Columbia University, New York, 11 October 2022
« What monetary policy narrative after Forward Guidance? »
Speech by François Villeroy de Galhau,
Governor of the Banque de France
Ladies and gentlemen, dear students and professors,
I am very grateful to Dr. Patricia Mosser for the invitation to speak at Columbia
University. I already had the honour of delivering a speech here in April 2017, and it
is great to be back. The current context is obviously quite different from five years ago:
-
today we face too high inflation compared with too low inflation in 2017 -, and we
are navigating through a geopolitical environment that looks unprecedented in its
uncertainty. Due to this uncertainty, binding forward guidance from Central Banks
appears less relevant, and has rightly been put aside in the recent past. But this is not
an argument for returning to the secrecy that characterised central banking until the
1990s. One of the most topical questions for central banks is therefore how to ensure
i
a "new
predictability".
Indeed, not having forward guidance does not mean, cannot mean, not having a
narrative and a monetary strategy. Let me elaborate on this today, first laying out the
reasons why we have to act in a determined way to deliver our 2% inflation target (I),
then proposing some milestones on our normalisation path (II) and finally shedding
light on one sensitive coordination issue (III).
I. We have to act in a determined way to deliver our 2% target
Inflation has reached levels that we have not seen in decades in the United States
and in the euro area. HICP inflation in the euro area was 10.0% in September 2022
and excluding energy and food reached 4.8%. We decided to frontload our monetary
policy normalization in September with a 75bp increase in all our policy rates, taking
them into positive territory for the first time since July 2012. When anyone acts fast,
there are always people to ask whether they are overreacting or could wait and move
more slowly. For some in Europe, there would be two arguments in favour of inaction
or at least caution: namely the supply-side origin of the shock and the risk of a
recession. Let me tell why I don't think such fears should derail us from our
normalisation course.
On the nature of the inflation shock, there is obviously a significant energy and supply
component in the current euro area inflation, reflecting pandemic-related supply
disruptions in 2021, and on top of the sharp increase in energy prices this year after
Russia's invasion of Ukraine. When central banks are faced with temporary supply
shocks, they are often supposed to "look through" the immediate effect and extend
the horizon over which inflation returns to target if necessary. But due to pressures
along the pricing chain, inflation has not only heightened, it has broadened into
industrial goods and services. In the euro area, core inflation has been above 2%
since October 2021 and above 4% since July 2022.
Another feature of the inflation shock we are facing is its persistence. This may affect
inflation expectations and lead to a de-anchoring. Current inflation levels require that
we clearly show our monetary determination. We know, though, that the significant
changes in monetary policy we have taken already will take at least a year or more to
affect the economy. But it is our clear forecast and will to bring inflation back towards
2% within the next two to three years.
I am not convinced either by the trade-off between fighting excessive inflation and
avoiding a recession. There are at least three clear reasons to prioritize price stability
(i) legal: our mandate is focused on price stability (ii) political: our fellow citizens care
first and foremost about inflation and its impact on purchasing power (iii) economic:
entrenched inflation would mean less confidence, higher risk premia, and greater price
distortion, and hence less long term growth.
Furthermore, the euro area economic starting point remains relatively favourable this
year. The labour market is very strong with many vacancies and the unemployment
rate stood at a historical low of 6.6% in July and August. Annual GDP growth in 2022
-
is expected to reach 3.0% according to the latest IMF projection almost twice the
US growth -, although a slowdown is forecast in the second half of the year after the
robust growth of the first semester. We cannot exclude a temporary recession next
year, especially in case of even more severe developments in the gas and electricity
- -
markets: but a short-lived and limited recession would be less detrimental than a
protracted stagflation.
II. No Forward Guidance but some milestones on the monetary path
At its meeting in July, the ECB Governing Council formally ended its forward guidance
on policy rates and switched to meeting-by-meeting decision-making. This move is
appropriate, as we live through especially uncertain times and must not have our
hands tied. That said, since we know that medium to long term interest rates are an
important part of the transmission mechanism of monetary policy, having a yield curve
that roughly corresponds to the policymakers' own
intentions is important: this is why
we central bankers still want to provide some predictability about our reaction function.
Of course, central bankers don't actually follow a mechanical
function; nevertheless,
in normal times, simple feedback rules do a reasonable job in summarising what we
expect to do. But we do not live in normal times and decision-making is more difficult
than usual. What are the possible approaches to summarise our monetary policy
framework, or narrative? I will first mention two opposite and extreme ones, before
proposing useful milestones along the way.
1. Two polar approaches
The first, which I will call the
"empiricist approach" would conduct policy looking only
