the auctioning of allowances from the EU’s EU ETS, it has already held two large-scale calls awarding €1.1 billion and €1.8 billion in grants to 7 and 17 projects respectively (see the Innovation Fund Project Portfolio Dashboard).
With a currently estimated revenue of approximately €38 billion until 2030, the Innovation Fund aims to create the right financial incentives for companies and public bodies to invest now in the next generation of low-carbon technologies and give EU companies a first-mover advantage to become global technology leaders. As proposed under the Fit for 55 package currently being negotiated by the co-legislators, the Fund would be substantially increased to channel even more investments in breakthrough green technologies.
The Innovation Fund is implemented by the European Climate, Infrastructure and Environment Executive Agency (CINEA), while the European Investment Bank provides the project development assistance to promising projects that are not sufficiently mature.

Today more than ever, we need to boost innovation and scale up technological solutions that tackle the climate crisis and bring Europe energy sovereignty. The faster we do so, the quicker we will become immune to Russian energy blackmail. With this new call of € 3 billion, the EU Innovation Fund will support even more clean tech projects than before, speeding up the replacement of fossil fuels in hard-to-decarbonise industries and accelerating the uptake of renewable hydrogen in the EU market.

Executive Vice-President Frans Timmermans

Compliments of the European Commission.
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If we do not account for the impact of climate change on our economy, we risk missing a crucial part in our work to keep prices stable, argues Christine Lagarde in the ECB Blog. This is the second entry in a series of climate related entries on the occasion of COP27.

A year ago, in his speech at COP26 in Glasgow, Sir David Attenborough asked us: “Is this how our story is due to end? A tale of the smartest species doomed by that all too human characteristic of failing to see the bigger picture in pursuit of short-term goals?” That question remains ever more pressing, and, worryingly, unanswered.
The world, and especially Europe, face a host of pressing challenges that require urgent attention, including from us at the European Central Bank: the economic fall-out from the coronavirus (COVID-19) pandemic, Russia’s invasion of Ukraine, and the cost-of-living crisis due to surging energy prices, to name just a few.
These challenges are complicated and painful, particularly for those struggling every day to make ends meet. As the guardian of the euro, we are fully committed to playing our part in common efforts to address them here and now. In particular, we are determined to do everything to ensure that inflation returns to our medium-term target of 2%. However, we must not lose sight of the challenges we will face tomorrow, and in the years to come.
Last summer, we were already confronted with record-breaking droughts across the globe, and with heatwaves and floods that caused suffering and damage across every continent. Science tells us that this is only a preview of the impact climate change will have on our planet. We also know that the only way to avoid the worst is to green our economy. We must reduce our greenhouse gas emissions all the way to net zero. If we do this early on, the long-term benefits will far outweigh the short-term costs of doing so.
Making our monetary policy fit for climate change
At the European Central Bank, our primary objective is to keep prices stable. That is the compass guiding every one of our actions, now more than ever. To deliver on this core responsibility, we need the full picture on all factors affecting inflation so that our policies remain effective.
Climate change is one of these factors, given its widespread effect on our economy. Extreme weather events can damage infrastructure, ravage harvests and disrupt supply chains. This can push up prices for key products and thereby fuel inflation, making it tougher for us to keep prices stable. By contrast, reinforced efforts to shift our energy supply towards more economical renewables should ultimately help to slow inflation.
If we do not account for the impact of climate change on our economy, we risk missing a crucial part of the overall picture. This means that our job of preserving price stability must include further work on better understanding how climate change affects our role. We must incorporate climate change into everything we do: our models, data, projections and analyses. Ultimately, we need to ensure that our monetary policy accounts for the impact of climate change.
Over the past year, we have moved beyond words and on to real action. We have adjusted our corporate bond holdings, collateral framework and risk management practices to better account for climate-related risks. As supervisors, we work to ensure that banks account for climate-related risks in their business and lending decisions. We also analyse the impact of climate change on the economy and financial stability. And naturally, we work to reduce the environmental footprint of our day-to-day corporate activities in line with the goals of the Paris Agreement.
With our work on climate change, we aim to better manage climate-related risks, support the green transition in line with the European Union’s net-zero objectives and foster wider action from others, always within our mandate.
Looking ahead: paving the way towards a greener economy
Speeding up the green transition has never been more important: surging energy prices have highlighted just how reliant we are on fossil fuels and how vulnerable this makes us. Harnessing the opportunity to push ahead with a timely shift of our energy system towards more renewable energy would not only make our economy greener and more self-sufficient, but it would also reduce the risk of spikes in energy prices. The resulting lower and more stable inflation rates would make our economies work better for the benefit of all.
Of course, we cannot do this alone. All of us need to work hard to lay the groundwork for a greener and brighter world. International cooperation and transparency will be key to achieving this long-term transformation. Pricing in the negative effects of carbon, plentiful investment in innovative green technology and climate adaptation, consistent and comparable climate-related disclosures and clear and timely transition paths with intermediate milestones are just some of the tools that we can use to green our economy. If we all know about the processes at work and are transparent about the true costs of climate change and the benefits of the green transition, people and businesses will understand that changing their behaviours and practices is not just good for the planet, but also makes simple economic sense.
We must do everything in our power to prevent Sir David’s worst fears from coming true. We must make sure that we can turn the page and continue our story. In doing so, may we also find encouragement in his words: “If working apart we are forces powerful enough to destabilise our planet, surely working together we are powerful enough to save it.”
Author:

Christine Lagarde, President of the ECB

Compliments of the European Central Bank.
The post ECB | Painting the bigger picture: keeping climate change on the agenda first appeared on European American Chamber of Commerce New York [EACCNY] | Your Partner for Transatlantic Business Resources.

