Christian Noyer: Global inflation and monetary policy response in the
Euro area
Keynote speech by Mr Christian Noyer, Governor of the Bank of France and Chairman of the
Board of Directors of the Bank for International Settlements, at the "Real Return: The
Euromoney Global Inflation Conference", Paris, 19 May 2015.
* * *
The paths of inflation in advanced countries have been puzzling over recent years. While
inflation rates fell sharply during the financial crisis and thus behaved as expected, it is much
harder to explain their behaviour since then. In fact, rather than rebound as might have been
expected as economic activity stabilised and then recovered, the global inflation rate fell from
4.2% in 2012 to 3.5% in 2014 and, in OECD countries, prices dropped from 2.3% to 1.7%.
The drop in inflation is lasting despite the fact that oil prices have stabilised and a recovery is
under way in the US and UK and burgeoning in the euro area. In the US for example, core
CPI inflation has fallen from 2.3% in January 2012 to 1.8% in March 2015. In the UK inflation
rate fell during the same period from 2.6% to reach 1%, below the targeted 2%.
This persistence of low inflation has consequences for the economic outlook and monetary
policy. When inflation is low, companies, households and governments have a harder time
cutting their debt loads, a problem that is still acute in a number of countries in the Eurozone.
Moreover, with low inflation expectations, the private sector may postpone expenditures,
thereby weakening economic activity.
In fact, inflation is now below target in most advanced economies. As a result central bankers
are asking themselves whether this decline is caused by common shocks, by a coincidence
of domestic factors or by structural changes in the reaction of prices to the output gap.
While recent price developments in the US and in the UK are largely explained by global
disinflationary forces, oil prices, currency appreciation and the sensitivity of inflation to
unemployment in a context of ongoing economic recovery,1 my overall assessment regarding
the euro area situation is that a sizeable domestic component is at play. This has motivated
the bold steps taken by the Eurosystem to counteract the risk of inflation remaining too low
for too long a period of time.
Part A - What happened to Euro-area inflation
Let me now describe recent price developments in the euro area in more detail. HICP
inflation has fallen consistently below our target since January 2013, declining from 2% to
-0.1% in March 2015. Forecasters have repeatedly been surprised by this evolution. Three
main reasons have been put forward to explain this.
A first explanation is that forecasting has been complicated by the fall in global crude oil
prices and raw materials and its transmission to other sectors. In this regard, recent research
conducted at the Banque de France supports this view by showing that forecast errors for oil
prices explain about half of the errors for headline inflation. The oil price futures used in our
forecasts turned out to be poor predictors in volatile oil markets.2
But downside surprises also occurred for core inflation suggesting the need for
complementary explanations. One candidate is the continuous appreciation of the euro
between mid-2012 and the beginning of 2014, which has lowered prices of many imported
non-energy industrial goods. One can expect this impact to be transitory as the euro has
subsequently depreciated since the middle of 2014. This depreciation reflects the differences
in the growth cycle between the euro area and its main partners and accordingly the
differences in monetary policy.
Those explanations do not account for the slowdown in domestic prices, which must then be
attributed to an increase in domestic slack. For the European Commission the output gap
widened from -2% in 2012 to -3% in 2013. This came as a surprise because realized GDP
growth rates in 2013 and 2014 were about 0.5 percentage points lower than forecasts made
in 2012.3 Our analysis suggests that this economic slack contributed substantially to low
inflation. For example, in the fourth quarter of 2014, if we assume no economic slack, HICP
inflation would have been higher by around 0.8 percentage points. Such a counterfactual
exercise is however surrounded by a large uncertainty. First, potential output is hard to
estimate. That said, if potential output and domestic slack were lower than assumed, the
weakness of inflation would be all the more puzzling. Second, some observers argue that the
Phillips curve of the euro area is steeper than before,4 partly explaining the low level of
inflation. Although we do not share this diagnosis for the recent past,5 a stronger sensitivity of
prices to slack might be observed in the future as a result of labor market reforms and lower
unemployment in several countries. Third, downward nominal wage rigidity may blur the
relationship between inflation and domestic slack. Nominal wage inflation, which remained
persistent during the crisis, is likely to stay subdued during the recovery, thus leading to a
lower inflation.
