The ECB will be concerned about the stickiness functioning of monetary policy. The introduction of inflation, particularly in the services of the Transmission Protection Instrument will component, amid a still-tight labor market. help allay concerns here. In our central scenario, Indeed, the unemployment rate is at a record the presence of this tool, coupled with a delay of low 6.5% (as of October 2022), wage growth quantitative tightening until the second half of has increased to 4% year-over-year compared 2023, will limit any material blowout in peripheral 5 with a pre-pandemic average of 2%, and there spreads. is tentative evidence that high inflation is now flowing through to longer-term inflation Finally, given our central scenario of recession, expectations (Figure I-21b). we expect euro-area governments to keep energy-related fiscal measures for at least the We therefore expect the ECB to build on the first half of 2023 in order to cushion demand, 200 basis points’ worth of rate increases it has which we estimate will average between 2% already delivered, with the deposit rate having and 3% of GDP. This will delay any plans for risen from –0.5% at the start of 2022 to 1.5% fiscal consolidation until the latter part of at the October 2022 meeting. (A basis point is 2023 at the earliest. Given weak growth, one-hundredth of a percentage point.) Our base continued energy support, and rising interest case is for the deposit rate to reach at least 2% costs, euro-area debt-to-GDP ratios are unlikely by year-end and to peak at 2.5% in early 2023. to fall meaningfully in the near term. Italy will be We expect this restrictive policy stance to be under the most scrutiny because of its relatively maintained through 2023, with risks to our high debt burden and the election of a new terminal rate view skewed to the upside given government. Debts will remain sustainable in the the underlying strength of the labor market.. near term, but solutions to growing debt burdens must be discussed going forward. As policymakers continue to raise rates, they will need to be mindful of the risk of euro-area fragmentation, which would impair the proper FIGURE I-21 Inflation is a challenge for policymakers a. Peak in inflation is yet to come b. Long-term inflation expectations have become stickier e  Forecast s  Above % target t Q  ng n a  de  h c n e  spo ag e t Headline r n e  y c inflation e  r v e r p u s r   a f e o y - ge r  Core a  e t v inflation o -  en  r c a er Q  e P Y –       <. . . . . . . . . . . ≥. to to to to to to to to to to . . . . . . . . . . Predicted inflation (%) Note: Monthly data from January 2020 to November 2022 and Vanguard forecasts thereafter. Note: Longer-term expectations refer to 2027 in Q4 2022 and to 2024 in Sources: Vanguard calculations, based on data from Bloomberg, as of Q4 2019. November 22, 2022. Sources: ECB and Survey of Professional Forecasters, as of October 28, 2022. 5 As measured by the euro-area employment cost index. 26