We need strong rules for strong banks. Basel III has what it takes. But planned EU laws might fall behind international standards, write ECB Vice-President Luis de Guindos, ECB Supervisory Chair Andrea Enria and EBA Chairperson José Manuel Campa in a joint Blog post

The EU banking package matters now more than ever. We need to stick to our global commitments, faithfully implement Basel III and strengthen supervisory powers. We call on the co-legislators to focus on the resilience of the banking sector. Strong rules lead to strong banks, and strong banks are better able to serve firms, citizens and the economy at large.
The post-financial crisis overhaul of the Basel standards has been a long and demanding journey. With the finish line nearing, Europe is now at a critical juncture: implementing the internationally agreed Basel III standards will be decisive in keeping our banking system safe and sound. Europe sat at the negotiating table in Basel, and the final agreement consequently incorporates many suggestions and adjustments put forward by European actors. Claims that the agreement is not a good “fit” for the EU financial sector are therefore misleading.
We are very concerned that in the ongoing legislative discussions in the EU Council and the European Parliament on the EU banking package, numerous calls have been made to deviate from the international standards. The ECB and the European Banking Authority (EBA) have consistently argued for a full, timely and faithful implementation of Basel III. The rules have been carefully articulated to ensure a worldwide minimum safety net against the plethora of risks that we painfully experienced during the global financial crisis.
The legislative proposal of the European Commission already included several deviations from the Basel III rules. The EBA and the ECB were critical[1] of these deviations, as they would leave pockets of risk unaddressed and could increase risks to financial stability.
In a report published in September 2022[2] the EBA estimated that the Commission’s proposal would reduce by 3.2 percentage points the expected increase in Tier 1 aggregate capital requirements stemming from the Basel III reform at the end of the phase-in period.[3] Even this estimate is likely to understate the actual differential, as due to limited data availability only some of the Commission’s proposed deviations could be quantitatively assessed.
The EU Council and the Parliament are assessing the introduction of further deviations from Basel III in different areas, including the risk weighting of equity intra-group exposures, of subordinated debt, exposures to land acquisition, development and construction and off-balance sheet trade finance exposures.
At stake here are the reputation, the competitiveness and, ultimately, the funding costs of the EU banking sector. Back in December 2014, the Basel Committee already deemed the EU to be “materially non-compliant”[4]. If all deviations under discussion make it into the final legislative package, we cannot rule out the Basel Committee labelling the EU to “non-compliant” (the lowest possible grade).
The Basel III rules were endorsed by both the Financial Stability Board and the G20. We therefore risk undermining global cohesion and weakening the EU’s standing in international negotiations if we do not keep our commitments. The current geopolitical disorder shows how important it is to safeguard cohesion and cooperation at global level. Most importantly, Europe and European banks would suffer not only in terms of reputation, but also in terms of resilience. The COVID-19 pandemic again demonstrated the virtue of strong banks for the economy. European banks acted not as shock amplifiers, but as shock absorbers during the pandemic. Today, the Russian invasion of Ukraine and the energy crisis are shaping a highly uncertain outlook. We are convinced that the overriding principle for this banking package – the needle in our compass – must be prudence.
Our concerns regarding the proposed deviations are not limited to the capital relief relative to the pure Basel regime. A leading principle for both the EBA and the ECB has been to introduce a regulatory regime that limits complexity as much as possible. However modest in terms of capital relief, the inclusion of additional deviations from the Basel standards will inevitably make the system more complex. This not only adds to the cost of compliance for banks, but also complicates the work of supervisors and market participants.
We also need strong supervision. This means empowering supervisors with all the tools necessary to ensure that banks keep their risks under control. Another priority for the banking package is to therefore close gaps in our current rulebook. We clearly need increased ambition on environmental, social and governance risks. However, the work of both the ECB[5] and the EBA[6] in this area shows that banks are lagging behind on this front. Not only will ambitious proposals in the EU banking package help banks to rectify these shortcomings, they will also ensure supervisors can step in should banks fall behind. This will also help cement the EU’s global leadership role in this important area, which is developing quickly. It will therefore be important that the final agreement not only shows the way in terms of ambition, but also sets out a framework that remains risk-based and which allows scope for future developments in an area that will evolve rapidly over the coming years.
Finally, we need sound and harmonised rules for third country branches. We also need tools to avoid inappropriate bank management and poor governance. In order not to fall short in addressing these risks, it is important that the co-legislators do not to lower the ambition compared to the Commission’s proposal. Notably on the fit and proper assessment of banks’ management, we need an ambitious improvement of the rules to tackle the challenges we see. Only capable decision-makers can enable sound decisions and sound risk management, and supervisors need to be able to intervene accordingly. Looking ahead, this is clearly the most effective way of avoiding problems in banks.
Authors:

José Manuel Campa, Chairperson of the European Banking Authority

Luis de Guindos, Vice-President of the ECB

Andrea Enria, Chair of the Supervisory Board of the ECB

Compliments of the European Central Bank.
Footnotes:

Opinion of the European Central Bank of 24 March 2022 on a proposal for amendments to Regulation (EU) No 575/2013 of the European Parliament and of the Council as regards requirements for credit risk, credit valuation adjustment risk, operational risk, market risk and the output floor (CON/2022/11) (OJ C 233, 16.6.2022, p. 14-21).

EBA (2022), “Basel III monitoring exercise – results based on data as of 31 December 2021”, 30 September.

This estimate refers to the steady state implementation in 2033 and therefore does not reflect that, due to adjustments in the calculation of the output floor for specific types of exposures that the Commission proposes to apply on a temporary basis until the end of 2032, the output floor will have an even lower impact before the steady state level kicks in. Moreover, we should not underestimate the fact that, whereas the Basel agreement proposed phasing in the reforms between 2023 and 2028, the Commission proposed doing so between 2025 and 2030, giving banks more time to prepare. Finally, the estimate does not include the decision to mute the impact of historical losses on the capital charge for operational risk. This is a legitimate choice, as the Basel agreement left this decision open to the discretion of the authorities but goes against the advice of both the EBA and the ECB and implies a further alleviation of average requirements of 110 basis points.

BIS (2014), “Assessment of Basel capital regulations in the European Union concluded by the Basel Committee”, press release, 5 December.