One caveat specific to the euro area is the asymmetric adjustment process currently at work
among jurisdictions. Member countries that experienced large capital inflows in the years
preceding the financial crisis experienced significant reductions in price competitiveness. The
subsequent fiscal and financial adjustments have put a strong downward pressure on prices
and wages (the HICP fell in 2014 in Greece, Spain, Portugal, Ireland and Cyprus). To
achieve relative price adjustment while keeping aggregate euro area inflation close to 2%
would require higher inflation in the so-called core economies. In principle, this could occur
through a rebalancing of financial flows from Core to peripheral countries within the euro
area and higher domestic spending in core economies. In practice, net savings rates have
remained high in several core economies with capital instead flowing outside of the euro
area, mirroring an increasing current account surplus. Downward price pressures are
therefore occurring in peripheral economies without offsetting upward price pressures in the
core economies. For example, the year-on year inflation rose in 2014 in Germany by 0.8%
and in France by 0.6%.
In summary, in the Euro area half of the decline in inflation can be attributed to a fall in
energy prices and another quarter to the fall in food prices. The remaining quarter is
explained by the slowdown in core inflation, which has declined by 0.7 percentage points,
reflecting a lower inflation in services and in non-energy industrial goods.
Part B - Monetary policy in the Euro Area
Let me turn now to monetary policy. The Eurosystem's decisions are based on its
assessment of the path of inflation over the medium term. Yet, measuring inflation
expectation is a difficult task. One reason is that monetary policy is transmitted to the price
level with a varying lag. Survey measures of inflation expectations can also be an unreliable
guide. For example, research conducted at the Banque de France has shown that survey-
based measures are biased in a systematic and predictable way.6 It has been shown that
professional forecasters surveyed by the ECB fail to systematically update their 1-year or
2-year ahead inflation forecasts when new information is released, and the distribution of
their forecasts is wider when they update them. This explains our preference for using a
range of indicators to gauge inflation expectations. Nevertheless, in the last couple of years,
most measures of inflation expectations, be they survey-based or market-based, have
pointed in the same direction of a prolonged period of too low inflation, well below our target
of being close to but below 2% over the medium term.
As a consequence, monetary policy has become progressively more accommodative. First,
in a context of fixed rate full allotment introduced on the 15th of October in 2008 to offset
liquidity risk in the market by ensuring banks' continued access to liquidity, we have
introduced forward guidance to avoid an unwarranted tightening of the effective monetary
policy stance. Initially implemented in July 2013, this guidance was "firmly reiterated" in early
2014 and remains in place today. Second, the Eurosystem introduced targeted longer-term
refinancing operations (TLTROs) and the asset purchase programs for covered bonds and
asset-backed securities in June 2014, with the goal of improving the transmission of our
monetary policy. Third, the main refinancing rate was cut to 5 basis points and the deposit
rate entered into negative territory in two steps (-20 basis points).
However, by January this year it was clear that economic recovery as well as monetary and
credit indicators were too weak to bring medium term inflation close to but below 2%. Market-
based measures of inflation expectations, even if prone to liquidity shocks, had been falling
further below the target and at longer term horizons. The Governing Council was determined
to act boldly to counteract the risk of a too low for too long inflation.
In this context, an expanded asset purchase programme was then launched. On March 9th,
the Eurosystem began purchasing public sector securities in the secondary market along the
curve from 2 to 30 years, being mindful of being market neutral. Purchases of securities at
negative yield are permissible, as long as the yield is above the deposit facility rate.
Marketable securities purchased under this program will be made available for securities
lending.
This programme is intended to stimulate the economy through different channels.
The first one is the portfolio rebalancing channel, in which the fall in yields on safe
government bonds induces investors to buy riskier assets, thereby stimulating the economy.
Since the launch of the programme yields have dropped not only for the assets purchased
but also for bank and corporate bonds and equity prices have continued to rise.
A second channel works through lowering and flattening the yield curve. The purchase
programme will continue until the end of September 2016 and beyond if we do not see a
sustained adjustment in the path of inflation. This reinforces the guidance that interest rates
will remain low for an extended period of time.
A third channel is related to increasing credit supply. If the Euro-system buys assets from
non-banks or institutions, then these funds will reappear as deposits in the banking system.
This creates an additional source of funding for banks which in turn increases the supply of
credit to the private sector.
A last channel is the signaling effect. By acting decisively and more aggressively than
anticipated, we hope to lift inflation expectations.
Conclusion
Let me conclude with my assessment of the impact of the QE. So far, recent indicators
suggest that our quantitative easing has had a positive effect on inflation expectations. This
is true when looking at market-based measures at short term horizons, although less so at
long term horizons. Looking at the recent release of the ECB survey of professional
forecasters, there is an upward trend in inflation expectations over the medium to long term.
But, as shown by the US experience, re-anchoring inflation expectations takes time. The
Eurosystem is ready to go further if necessary to deliver on its mandate of maintaining
inflation close to but below 2%. But monetary policy will be more effective if, at the same
time, governments increase the potential growth rate by implementing ambitious structural
reforms.