at Oversimplistic rules such as raising nominal interest
currently observable data.
rates until inflation returns to target would fall in this category. But this approach
ignores the fact that monetary policy is subject to time lags - of up to two years to pass
through fully to inflation - and that other factors can affect future inflation. It would put
us at risk of overreacting. Making decisions on a meeting-by-meeting basis and the
latest available data does not mean that we should be short-sighted, on the contrary
forward-looking.
bit of a stretch of my definition, another example of the "empiricist approach"
At a
would be to simply follow the US Federal Reserve, perhaps with a gap to reflect
different long-term neutral rates. This is obviously what countries with exchange rates
pegged to the dollar do. Of course central banks are aware of what their peers are
doing and there are undoubtedly some spill-overs from the actions of the Fed, not
least through the effect on the exchange rate, on which I will have more to say later.
But it would not make sense for the ECB to blindly follow the Fed: although inflation
has dramatically accelerated in both economies, the underlying causes are not the
same and hence the monetary policy stance should be different too. On the one hand,
the energy supply shock is considerably more intense in the euro area which is a large
energy net importer while the US is a net exporter. On the other hand, the post-
pandemic recovery in aggregate demand has been much stronger in the US, with a
much tighter labour market.
the -
At the opposite end of the spectrum is what I would call "academist approach"
although it comes from Lars Svensson, a one-time practitioner who was, among
others, Deputy Governor of the Swedish Riksbank between 2007 and 2013. It would
be to look purely forward and do inflation forecast targeting. The central bank then
works out an interest rate path that is compatible with bringing inflation back to the
target over the forecast horizon (and staying there). Simple models, such as the
one -
original Svensson's (1997)ii, can be inverted to find a single policy interest rate
"the rate". With more complex models,
target-compatible target-compatible paths can
be found through interest rate scenarios.
This approach is appealing in theory but raises several practical problems. First, it
relies heavily on having a very accurate model and clear identification of the shocks
hitting the economy, including how persistent these will be. The substantial forecast
revisions over recent quarters underline quite how difficult it is to calibrate policy based
on forecast targeting. A second, and more subtle, problem is the "stationarity" of most
macroeconomic models. This is either true by assumption in standard New-Keynesian
models or implicit in empirical forecasting models. For either reason, forecast inflation
has a tendency to revert to the target or the historical mean under almost any scenario.
Put another way, few applied macroeconomic models allow inflation to drift seriously
away from the target for a persistent period of time. Many models implicitly assume a
minimised probability of tail risks and shocks, and an exaggerated level of central bank
credibility. As a consequence they will tend to underestimate the reaction of interest
rates necessary to stabilise inflation forecasts at the target. Frankly, it is too early to
tell where the terminal rate could be, even if this time could come in the future.
2. Several useful milestones along the way
The preceding section has highlighted that unequivocal rules set once-and-for-all are
of low practical use in the current context; they put us at risk of either overreacting
(empiricist) or underreacting (academist). Yet we should not give up having any
reference points. In my view, the right balance consists of explaining an intermediary
step along our path. Beyond this intermediary step, I believe it would be useful for the
euro zone to set out a few decision criteria, both on interest rates and on the size of
our balance sheet.
2.1 The neutral rate as an intermediary step
About the first part of the journey, the ECB will continue the process of normalisation
until we reach at least the neutral interest rate. Of course, structural models of r* are
notoriously imprecise and volatile but nevertheless help us understand the evolution
of the natural rate over long periods of time.
In this slide I plot a measure with fewer technical assumptions: it uses the nominal
OIS curve and ILS swaps to create forward one-year real rates at horizons of 4 to 9
years; this can tell us where markets expect real rates to settle once current shocks
have dissipated. The solid line shows the first principal component as an estimate of
r* using this approach, with a real neutral rate now just below zero. Based on a target
inflation rate of 2%, the nominal neutral rate should then be a bit less than 2%. Given
the fact inflation is far above target and still rising, we should reach this level before
the end of the year. It is much more important to give the public this landmark than to
spark speculation and public betting game on the size of the next move in October:
this is why I won't
say anything today about this 50/75 bp discussion, which is
premature especially in the current volatile market environment and the additional
tightening of financial conditions.
2.2 A four-pronged approach for further interest rates decisions
won't stop raising rates there,
What will happen from that point onwards? We probably
but we will enter another part of the journey: a more flexible, and possibly slower one,
relying on a meeting-by-meeting precise economic assessment. This assessment
should according to me follow a four-pronged approach, with four key indicators:

First, actual inflation data, focusing on underlying inflation, as this is the part
for which monetary policy is relevant. In particular we should look at measures
of HICP excluding energy and food, and at negotiated wage growth: by the way,
we don't see so far signs of a generalised -
wage-price spiral. A turning point
which we don't see yet -
will be when underlying inflation is peaking.
Alternative measures of underlying inflation are less noisy than the standard
index excluding food and energy and thus can better signal the medium term
inflationary pressures. Indeed, in the aftermath of the pandemic, the three
alternative measures shown on this slide (persistent and common component
of inflation, trimmediii and finecoreiv) have turned up earlier than the standard
core index. And both in 2008 and in 2011-2012, they have also signalled earlier
the easing of inflationary pressures.

Second, future inflation. We will obviously use our models and forecasts, but
we should also give a strong attention to inflation expectations by financial
markets and still more by economic agents: entrepreneurs and households are
the real price- and wage-setters. Here so far, 3 to 5 year inflation expectations
remain well anchored in markets, but with some mixed signals from businesses
and households.
Any sign of stronger de-anchoring would call for a stronger monetary reaction.

Third, we will have to look more closely at the economic activity and the cycle.
In this tightening phase, unlike the phase of normalisation, the assessment of
the state of the economy and projections for growth and employment will play
-
a greater role. In case of a recession even if it should be limited and temporary
-, we would be certain to face calls to stop the tightening. This would miss the
point: to bring inflation back to target, a recession is neither necessary nor
sufficient per se. A more relevant discussion will be the assessment of the slope
of the Phillips curves. The current and rapid increase in core inflation has led
some observers to suggest that the flat Phillips curve paradigm of past decades
is now obsoletev. What is more likely is that price-setting in the economy is state
dependent, with firms reacting by more and quicker to large shocks so that the
Phillips curve is non-linear and convex. In any case, we cannot bet that a
a fairly "immaculate"
steeper Phillips curve will entirely do the job, allowing for
disinflation.

Last but not least, we will need a benchmark to measure the degree of
tightening. The real interest rate calculated with actual headline inflation would
provide misleading signals. A better gauge is provided by medium-term
forward real interest rates: they should be at least positive on all but the
shortest maturities.
And they could become more positive as a result of two possible changes:
downward move in inflation expectations, and further upward adjustments in
expected nominal interest rates.
2.3 Some initial thoughts on the balance sheet
Another issue that we will need to confront is the
normalization of our balance
sheet. It has expanded in recent years through numerous programmes (APP, PEPP,
TLTROs,..) and is now just short of 9 trillion euros.
It would not be consistent to keep a very large balance-sheet for too long in order to
compress the term premium, whilst at the same time contemplating tightening policy
rates above neutral. In addition, rising remuneration on very large excess reserves
may alter the transmission of the desired tightening through the bank channel. But
obviously, this question is less pressing than the rise of interest rates to neutral, and
should come only at a later stage.
Let me simply put forward at this stage a few preliminary principles that could in my
personal view guide the normalisation of our balance sheet, in due time:

First, our key interest rate should remain our primary instrument to adjust our
monetary policy stance. The size of our balance sheet should be used as a
complementary policy tool, whose effects are more difficult to calibrate or fine-
tune.

Second, we should follow a clear sequencing regarding the various
programmes: (i) the reimbursement of TLTROs comes first, and we should
avoid any unintended incentives to delay repayments by banks (ii) at the other
end, PEPP should be reinvested until the end of 2024, as stated (iii) this leaves
inbetween APP for which the Governing Council has said that reinvestment will
continue in full until "well past the date when it started raising the key ECB
interest rates".
Here we could start earlier than 2024, maintaining partial
reinvestments but at a gradually reduced pace.

Third, the phasing out of the asset portfolio should be orderly, announced
cautiously and well in advance. The 'stock effect' of asset holdings,
which is the
key transmission channel, primarily depends upon the expected end-point of
the balance sheet normalisation, in terms of both the terminal date and size.
Fluctuations in the pace of the run-off during the travel to destination do matter
less.