ECB (2022) “Walking the talk – Banks gearing up to manage risks from climate change and environmental degradation. Results of the 2022 thematic review on climate-related and environmental risks”, 2 November.

EBA (2020), “Discussion Paper on management and supervision of ESG risks for credit institutions and investment firms”, 30 October.

The post ECB | Strong rules, strong banks: let’s stick to our commitments first appeared on European American Chamber of Commerce New York [EACCNY] | Your Partner for Transatlantic Business Resources.

The devastation and destruction of climate change will only worsen if we fail to act now

Just this year we’ve seen the increasingly devastating effects of climate change—human tragedy and economic upheaval with typhoons in Bangladesh, unprecedented floods in Pakistan, heatwaves in Europe, wildfires in North America, dry rivers in China, and droughts in Africa.
This will only get worse if we fail to act.
If global warming continues, scientists predict even more devasting disasters and long-term disruption to weather patterns that would destroy lives and livelihoods and upend societies. Mass migration could follow. And, failure to get emissions on the right trajectory by 2030 may lock global warming above 2 degrees Celsius and risk catastrophic tipping points—where climate change becomes self-perpetuating.
If we act now, not only can we avoid the worst, but we can also choose a better future. Done right, the green transformation will deliver a cleaner planet, with less pollution, more resilient economies, and healthier people.
Getting there requires action on three fronts: steadfast policies to reach net zero by 2050, strong measures to adapt to the global warming that’s already locked in, and staunch financial support to help vulnerable countries pay for these efforts.
Net zero by 2050
First, it’s vital that we limit further temperature rises to less than 1.5 degrees to 2 degrees. Delivering on that by 2050 requires cutting emissions by 25‑50 percent by 2030 compared to pre-2019 levels.
The good news is that about 140 countries—accounting for 91 percent of greenhouse gas emissions—have already proposed or set net-zero targets for around mid-century.
The bad news is that net-zero rhetoric does not match reality.
Actually getting to net zero by 2050 means most countries need to do even more to strengthen their targets for cutting emissions—particularly large economies.
And there is an even bigger gap on the policy front. New IMF analysis of current global climate policies shows they would only deliver an 11 percent cut. The gap between that and where we need to be is massive—equivalent to more thanfive times the current annual emissions of the European Union.

We desperately need implementation to catch up.
That will require a mix of incentives to push firms and households to prioritize clean goods and technologies across all their decisions.
The ideal policy mix would include pricing carbon, including cutting fossil fuel subsidies, along with alternative measures that can achieve equivalent outcomes, such as feebates and regulations. To complement domestic policies, an international carbon price floor agreement would provide one way of galvanizing action: asking large emitters to pay a minimum price of $25-$75 per ton of carbon depending on their national income level. And with alternative policies, this does not mean taxes per se. It would be collaborative, pragmatic, and equitable.
Of course, the overall policy package should include measures to reduce methane. Cutting these emissions by half over the next decade would prevent an estimated 0.3 degree rise in the average global temperature by 2040—and help avoid tipping points.
It is also critical to include incentives for private investments in low-carbon technologies, growth-friendly public investments in green infrastructure, and support for vulnerable households.
The new IMF analysis has encouraging projections for an equitable package that would contain global warming to 2 degrees. We estimate that the net cost of moving to clean technology—including the savings made by avoiding unnecessary investments in fossil fuels—would be around 0.5 percent of global gross domestic product in 2030. This is a tiny amount in comparison the devastating costs of unchecked climate change.
But the longer we wait, making the shift would be far more costly and more disruptive.
Urgent need to adapt
But mitigation action is not enough. With some global warming already locked in, people and economies everywhere are paying the price every day.
And, while the world’s larger economies contribute the most and must deliver the lion’s share of cuts to global greenhouse gases, smaller economies pay the biggest costs and face the biggest bill for adaptation.
In Africa, a single drought can lower a country’s medium-term economic growth potential by 1 percentage point, creating a government revenue shortfall equivalent to a tenth of the education budget.
This underscores the importance of broad investments in resilience — from infrastructure and social safety nets to early warning systems and climate-smart agriculture. In fact, for around 50 low-income and developing economies, the IMF estimates annual adaption costs will exceed 1 percent of GDP for the next 10 years.
In many cases, these countries have exhausted fiscal space during nearly three years of crises ranging from the pandemic to rampant inflation. They urgently need international financial and technical support to build resilience and get back on their development paths.
Climate finance: innovate now
Doing more on climate financing is also vital. Advanced economies must meet or exceed the pledge of $100 billion in climate finance for developing countries—not least for equity reasons.
But public money alone is not enough—so innovative approaches and new policies to incentivize private investors to do more. After all, the green transformation brings vast opportunities for investments in infrastructure, energy, and more.
It starts with stronger governance and integrating climate considerations into public investment and financial management that can help unlock new sources of financing.
Proven financial instruments will also be important—such as closed-end investment funds that can pool emerging market assets to provide scale and diversify risks. And multilateral development banks or donors must do more to encourage institutional investors to come in—for example, by providing equity, which currently makes up only a small share of their commitments.
One promising new area: unlocking capital from pension funds, insurance companies and other long-term investors that collectively manage over $100 trillion of assets.
Another consideration is how better data facilitates decision and investment. That’s why the IMF and other global bodies are standardizing high-quality and comparable information for investors, harmonizing climate disclosures, and aligning financing with climate-related goals.
Role of the IMF
The IMF recognizes that the critical importance of the green transformation, and we have stepped up on this issue, including through our partnerships with the World Bank, the Organisation for Economic Co-operation and Development, Network for Greening the Financial System, and others.
We are already incorporating climate considerations in all aspects of our work. This includes economic and financial surveillance, data, and capacity development, together with analytical work. And our first ever long-term financing tool, the Resilience and Sustainability Trust, now has more than $40 billion in funding pledges, along with three staff-level agreements with Barbados, Costa Rica, and Rwanda.
The support for this instrument shows the enduring power of cooperation to overcome global challenges.
If we don’t act now, then the devastation and destruction of climate change—and the threat to our very existence—will only get worse.
But if we work together—and work harder and faster—a greener, healthier, and more resilient future is still possible.
Author:

Kristalina Georgiev, Managing Director, IMF

Compliments of the IMF.
The post IMF | Getting Back on Track to Net Zero: Three Critical Priorities for COP27 first appeared on European American Chamber of Commerce New York [EACCNY] | Your Partner for Transatlantic Business Resources.

