The Global Interdependence Center
GIC's Central Banking Series -
Paris, 6 May 2022
The Eurosystem and its monetary policy:
from an "impossible dilemma" to a
possible roadmap for normalisation
Speech by François Villeroy de Galhau,
Governor of the Banque de France
Good morning, and welcome in Paris for this new GIC-Banque de France
Conference.
Europe is facing an historic turning point with the Russian aggression against
the democratic state of Ukraine. The economic consequences of this war are
maximal in Russia, with a GDP fall of -8.5% expected this year, but also sizeable
in Europe: more inflation, less growth, and above all more uncertainty.
That said, we shouldn't
at this stage rush to the stagflation conclusion: the carry-
over in growth for the euro area in 2022 is already 2,1 % at the end of Q1, after
an actual growth rate of 5,4% in 2021. Unemployment is at a historically low
level at 6.8% in March.
Admittedly, these are rough waters that monetary policy is currently navigating.
Some allege an "impossible dilemma" between fighting excessive inflation and
escaping recession.
I don't think so.
There are arguments in principle against the dilemma: legally,
our mandate clearly prioritises price stability; politically, our fellow citizens care
first and foremost about inflation and its impact on purchasing power; and
economically, entrenched inflation would mean less confidence, higher risk
premia, and greater price distortion, hence less long term growth. But today, I
will discuss from the operational standpoint about the journey toward
normalization of our monetary policy. This journey is delicate, but I am confident
that we can successfully manage it. We have already clarified its first part. At
under Christine Lagarde's leadership
our Governing Council meeting in
December last year, we agreed to phase out net purchases under the Pandemic
Emergency Purchase Program (PEPP), which has now smoothly ended.i At our
March and April meetings we decided to wind-down the monthly net purchases
under the APP, and to end them in the third quarter.ii
What I want to do now is to take a broader view of the journey. Let me share
some personal reflections about a possible roadmap to help us arrive at the right
destination. They can be summarized into three rules of travel. (I) This journey
is a fully warranted policy normalization, but not a tightening so far . (II) The pace
and the length of the journey will be guided by an active use of optionality and
gradualism. (III) The journey should prevent unwarranted fragmentation among
travellers. Let me elaborate on each of these.
**
I. This journey is a fully warranted policy normalisation, but not a
tightening so far
1. Normalisation of monetary policy is now fully warranted
To begin with, let us be humble: we were surprised by the inflationary surge last
autumn. As late as October of last year, core inflation was still at 2% in the euro
areaiii. The surprise was for everyone: on both sides of the Atlantic; including
- -
both private and public forecasters, and yes Central bank projections. What
did we miss? There was excessive reliance on inaccurate energy price futures,
as the ECB recently acknowledgediv. But let me stress another element: we
missed the intensity and contagion of supply chain disruptions, due at the time
to the strength of the recovery in demand and the persistence of supply
bottlenecks especially in transportation and goods, and in China. And then came
the war: awful, unexpected, incorporated as an energy shock but probably
- -
understated again in supply chain disruptions in Europe regarding other key
inputs, from aluminium, to fertilizers, or neon. There is probably a general lesson
complement "macromodelling" by more
from that: we need to continue
"microlistening"
to entrepreneurs. They are not always right, but this time they
were right earlier than us, and they are the real price and wage setters.
Is surprise a polite euphemism for "mistake"? In
forecasting yes, but it was a
very collective one. In policy it is not, and this is a powerful foundation: there is
wide agreement that the strong monetary accommodation implemented in
March 2020 helped avoid lasting economic, financial and social damage,
allowing Europe to emerge from the pandemic with a strong recovery. And
nobody seriously argues that monetary policy, or monetary aggregates, are the
main culprit for actual inflation in the euro area: bottlenecks in construction or in
the automotive industry can hardly be attributed to, say, excess liquidity.
By now, it is clear that our monetary policy cannot simply look through the
ongoing supply side shocks. This would have been the textbook response if the
shocks were purely transitory but the original energy price shock has
only higher,
propagated: inflation is not it's much broader. Food price inflation
has accelerated. Core inflation in the euro area climbed to 3.5% in April, still far
below the US core inflation rate of 6.5% in Marchv, but well above our 2% target.
The ECB is highly vigilant about second-round effects and wage developments,
knowing that at times they can move quite abruptly. We also monitor inflation
expectations closely, not only from market participants but also from households
- -
and firms. There are signs including in BDF business surveys that these
expectations are becoming less and less anchored at 2%.
Against this backdrop, we need to carefully watch exchange rate developments.
don't have an exchange rate
We target, but the level of the euro matters
significantly for imported inflation. A euro that is too weak would go against our
price stability objective.
