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The ECB has taken forceful action in response to the unprecedented surge in euro area inflation. We have embarked on the fastest tightening cycle in our history, raising our key policy rate – the deposit facility rate – from -0.5% to 3.5%, and started reducing the size of our balance sheet.

Our actions are being swiftly transmitted to borrowing conditions, slowing the pace of credit creation. Inflation has started to come down from its historically high level, largely reflecting the sharp drop in energy prices. Underlying inflation has also moderated recently, but it has proven more persistent than expected.

Despite the welcome turn in inflationary developments, the path towards sustained price stability remains uncertain and fraught with risks.

In my remarks today, I will reflect on the outlook for inflation in the euro area. I will first explain the factors that are expected to drive the continued decline in headline inflation under the latest Eurosystem staff projections. I will then describe some risks around the baseline scenario and discuss what these imply for the optimal conduct of monetary policy.

Profit margins expected to absorb rising labour costs

In the June 2023 Eurosystem staff projections, headline inflation is expected to decline notably over the coming months and to gradually converge to levels somewhat above 2% in 2025 (Slide 2, left-hand side).

The projected decline in headline inflation rests, to a significant extent, on a further decline in energy inflation and a marked drop in food inflation, both driven by large base effects (Slide 2, right-hand side). Core inflation is projected to moderate more gradually, from an average of 5.1% this year to 2.3% in 2025, as pipeline pressures recede and the tightening of monetary policy increasingly weighs on economic activity.

Over the near term, disinflation is hence primarily driven by a reversal of the supply-side shocks that had caused the unprecedented surge in inflation (Slide 3, left-hand side). Surveys show that bottlenecks in the global manufacturing sector have by now fully unwound and that input prices have fallen to the lowest level in many years as gas and oil prices have continued their sharp descent.

Softening demand, as reflected in a decline in new orders, should further support the disinflationary impulse in the manufacturing sector, which is particularly sensitive to higher interest rates.

As the energy shock unwinds and supply chains normalise, domestic demand, and wage growth in particular, has become the dominant factor driving recent inflation developments, and is expected to remain so over the projection horizon (Slide 3, right-hand side).

Demand-side shocks tend to be more persistent, especially in the euro area’s institutional environment built on centralised collective bargaining, with wage agreements having an average duration of around two years.

Price pressures in the services sector, where labour costs represent a larger share of total costs, are therefore expected to fade more gradually. The catch-up in wages is assumed to moderate on the back of falling headline inflation, while current high nominal wage growth is expected to be absorbed, to a large extent, by firms’ profit margins, thus breaking the vicious circle between wages and prices.

Firms’ selling price expectations, which have been correlating closely with consumer price inflation over the past two years, corroborate the assumptions underlying the projections (Slide 4, left-hand side).

In the manufacturing sector, the share of firms expecting to raise prices further has fallen back to prepandemic levels. In the services sector, the share remains higher but has also been coming down for four consecutive months