Keynote speech by Fabio Panetta, Member of the Executive Board of the ECB, at the ECB Money Market Conference |
The euro area is facing a sequence of unprecedented supply shocks resulting from the pandemic and Russia’s aggression against Ukraine. These shocks have compounded each other and caused the current spike in inflation. Price pressures have broadened as firms have sought to pass higher costs on to consumers as the economy reopened.
As a result, the ECB has accelerated the adjustment of monetary policy to keep inflation expectations anchored at levels consistent with its target. Across the last three Governing Council meetings, we have increased our interest rates by 200 basis points. This is the fastest rate hike in the ECB’s history.
Looking ahead, the medium-term inflation outlook presents clear upside risks in a general context of extraordinary uncertainty about the future evolution of the European economy.
Today I will argue that, at present, the direction of monetary policy is clear. A further policy adjustment is warranted in order to keep inflation expectations anchored and stave off second-round effects. However, the calibration of our stance should not rely on a one-sided view of risks − especially as we continue normalising our monetary policy in a highly uncertain economic environment. And it should remain focused on medium-term inflationary developments.
We need to bring inflation back to our 2% target as soon as possible, but not sooner.
We might otherwise create unintended effects, achieving little reduction of inflation in the short term, but causing excessive market volatility and a protracted economic slowdown beyond what is necessary to stabilise inflation in the medium term.
Implementing the correct calibration of monetary policy will be challenging. We will need to carefully consider the resilience of our economy, the implications of global monetary spillovers, and emerging threats to financial stability.
Trade-offs in setting the appropriate monetary policy stance
In the current situation, the direction of our monetary policy is clear.
Inflation in the euro area is too high and will remain above our target for an extended period. Headline inflation reached 10.7% in October. Core inflation is around 5%.[1]
Monetary policy normalisation is necessary when repeated supply shocks drive inflation higher for longer.[2] It signals that the central bank will not tolerate a de-anchoring of inflation expectations, reducing the likelihood of such a de-anchoring occurring. And it guards against the risk that monetary policy could exacerbate inflationary pressures by stimulating demand.[3]
But while the direction of the adjustment is clear, its calibration is not and its end point depends on the evolving medium-term economic and inflation outlook.
The neutral interest rate provides limited guidance here. It is an asymptotic concept that describes the point when interest rates are neither accommodative nor contractionary in a situation where growth is around potential, inflation is not far from target and no transitory shocks are disrupting the inflation path. But that is not the world in which we find ourselves.
Moreover, the neutral rate is unobservable. As I have argued elsewhere,[4] estimates of the neutral rate are imprecise and widely dispersed. They are subject to considerable uncertainty in a post-pandemic world that has undergone structural change.[5]
Today, I find it more helpful to discuss the target-consistent terminal rate.
This is the level of the policy rate that − if reached at the end of a short normalisation phase and then held constant − stabilises inflation at target by the end of the policy-relevant horizon in the absence of new shocks. I prefer the concept of the target-consistent rate to that of the neutral rate because it emphasises that we can gear our policy to a clear state-contingent reference in order to bring inflation back to target within a clearly defined period.
Eurosystem staff regularly calculate estimates of the target-consistent terminal rate, which are an input into the preparation of our monetary policy meetings.[6] But let me stress that these estimates are conditional on the economic and inflation outlook. They need to be continually reassessed in the light of incoming information.
Specifically, we need to navigate a complex set of risks to medium-term inflation.
On the upside, we could face the emergence of what I have called “ugly” inflation.[7] This arises when above-target inflation de-anchors expectations, causing excessive wage and price-setting dynamics that eventually fuel further inflation increases (the second-round effects).
At present, this risk is mostly driven by high energy prices and their pass-through to prices of other items. Annual energy inflation is running at around 42%. Energy has been the main contributor to headline inflation for the past 18 months (Chart 1). Higher energy input costs have contributed to extraordinarily high food inflation. They have been a key driver of goods and services inflation (Chart 2). And by dragging down the trade balance and weighing on the economic outlook, they are contributing to the depreciation of the euro, further reinforcing inflationary pressures (Chart 3).

Chart 1
Contributions of components of euro area headline HICP inflation

(annual percentage changes and percentage points contributions)

Sources: Eurostat and ECB calculations.
Notes: NEIG stands for “non-energy industrial goods”. The latest observation is for October 2022.

Chart 2
Contributions of energy-sensitive components to goods and services inflation in the euro area

(annual percentage changes and percentage point contributions)

Sources: Eurostat and ECB staff calculations.
Notes: The term “energy-sensitive component” reflects items with a share of energy in direct costs above the average share of energy across services items (left-hand panel) and non-energy industrial goods (NEIG) items (right-hand panel). The latest observations are for September 2022.

Chart 3
Drivers of the euro-US dollar exchange rate

(cumulative changes since January 2022, percentage changes and percentage point contributions)

Sources: ECB and ECB calculations.
Notes: A decrease denotes a euro depreciation against the US dollar. The decomposition of exchange rate changes is based on an extended two-country Bayesian vector autoregression (BVAR) model including ten-year euro area overnight index swap rate, euro area stock price, EUR/USD, ten-year euro area overnight index swap-US Treasury spread, US stock prices and the relative Citi commodities terms-of-trade index in the euro area compared to the United States. An adverse euro area terms-of-trade shock is assumed to depreciate the euro against the dollar, reduce euro area equity prices, and increase euro area yields and yield spreads against the United States. Identification via sign and narrative restrictions, using daily data. The latest observation is for 24 October 2022.