I want to stress one further argument in favour of normalisation: even if inflation
-
returns progressively to around 2% by 2024 which is our forecast and remains
-
my view the present monetary accommodation will no longer be warranted.
-
Strong unconventional measures such as net asset purchases, or negative
- were necessary when inflation was "too low for too long". As it
interest rates
comes back to our target, which will be good news, this exceptional support is
no longer warranted.
But normalisation does not imply "tightening"
2.
While policy normalisation is appropriate, and already under way, words matter
in Central banking and in economic life as it is about avoiding excessive
slowdown. We are still far away from monetary tightening, as real interest rates
will remain significantly negative and below the neutral rate for some time. The
neutral rate is a reference pointvi, at which inflation (and economic growth) does
not accelerate further, nor slow down. Using a metaphor, it is the moment when,
while driving your car, you lift your foot from the accelerator pedal as you
approach the desired speed. Only when you actively push on the brakes would
the action be considered as monetary tightening. Raising our interest rates from
the exceptionally low level where they are now is reducing accommodation, or
pursuing normalisation, not a monetary tightening. Obviously, the natural rate of
interest cannot be precisely observed: I will come back to this debate for both
the US and Europe.
Let me add one element on the side of "normalisation": we, and rightly so in the
euro area, will maintain a significant size of our balance sheet through our policy
of full reinvestment, for PEPP until at least the end of 2024. Here again, is a
significant difference with the "quantitative tightening" that the Fed for instance
will start next month by shrinking actively its balance sheet. I expect that
discussion of balance sheet normalisation will only start once our journey toward
policy normalisation is well advanced and the runoff will be quite mechanical.
II. The pace and the length of the journey will be guided by an active use
of optionality and gradualism
Let me now be more specific about the pace and the possible end of the journey.
strongly advocated and so
Christine Lagarde has "optionality", have I.vii It
means acting in due time, according to the latest real data in a very uncertain
period. Not being precommitted is an absolute imperative: avoid too "long"
viii
But optionality doesn't mean inaction, or
forward guidance, favour agility.
adopting a wait and see attitude. And I think the time has come for further clarity
and action on the start of the journey.
1. On the beginning of interest rate normalization
First, in the preannounced order of our sequencing, we will stop net asset
purchases, and decide in our June meeting precisely when in Q3. I have seen
- -
much perhaps too much speculation, predictions, statements on that end
date. Let me simply stress that seen from today the case for continuing to press
the accelerator and adding further net purchases after June is not obvious.
Then will come a more important decision on the timing of our first interest rate
increase, what we refer to as lift off. This decision is now fully separate from that
of ending net asset purchases: I advocated some months ago dropping the
"shortly before" and the automatic
link,ix and we indeed decided in March that
the first hike would come "some time after". How much is some time? We will
decide it in June or later, but let me share two reflections:

The three conditions of our forward guidance on interest rates are,
according to my personal judgment, fulfilled, even if they provide a
prerequisite for the lift-off without implying necessarily a mechanical and
immediate decision. The most important condition, consistent with what I
said about normalisation and not simply looking through the energy
shock, is the third one: that "realised progress in
is
underlying inflation
sufficiently advanced to be consistent with inflation stabilising at 2% over
the medium term".
Well, here we are. By all measures, underlying inflation
is clearly above 2% at present.

There have also been many comments about the precise month of the lift-
While I wouldn't preclude the next few Governing Council meetings, I
off.
would rather set a marker a bit further down the road: barring unforeseen
new shocks, I would think it reasonable to have entered positive territory
by the end of this year. As the most obvious next step, rate increases
towards zero may have dampened effects, as bank margins and
profitability might increase and improve the ability of banks to provide
credit, although the evidence here is far from clear-cut.
-
As we raise the DFR which is at present our key rate -, the level of MRO
- -
rate presently at zero and MLF rate will have to be increased at some
stage, to preserve a smooth functioning of the interbank market.
2. On the duration of interest rate normalization
As the start of the journey is becoming clearer, the attention is currently shifting
more towards its end. The IMF interestingly suggested in its latest WEO that
"Central banks should communicate clearly their perspective on the
post-
pandemic neutral rate [...] giving markets some clarity on the likely endpoint for
rate hikes".x True, our current forward guidance does not provide information on
the path of nominal rates post lift-off. The notion of gradualism, introduced in
the March meeting,xi fills this gap to some extent, as it rules out too abrupt rate
hikes.
There are two traditional and strong arguments for gradualism: first, avoiding
the economic and financial instability created by 'stop and go'
policies; second,
-
dealing with uncertainty in convergence with the other principle of optionality,
or with the famous Brainard principle of 1967. That said, research by the Banque
xii
shows that gradualism shouldn't mean excessive caution or inertia:
de France
if, in the case of persistent shocks, the central bank reacts too cautiously,
inflation expectations are likely to increase putting higher upward pressure on
inflation. The bottom line is that the pace of normalization will have to be
calibrated in order to reduce the uncertainty on future inflation.