Fourth, as taught by US experience in 2017-2019, the pace of the balance sheet
completely on "automatic pilot". Starting slowly,
reduction should not be left
assessing markets reaction, and gradually accelerating seems like a sound
approach. Some flexibility should be kept, in case of sudden liquidity shocks.
Indeed, the 'flow effect' may temporarily play a role when market liquidity
abruptly dries up.
III. A sensitive co-ordination issue
This is the way we should run our domestic monetary policy. But in conclusion, let me
touch a sensitive coordination issue between various monetary policies. Given the
financial importance of the dollar, and the need for the Fed to tighten decisively in
order to reach its own price stability objective, other Central banks could be exposed
to a dilemma. This is not exactly the one put forward by Helene Rey in her famous
2013 paper vi, but a delicate trade- off as a consequence of free capital movements:
- Some Central banks already fighting inflationary pressures could be at risk of
overtightening to avoid an excessive slippage of their currency. This would be mainly
but not exclusively the case for emerging markets, and justifies the fear expressed by
M.Obstfeldvii and others of an excessive global monetary tightening. The IMF judges
nevertheless that we are not there yet, and I agree.
-Others would see a significant fall of their currency (versus the dollar) if they seek to
maintain accommodative domestic monetary conditions. This could explain the recent
intervention by Japanese authorities in favour of the yen.
As said earlier, I think that the ECB should and can run its own monetary course. Not
only today, but as a structural consequence of the significant weight of the euro area
in the world economy: I stressed it four years ago in our IMF Bali meetingsviii.
Obviously the exchange rate matters for our inflation outlook: we don't target it, but
we look at it closely.
That said, I wouldn't conclude that we are not at risk of coordination failures. Let me
share two reflections in this regard:
1.
Our collective "doctrine"
on monetary policy, in the G7 and G20, remains valid:
that we central banks target domestic price stability and not exchange rates.
But it implies as a counterpart an in-depth and confident dialogue, in
Washington, Basel and elsewhere, on our intentions: there should be mutual
predictability of policy making. We will achieve the closest to a cooperative
solution if we avoid significant surprises between policy makers. As Jay Powell
rightly said in 2019 in Paris "Pursuing our domestic mandates in this new world
requires that we understand the anticipated effects of these interconnections
and incorporate them into our policy decision making."ix Lael Brainard reiterated
this welcome statement no later than yesterday: "The combined effect of
concurrent global tightening is larger than the sum of its parts. The Federal
Reserve takes into account the spillovers of higher interest rates, a stronger
dollar, and weaker demand from foreign economies into the United States, as
x
well as in the reverse
direction".
2. But there can be market misperceptions of policy intentions or overshooting,
and exchange rates can become fundamentally misaligned. Under such
circumstances, there were G7 interventions in the past. Several of them were
which we shouldn't forget. But in order to be such, let me only remind
effective,
they had to fulfil two conditions: (I) to result from a shared diagnosis about fair
levels of exchange rates and possible misalignments - here the IMF traditionally
played a strong role as a trustworthy and third party expert - and (II) to be
coordinated in their implementation, or at least in their communication.
Conclusion
-
Let me wrap up: we are totally committed to our end objective inflation back to 2%;
we are more open about our path to meet this objective. But we should have an orderly
use of our palette of instruments: first, interest rate hikes, with a rapid increase towards
neutral and then a possibly more flexible pace; second, and at some later stage,
balance sheet normalisation, with a more cautious start followed by a gradual
amplification. Giving such partial predictability to markets is not being precommitted
as with a precise and binding forward guidance; but it will help to align financial
conditions with our target, and to avoid excessive volatility. And rest assured we will
- -
maintain two strong virtues for uncertain times: pragmatism and data dependency
- -
rather than pre-set ideology; international coordination and in-depth dialogue
rather than fragmentation. Thank you for your attention.
i
Villeroy de Galhau, F., Monetary policy post-pandemic : balancing between science and art, predictability and
reactivity, speech, Jackson Hole Economic Symposium, 27 August 2022
ii
Svensson, L. (1997), Inflation forecast targeting: Implementing and monitoring inflation targets European Economic
Review, pp 1111-1146.
iii
Measures of underlying inflation for the euro area, issued as part of the ECB Economic Bulletin 4/2018
iv
A possible new indicator to measure core inflation in the euro area, Banque de France Bulletin, 240/1, 2022
v
Gopinath, G., How will the pandemic and war shape future monetary policy? Prepared for the Jackson Hole
Symposium
vi
Rey, H., Dilemma not trilemma: the global financial cycle and monetary policy independence, paper presented at the
25th Jackson Hole symposium, 2013
vii
Obstfeld, M., Uncoordinated monetary policies risk a historic global slowdown, blog, September 2022.
viii
Villeroy de Galhau, F., Monetary policy in the present environment: reconciling clarity and flexibility, as well as
independence and cooperation, speech in G30, 15 October 2018
ix
Powell, J.H., Monetary policy in the post-crisis era at "Bretton Woods: 75 Years Later - Thinking about the Next", a
conference organized by the Bank of France and the French Ministry for the Economy and Finance, Paris, 16 July 2019.
x
Brainard, L., Restoring price stability in an uncertain economic environment, speech, 10 October 2022