So far, inflation expectations have remained anchored and the risk of an incipient wage-price spiral in the euro area has been contained. Nominal negotiated wage growth has ticked up recently but is still far from compensating for the drop in real incomes caused by higher inflation.[8] And the outlook for wage growth and unit labour costs remains consistent with our target overall.[9] But we need to remain extremely vigilant in view of prolonged high inflation, which increases the likelihood of a pass-through to wage growth[10], especially as labour markets are now tighter than before the pandemic.
But other forces may increasingly push in the opposite direction and contain the risk of second-round effects, as what I have dubbed “bad” inflation – the inflation resulting from supply shocks – compresses real incomes.
The reduction in real wages and purchasing power is weakening domestic demand, with several leading indicators already pointing to a likely contraction in economic activity, starting from the last quarter of this year. The euro area PMI composite output index fell in October to its lowest level since November 2020,[11] with forward-looking indicators of activity particularly weak.[12] Consumer confidence plummeted to historical lows.[13] And financial and credit indicators also point to significant downside risks to GDP growth (Chart 4).[14]

Chart 4
Downside risks to euro area real GDP growth

Lower tail of the distribution of real GDP growth forecasts for Q1 and Q3 2023 based on “GDP-at-risk” models
(quarter-on-quarter change in percentage points)

Source: ECB calculations.
Notes: For each horizon, the chart shows the median of estimates of the lower quantile (10th percentile) forecast across the suite of “GDP-at-risk” models maintained by ECB staff, as well as the interquartile range to account for model uncertainty. These estimates are predicated mainly on developments in financial conditions, credit, risk, and the macroeconomy. Forecasts are conditional on financial data up to mid-October 2022 and real economy indicators up to the end of September 2022.

These forces pushing on the downside might be reduced if supply bottlenecks continue to ease (Chart 5) and energy commodity and electricity prices continue to fall from their highs (Chart 6).[15] But this would then also improve the inflation outlook and reduce the likelihood of “ugly” inflation taking hold.

Chart 5
Easing of supply chain bottlenecks

PMI suppliers’ delivery times (left panel) and Global Supply Shortages Index (right panel)
(diffusion indices)

Sources: S&P Global, Markit and ECB staff calculations.
Notes: The Global Supply Shortages Index measures how many selected items have been in short supply against their long-run average for each month. The long-run average refers to value 1 of the index. The shaded minimum-maximum range refers to the 5th-95th percentile range across 20 items (e.g. chemicals, electrical items, packaging, steel and textiles). The latest observation are for September 2022 and October 2022 (Flash PMI estimates for the United Kingdom and the euro area).

Chart 6
Spot prices of oil, gas, coal and electricity

(EUR/MWh for gas and electricity (left-hand scale), USD/barrel for oil (right-hand scale))

Sources: Refinitiv, HWWI, Energy Intelligence and ECB staff calculations.
Note: The latest observation is for October 2022.

To sum up, the implementation of monetary policy presents us with a difficult trade-off. On the one hand, our need to ensure that inflation expectations remain anchored speaks for targeting the upper part of the range of estimates of the target-consistent terminal rate. And this range would move higher if upside risks to medium-term inflation materialised.
But, on the other hand, in setting the monetary policy response we need to keep basing our decisions on the latest evidence and factor in downside risks to the economic outlook.
Policy normalisation, transmission lags and global spillovers
In recent months, the public debate has stressed the risks of doing too little to curb inflation, since this would require a more painful future adjustment. But this should not make us underappreciate the risk of doing too much.
First, we should bear in mind that it takes time before the full impact of our measures is felt in the economy.[16] Moreover, monetary policy is transmitted to different variables with different lags.
It immediately affects market expectations and financial market conditions through bond yields, equity prices and exchange rates. Since we started normalising monetary policy at the end of 2021, the one-year forward real rates have moved significantly higher across the entire term structure (Chart 7) and the one-year forward real rate one year ahead is now in positive territory. Likewise, nominal and real ten-year rates have increased by around 300 and 250 basis points respectively (Chart 8).

Chart 7
Change in euro area forward real interest rates

(percentage points)

Sources: Bloomberg, Refinitiv and ECB calculations.
Notes: Real forward rates are calculated by subtracting the inflation-linked swap forward rates from the nominal overnight index swap forward rates for each maturity. The latest observation is for 20 October 2022.

Chart 8
Ten-year real, nominal and inflation-linked swap rates for the euro area

(percentages per annum)

Sources: Refinitiv and ECB calculations.
Note: The latest observation is for 20 October 2022.

Crucially, however, it takes longer for our decisions to be transmitted to the real economy through changes in lending conditions and, subsequently, demand and prices. The debate should thus not be distorted by an excessive focus on short-run inflationary developments, which cannot be controlled by monetary policy. The full impact of our measures will likely reach the economy when activity and inflation are already on a declining path.[17] This implies that our tightening will need to end when inflation is still above our target.
Second, we need to factor in global monetary policy spillovers when defining the domestic stance.
With central banks across advanced economies adjusting their policies simultaneously (Chart 9), they could accentuate each other’s policy impacts if they do not sufficiently factor in the feedback loop they create.[18] ECB analysis finds that a tightening by the Federal Reserve System generates spillovers to euro area real activity and inflation that are comparable to its effects on the US economy.[19]

Chart 9
Financial conditions indices in advanced economies and emerging market economies

(standardised indices)

Sources: Refinitiv, Bloomberg and ECB staff calculations.
Notes: National financial conditions indices are aggregated using GDP purchasing power parity shares. The latest observations are for 6 October 2022.

It is sometimes argued that domestic inflation having a large global component should mean that domestic monetary policy needs to be tightened more forcefully to compensate for this weakened grip on prices. But if central banks across advanced economies are simultaneously tightening monetary policy – as is the case today – the opposite is true.[20]
If central banks do not fully factor in the effects of other central banks’ policies, the current phase of global adjustment may give way to a more severe slowdown than anticipated. In recent decades, episodes of highly synchronised global monetary policy tightening have been associated with subsequent global recessions (Chart 10).