Measuring monetary policy stance
To calibrate the normalisation of policy rates we need to assess the monetary
policy stance appropriately. Firstly, what is the correct horizon of real interest
rates to measure the stance? Current levels of headline inflation are very high,
leading to deeply negative ex post short-term real interest rates.
Larry Summers has noted that this goes against established rules to stabilise
inflation. However, if we look at longer term implied real rates, there is less
reason to be alarmed. While current inflation is quite high, inflation is expected
to recede back to 2% over the medium term at the same time as policy rates are
expected to increase.
The neutral rate
As I mentioned earlier, the level of the neutral rate cannot be precisely
determined ex ante. However, current estimates of real neutral rates point to
levels between -1% and 0% in the euro area, and between 0 and +1% in the
US.xiii Such natural real rate gap can be largely explained through less dynamic
demographics and potential growth in the euro area compared to the US. Given
an inflation target of 2% on both sides of the Atlantic, this suggests a nominal
short-term neutral rate possibly between 1% and 2% in the euro area and
between 2% and 3% in the US. These values seem indeed consistent with
financial market-based interest rate expectations, for short-term rates or nominal
terminal rates of about 1.5% in the euro area and 2.5% in the US, as proxied for
the OIS with a maturity of one year in 9 years.
But we will have to be pragmatic along the way: when short-term nominal rates
in the euro area approach such a range, we will then have to judge whether or
not this is sufficient according to the inflation outlook at that time. If this seems
compatible with a stabilised inflation outlook of 2% over the medium term, then
we can say that we are close to the end our normalisation journey. If not, we
would have to pass over this neutral rate zone, which means that a tightening
of the stance would then - and only then- be necessary.
The speed of convergence towards this neutral zone could also depend on the
degree of economic slack. Unlike the US, which is currently in a situation of
excess demand, it might justify a slower journey in the euro area.
III. The journey should prevent unwarranted fragmentation among
travellers
Let me now come to our specificity as a Monetary Union, and elaborate on a
third principle put forward by our Governing Council: flexibility.
Flexibility supporting interest rate normalisation
While monetary policy normalisation requires an appropriate calibration of
nominal interest rates to reach the right stance, equally important in the euro
area is ensuring an even and smooth transmission across jurisdictions and
asset classes. In a widely remarked speech in Jackson Hole in 2010, Jean-
Trichet set out the idea of a principle" xiv: "The monetary
Claude "separation
stance
policy is always designed to deliver price stability in a medium and longer
term perspective. The non-standard measures have a clear purpose: ensuring
that the standard measures themselves are transmitted as effectively as
functioning of some markets."
possible despite the otherwise abnormal
less relevant in an environment of "too low
This separation was afterwards
inflation for too long", in which
non-standard measures contributed importantly
to providing monetary policy stance to close the inflation gap. Indeed, the PEPP
and TLTRO-III had both stance and transmission effects. But here we are again,
close to a separation principle.
During the normalisation phase, we are prepared to confront two possible
transmission perils. First, liquidity shortfalls in the banking sector in some
jurisdictions can be addressed any time by longer-term refinancing operations;
this is why I propose new LTROs. During the normalisation period, the
remuneration of such a liquidity backstop should be designed at "normal" prices,
indexed on MRO, to protect transmission only, without undesired interference
with the desired stance.
Second, unwarranted market fragmentation in public or private bond markets
(or specific asset classes such as commercial paper in March 2020) could
happen. I stress here the "unwarranted
"; at its December 2021 meeting, the
"Under
Governing Council has taken a strong and clearly defined commitment:
stressed conditions, flexibility will remain an element of monetary policy
whenever threats to monetary policy transmission jeopardise the attainment of
price stability ". As regards all the lasting consequences of the pandemic, we
are ready to be flexible in PEPP reinvestments, or even resume its targeted net
purchases if necessary. But our commitment against unwarranted
fragmentation is broader, as Christine Lagarde strongly said in the April press
conference: "We need to continue to integrate flexibility in our monetary policy
determination, if warranted, and if necessary we can move very
promptly".xv To
we don't need to be
be determined in our commitment, specific about
technicalities: the precise design of a new instrument, or the conditions
which would trigger appropriate interventions. But we can at any time draw the
positive lessons from the PEPP flexibility efficiently used in 2020. Everybody
should be aware that we have in our toolbox this contingent backstop:
preventing fragmentation belongs to succeeding in normalisation.