Chart 10
Inflation surges, tightening synchronisation and global recessions

(percentages of countries)

Sources: ECB calculations, BIS data and Haver Analytics.
Notes: The global “inflation surges” index (red dashed line) shows the share of countries which, at time t, are simultaneously experiencing: (1) year-on-year inflation that is higher than at time t-1; and (2) year-on-year inflation that is above a certain threshold. In this case, the threshold is given by the average of the year-on-year inflation in the post-Volcker period, from the first quarter of 1984 to the second quarter of 2022. The global “tightening synchronisation” index (blue solid line) is constructed using BIS data on the policy rates set by central banks and shows the share of countries which are tightening at time t. Global recessions are periods when: (1) annual growth of global GDP per capita is negative or close to zero; and (2) a high share of countries are in a technical recession. The latest observations are for the second quarter of 2022.

Such a scenario could have particularly negative implications for the euro area. Our economy is not only more vulnerable than others to the energy crisis, it is also more open than economies such as the United States, China and Japan, and thus more exposed to a global recession. And because it is less flexible than the US economy, reversing course may be more difficult if demand and production weaken too much.[21]
Avoiding unintended effects in a volatile market environment
Incorrectly calibrating our monetary policy could also have unintended effects for financial stability and the transmission of our monetary policy.
The highly uncertain outlook has increased the sensitivity of market rates to new developments and shifts in risk sentiment. In turn, higher rates are exacerbating risk aversion, exposing the vulnerabilities of certain highly leveraged segments – such as residential property markets[22] – and some types of non-bank financial intermediaries[23]. These segments are vulnerable to adverse loops, with falling prices and rising rates feeding into higher debt refinancing costs, especially as falling real incomes make those costs less affordable.
This market volatility is being compounded by global financial spillovers (Chart 11). These come mainly from the United States[24], but were also visible in the reaction of euro-denominated yields to the recent episode of market repricing in the United Kingdom.

Chart 11
Global component in yields

Correlation of sovereign bond yields in advanced economies, expectations components and term premia
(correlation coefficient)

Sources: Datastream and Haver Analytics.
Notes: The sample consists of ten advanced economies (Australia, Canada, Denmark, euro area, Japan, New Zealand, Sweden, Switzerland, United Kingdom and United States). The bilateral correlation coefficients are averaged across these countries and time periods. The term premia and expectations components are the average of estimates from three models (dynamic Nelson-Siegel, rotated dynamic Nelson-Siegel and dynamic Svensson-Soderlind). The latest observations are for 21 October 2022 (daily data).

In the euro area, an additional source of volatility is the risk of financial fragmentation along national lines, which can impair the homogenous transmission of monetary policy throughout the euro area.
The current environment therefore requires us to be prudent in adjusting our monetary policy across all instruments. There are three key considerations here.
First, our decisions and communication on the pace of normalisation should avoid amplifying market volatility.
There is a case for frontloading our policy adjustment given the need to keep expectations anchored, especially in view of the very accommodative stance from which normalisation started. But such frontloading should remain commensurate to the benefits and risks it creates.
When it comes to managing inflation expectations, ECB staff analysis finds that the benefits of surprising markets with bigger-than-expected rate increases is limited in the euro area.[25] And if these bigger-than-expected increases are interpreted as signalling a higher terminal rate, rather than simply frontloading the normalisation, we could have a stronger impact on financing conditions – and ultimately on economic activity – than intended.
Additionally, a bigger-than-expected rate increase may heighten volatility and have a stronger impact in the current highly leveraged environment after a decade of very low rates and ample liquidity. So when calibrating our stance, we need to pay close attention to ensuring that we do not amplify the risk of a protracted recession or trigger market dislocation.[26]
Second, we must be clear about the sequencing of the normalisation process. We should avoid “cliff effects”, continually monitor the market response to our measures and consider the feedback between our different instruments.
Currently, our policy rate remains a suitable marginal instrument of normalisation. It is the instrument we know best. We have a comparatively limited understanding of the effects of reducing the size of our balance sheet.[27]
The size of our balance sheet will be significantly reduced as targeted longer-term refinancing operations (TLTROs) mature and banks likely make early repayments after the decision we took last week to adapt the TLTROs’ terms and conditions to the current monetary policy context.
We should take the necessary time to assess the impact of our rate hikes and of phasing out the TLTROs. As we normalise our monetary policy, we should expect bank lending conditions to tighten. What we need to avoid, though, is a sudden stop in the supply of credit to the broad economy.
We should ensure that TLTRO repayments have been absorbed before we stop fully reinvesting the principal payments from maturing securities purchased under our purchase programmes. And when considering how we would then reduce the size of our bond portfolios, a controlled reduction – whereby only redemptions above a cap are not rolled over – is preferable to active sales, which may unsettle markets in an already volatile financial environment.[28]
Third, we must ensure the smooth transmission of our stance as we normalise monetary policy.
Maintaining ample liquidity in the system will help ensure smooth money market functioning. This will allow us to continue tightly steering money markets through changes in our deposit facility rate.
But preserving smooth transmission also means being ready to intervene in a timely manner to counter unwarranted market dysfunctions, should they arise.
Our reinvestment flexibility under the pandemic emergency purchase programme – alongside the availability of the Transmission Protection Instrument, if required – protects the transmission of our monetary policy to all parts of the euro area, allowing us to set the appropriate stance. Recent months have shown that a credible ex ante commitment helps to establish a good market equilibrium, where higher yields do not drive spreads to higher levels that are disconnected from fundamentals.
We also need to stand ready to address collateral issues. Collateral scarcity has recently impaired the pass-through of our policy rates to repo rates.[29] The change in TLTRO III conditions should help alleviate tensions in the repo market[30], but we will continue to monitor the situation closely.
The importance of a consistent policy mix
As recently seen in other economies, an inconsistent policy mix can prove destabilising. So a successful normalisation process requires other policies to be consistent with monetary policy. For instance, well-designed energy and fiscal policies can make a key contribution to dampening short-term inflationary pressures, thereby helping to keep inflation expectations anchored[31] and reducing the amount of monetary tightening necessary.
To take a concrete example, the measures that have been taken to find alternatives to Russian gas, reduce gas demand and refill gas storage are likely playing an important role in bringing down gas prices. Likewise, joint initiatives at European level, common purchases and the redistribution of surplus energy sector profits can mitigate the impact of supply disruptions on energy prices. At the same time, energy policies should preserve price incentives and support energy efficiency.
Fiscal policies should aim to cushion the impact on the most exposed and fragile households and firms, while not hindering the necessary trend reduction of energy demand and adding to inflationary pressures. At the same time, they should protect economic potential and ensure that the energy shock does not permanently reduce productive capacity. Just as excessively high energy demand would risk keeping inflation high for longer, so would a slump in economic potential.
In response to the pandemic, Europeans acted together with consistent policies to protect productive capacity during the downturn.[32] To tackle the energy shock effectively, we can take inspiration from some of the EU pandemic-era instruments – such as SURE – to protect jobs and businesses that may be forced to temporarily reduce their activity. Common interventions at European level would preserve a level playing field, avoiding competitive distortions that would otherwise be detrimental to economic efficiency and the integrity of the Single Market.
Beyond targeted support in the short term, however, fiscal policy will need to focus on investment to reduce the European economy’s exposure to supply shocks, strengthen its strategic autonomy and support potential growth. Here we could take inspiration from the Next Generation EU (NGEU) instrument and move beyond reshuffling existing funds in the financing of Repower EU, matching additional investment and reform needs with adequate resources.[33]
But we should also ensure that we are implementing, in full, the agreed investments and reforms that are tied to NGEU. This will contribute to economic resilience and debt sustainability, which are crucial in view of the prevailing interest rates and growth outlook.
Conclusion
Let me conclude.
We find ourselves in an exceptionally volatile environment, with multiple and complex risks for the inflation outlook and the appropriate monetary policy response.
We are normalising our monetary policy to keep inflation expectations anchored and bring inflation back to 2% over the medium term.
But we cannot ignore the sizeable challenges that we are facing.
So we must calibrate our monetary policy carefully to ensure that inflation durably returns to our target, while also guiding market expectations and limiting excess volatility.
Our policy stance must remain evidence-based and adapt to changes in the medium-term inflation outlook, avoiding an excessive focus on short-run developments and fully taking into account the risks emanating from the domestic and global economic and financial environment.
This approach will allow us to successfully navigate the risks we face while avoiding the danger of tripping over unintended effects.
Let’s therefore mind the step in adjusting our monetary policy, so we can proceed steadily through the current shocks and bring the economy back to price stability and solid growth.
Compliments of the European Central Bank.
Footnotes:

When excluding energy, food, alcohol and tobacco. Core inflation is calculated by excluding more volatile components from headline inflation.

Panetta, F. (2022), “Normalising monetary policy in non-normal times”, speech at a policy lecture hosted by the SAFE Policy Center at Goethe University and the Centre for Economic Policy Research, 25 May.

Lagarde, C. (2022), “Monetary policy in the euro area”, Karl Otto Pöhl Lecture organised by Frankfurter Gesellschaft für Handel, Industrie und Wissenschaft, 20 September.

Panetta, F. (2022), op.cit.

See Weber, A., Lemke, W. and Worms, A. (2008), “How useful is the concept of the natural rate for monetary policy?”, Cambridge Economic Journal, October, Vol. 32, No 1, January, pp. 49-63.

For instance, recent estimates by Banco de España staff suggest that the median value of the target-consistent terminal rate across a suite of macroeconomic models lies in a range between 2.25% and 2.5%. See Hernández de Cos, P. (2022), “Monetary policy in the euro area: where do we stand and where are we going?”, XXI Congreso de Directivos CEDE, Bilbao, 29 September.

Panetta, F. (2021), “Patient monetary policy amid a rocky recovery”, speech at Sciences Po, 24 November.

In the euro area, the pick-up of wage growth has been more moderate and gradual than in the United States. The annual growth rate of compensation per employee is still distorted by the impact of the government measures to prevent job losses during the pandemic. Negotiated wage growth, which is less affected by these measures, stood at 2.4% (including volatile one-off payments) in the second quarter of 2022.

To be consistent with the 2% inflation target under typical conditions, nominal wage growth should be equal to productivity growth plus 2%, which the September ECB staff projections expect to be the case in 2024.

Inflation can play a formal or an informal role in wage setting. For more than half of the private sector employees in the euro area, inflation does not play a formal role in wage setting – but is an important factor in wage negotiations especially if inflation is high. While indexation of wages to inflation applies only to around 3% of private sector employees in the euro area, inflation plays a formal role in wage setting for one fifth of euro area private sector employees. Countries in which only minimum wages are indexed to inflation account for another fifth of private sector employees. For details, see Koester, G. and Grapow, H. (2021), “The prevalence of private sector wage indexation in the euro area and its potential role for the impact of inflation on wages”, Economic Bulletin, Issue 7, ECB.

Excluding the pandemic lockdown months, this was the lowest level since April 2013. See S&P Global Flash Eurozone PMI (2022), “Eurozone economic contraction intensifies in October”, October.

The weakening is especially pronounced for indicators of new business and new orders.

The series starts in January 1985. See European Commission (2022), “Flash Consumer Confidence Indicator”, 21 October.

Downside risks are reflected in Chart 3 by depicting the lower tail (specifically the 10th percentile) of the distribution of quarterly real GDP growth forecasted for the first and third quarters of 2023 respectively. Notably, the current estimates are well below the unconditional estimate which reflects average tail risks over a long horizon. An analysis of the underlying drivers suggests that the intensification of the downside risks to real GDP growth can be traced back predominantly to heightened financial and geopolitical risk, a bleaker macroeconomic outlook, and some deterioration in credit and financial conditions.