In order to avoid any influence on the stance, an option worth considering would
be to sterilize flexible asset purchases, that is to absorb the liquidity injected
through adequate (liquidity) off-setting operations, as it is was practiced under
the Securities Markets Program (SMP) until June 2014. Other innovative design
options could include selling a particular asset sometime after its purchase, once
the market stress episode has disappeared. The key mechanism behind this
strategy is an asymmetric flow effect between purchases and sales: the central
bank can buy bonds during a market stress episode and sell them more
gradually over time once market conditions normalise, with no long term
implication for the overall balance sheet size and thus for the stance. This would
further underline the differential impact that the flow of purchases versus
the size of the overall balance sheet have for monetary policy transmission and
stance. Regarding the stock, let me reiterate the point that we should maintain
the size of our balance sheet for an extended period of time: this will ensure
through reinvestments a significant presence of the Eurosystem in markets, and
also contribute to prevent fragmentation or too brutal adjustments in the term
premium.
-
Note however that the coexistence of a large balance sheet and hence
-
significant excess liquidity and positive ECB rates will raise new technical
about banks' we'll solve them in
issues reserve remuneration. I have no doubt
due time.
**
Let me conclude. While the first part of the journey towards policy normalisation,
namely the exit from asset purchase programs, is almost concluded, it is time to
provide a possible roadmap on the next part of the journey, including the
possible endpoint. By the way, I spoke today about travellers, not about birds. I
never believed in the ornithological taxonomy, still less today: describing our
discussion as "the hawks taking control", or "the doves resisting" is a bit of
intellectual laziness. It's about a new and challenging situation faced by 25
independent and open-minded Council members, whose views are presently
"When facts change, I change my mind", Keynes rightly
significantly converging.
said. In this regard, we are all Keynesian ! And I am confident that the three
travel rules I proposed today, beyond their technical content, will enable us to
fulfil our commitment towards our fellow citizens. Let me say it for the wider
public of 340 million Europeans: you can trust us, your central bank, to ensure
price stability and bring inflation back firmly and durably to 2%. We have the
- -
duty to act, the will to act, and decisively the capacity to act. I thank you for
your attention.
References
i
Monetary policy decisions, 16 December 2021.
ii
Monetary policy decisions, 10 March 2022, Monetary policy decisions, 14 April 2022
iii
This refers to core inflation as measured by year-over-year changes in the Harmonized Index of Consumer
Prices, all items excluding energy, food, alcohol and tobacco.
iv
Chahad, Hofmann-Drahonsky, Meunier, Page, and Tirpak (2022) „What explains recent errors in the inflation
projections of Eurosystem and ECB staff?", ECB Economic Bulletin, Issue 3/2022.
v
As measured through the CPI Index
vi
Wicksell, Knut (1898). "Interest and Prices", Nihon Keizai Hyoron Sha.", Friedman, Milton (1968) "The role of
monetary policy", American Economic Review 58(1), 1-17; Presidential address delivered at the 18th Annual
Meeting of the American Economic Association, Washington, D.C., and Woodford, Michael (2003): Interest and
Prices: Foundations of a Theory of Monetary Policy, Princeton, N.J.; Woodstock, Oxfordshire England: Princeton
University Press.
vii
F. Villeroy de Galhau, Monetary policy in uncertain times, Speech - London School of Economics, 15 February
2022.
viii
Ibid.
ix
This choice has the merit of enhancing optionality because it brakes the quasi-automatic temporal link
between the two instruments whilst retaining the sequencing. Optionality would mean that the lift-off could
possibly take more time, if warranted.
x
IMF, World Economic Outlook, April 2022
xi
Monetary policy decisions, 10 March 2022.
xii
Dupraz, Guilloux-Nefussi, Penalver 2020, A Pitfall of Cautiousness in Monetary Policy, BdF WP no. 758,
forthcoming International Journal of Credit Banking.
xiii
See Holston, Laubach, and Williams. 2017. "Measuring the Natural Rate of Interest: International Trends and
Determinants," Journal of International Economics 108, supplement 1 (May): S39-S75 and Garnier, O., S.
Lhuissier and A. Penalver (2019) "Taux d'intérêt bas, quelle responsabilité de la politique monétaire?",Risques,
No. 120, Décembre 2019, 71-78 A survey of the literature is provided by Brand, Bielecki and Penalver (editors).
2018. "The natural rate of interest: estimates, drivers, and challenges to monetary policy", ECB Occasional
Paper Series No. 2017.
xiv
"Central banking in uncertain times: conviction and responsibility", speech by Jean-Claude Trichet, President
of the ECB, at the symposium on "Macroeconomic challenges: the decade ahead", Jackson Hole, Wyoming, 27
August 2010.
xv
ECB Press Conference, "Monetary Policy Statement & Transcript of the Questions and Answers", Christine
Lagarde, President of the ECB, and Luis de Guindos, Vice-President of the ECB, 14 April 2022.