Supply bottlenecks have started to ease in recent months and orders-to-inventory ratios have been falling rapidly. European gas prices have also fallen sharply in recent weeks.

Model-based analysis by ECB staff suggests that, on average, the impact on inflation of a 100 basis point policy rate shock builds up gradually over time to reach its peak impact during the second year following the initial shock. See Lane, P. (2022), “The transmission of monetary policy”, speech at the SUERF, CGEG|COLUMBIA|SIPA, EIB, SOCIÉTÉ GÉNÉRALE conference on “EU and US Perspectives: New Directions for Economic Policy”, 11 October.

ECB staff estimates that the downward impact on GDP growth coming from policy normalisation is on average 1 percentage point per year until 2024, while the downward impact on inflation increases gradually, reaching 1 percentage point in 2024. The estimated impact refers to the average across a set of models used by the ECB for policy simulations, including the NAWM-II model (Coenen, G., Karadi, P., Schmidt, S. and Warne, A. (2018), “The New Area-Wide Model II: an extended version of the ECB’s micro-founded model for forecasting and policy analysis with a financial sector“, Working Paper Series, No 2200, ECB, November (revised December 2019)), the ECB-BASE model (Angelini, E., Bokan, N., Kai, C., Ciccarelli, M. and Zimic, S. (2019), “Introducing ECB-BASE: The blueprint of the new ECB semi-structural model for the euro area”, Working Paper Series, No 2315, ECB, September), and the MMR model (Mazelis, F., Motto, R. and Ristiniemi, A. (2022), “Monetary policy strategies in a low interest rate environment for the euro area”, forthcoming).

Obstfeld, M. (2022), “Uncoordinated monetary policies risk a historic global slowdown”, Realtime Economics Blog, Peterson Institute for International Economics, 12 September.

Estimates are obtained based on a sample spanning 1991 to 2019, using high frequency-based US monetary policy shocks (sum of conventional, Odyssean forward guidance and quantitative easing) in monthly smooth local projections (see Jarociński, M. (2021), “Estimating the Fed’s Unconventional Policy Shocks”, Working Paper Series, No 2585, ECB, August (revised June 2022)).

Obstfeld, M. (2022), op. cit.

Recent analyses show that the euro area lags notably behind the United States in terms of labour market efficiency (although levels for individual euro area countries vary, see Chart 1 in Sondermann, D. (2018), “Towards more resilient economies: The role of well-functioning economic structures”, Journal of Policy Modeling, Vol. 40, No 1, pp. 97-117). Productivity growth has also generally been lower in the euro area than in the United States for some time (see Chart 7 in Masuch, K. et al. (eds.) (2018), “Structural policies in the euro area”, Occasional Paper Series, No 210, ECB, June). These factors may limit the euro area’s relative capacity to bounce back from a recession.

ESRB (2022), “Warning of the European Systemic Risk Board”, 22 September.

Work stream on non-bank financial intermediation (2021), “Non-bank financial intermediation in the euro area: implications for monetary policy transmission and key vulnerabilities”, Occasional Paper Series, No 270, ECB, September (revised December 2021); Financial Stability Board (2021), “Global Monitoring Report on Non-Bank Financial Intermediation 2021”, December; European Systemic Risk Board (2022), “EU Non-bank Financial Intermediation Risk Monitor 2022”, July.

These financial spillovers work partly through the exchange rate. In particular, monetary policy tightening in the United States is seen as exporting inflation through the exchange rate and driving further tightening elsewhere. It is notable that this market reaction reflects the expectation that central banks are reacting to the short-term effects of exchange rates on inflation, since the empirical evidence suggests that these short-term effects are outweighed over time by the disinflationary spillovers of the Federal Reserve’s tightening.

ECB staff analysis, based on a sensitivity exercise of longer-term market-based measures of inflation compensation to larger versus smaller monetary policy shocks, suggests that, unlike in the United States, in the euro area larger monetary policy surprises do not significantly lower five-year forward five-year ahead inflation-linked swap (ILS) rates compared with smaller policy surprises.

Several episodes in the recent past – such as the “taper tantrum” of 2013, the developments in the US repo market in 2019 and the recent turmoil triggered in the UK bond market by liability-driven investors – have emphasised the importance of managing risks to market functioning.

As Olivier Blanchard recently observed in a tweet on 29 September, “When you have two instruments, and the effects of one are much better understood than those of the other, rely mainly on the instrument you know better. Focus on using interest rates, go slow on QT. There will be time to decrease your balance sheet.”

Panetta, F. (2022), op. cit.

Repurchase agreements, or repos, essentially function as a short-term secured loan in which cash is exchanged for a security (or collateral), under the agreement that the transaction is reversed at some point in the future. Repo markets are of critical importance for the smooth functioning of secondary sovereign bond markets and for providing short-term secured funding and investment opportunities for a wide range of market participants.

The change in the terms and conditions of TLTRO III makes early repayments of banks’ TLTRO borrowing more likely. These repayments will alleviate banks’ balance sheet constraints and release collateral that is currently pledged with the Eurosystem, which will increase the intermediation capacity of banks in repo markets and help to mitigate the current collateral shortage.

Respondents to the Consumer Expectations Survey who have become more positive in rating the adequacy of governmental measures in preserving their spending capacity have increased their inflation expectations by a smaller amount. Likewise, they have decreased their expectations of economic growth over the next 12 months by a smaller amount.

Panetta, F. (2022), “Europe’s shared destiny, economics and the law”, Lectio Magistralis on the occasion of the conferral of an honorary degree in Law by the University of Cassino and Southern Lazio, 6 April; Panetta, F. (2022), “Europe as a common shield: protecting the euro area economy from global shocks”, keynote speech at the European Parliament’s Innovation Day “The EU in the world created by the Ukraine war”, 1 July.

See footnote 28.

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