Nordic Summit 2021 - 25 May 2021
Inflation and monetary policy in a post-Covid-19 world
Speech by François Villeroy de Galhau,
Governor of the Banque de France
Press contact: Mark Deen (mark.deen@banque-france.fr), Déborah Guedj
(deborah.guedj@banquefrance.fr)
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Ladies and Gentlemen,
I am delighted to be with you today. Denmark and the Nordics are among the
most successful countries in Europe, and even worldwide: a unique mix of
economic innovation, social cohesion, and environmental commitment. But
today, in the country which is with its currency at the closest frontier of the euro
area, you invite me to speak about "Inflation and monetary policy in a post-
Covid-19 world".
As of 2006, Olivier Blanchard said : "Monetary policy can pretend to be close to
science if it can be conducted using simple and robust rules [...] Monetary policy
must be closer to art if it is frequently confronted to new, poorly anticipated and
poorly understood, contingenciesi." The current debate on monetary policy is a
perfect illustration. While a few years and even a year ago everybody feared the
disappearance of inflation, the world is now worried by its comeback. While a
few months ago the emergency support in the face of the Covid crisis was the
No.1 concern, we are now talking about exit and post-Covid world. This is
precisely the title of the speech you invited me to give.
Faced with such swings in sentiment, I want even more to stress today two ideas
that are constant and consistent:
(A) the ECB has been an innovative and efficient inflation-targeter,
including in the Covid-crisis;
(B) beyond Covid, the ECB has a powerful "quartet of tools" to keep its
monetary policy as accommodative, and for as long as necessary.
A. The ECB as an innovative and efficient inflation targeter
In the first part of my remarks, let me try to answer three questions: is the ECB
clear in its objective? is it consistent in its instruments? and is it efficient in its
results?
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I. Is the ECB clear in its objective?
For the ECB, like all other major central banks, our inflation objective is our
lodestar. That means our definition of price stability should be simple,
symmetric, and medium-term oriented. However, not everyone may perceive it
this way. Hence, in the context of the Strategy Review launched by Christine
Lagarde, we are currently reflecting on whether it can be communicated more
clearly. To make it even simpler, we should reexamine the overly sophisticated
qualifiers attached to the 2 % figure ("close to but below"). There is no benefit in
appearing ambiguous about what we are aiming at.
"Symmetric" refers to the fact that our objective is a target and cannot be a
ceiling. Looking backwards, a central bank that has been successful in achieving
its target on average will have had roughly as many episodes of inflation above
its target as below. We are, though, in an asymmetric world. The effective lower
bound on nominal interest rates is a serious impediment to counteracting
deflationary shocks, and weighs on inflation expectations. In these
circumstances, it is even more important to stress that we are ready to accept
inflation moderately higher than 2% for some time to anchor fully medium-term
inflation expectations. I will come back to that later, speaking of our forward-
guidance.
Finally, "medium term" means that we assess inflation performance over a
long enough period, looking forward, but also not ignoring the past.
To cut through the debates, sometimes a bit esoteric, the ECB is clearly an
inflation-targeter, albeit a flexible oneii. We are focused on hitting our inflation
target but we set policy in the context of the economic cycle, including looking
at output gaps and employment. In general, we see no contradiction in full
commitment to our inflation target and stabilizing employment.
II. Is the ECB consistent in its instruments?
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Monetary policy is not a contest and there is no prize for doing the most.
Nevertheless, it is sometimes said that we have not reacted as much as the US
Fed. This is simply not true. The ECB is at least as accommodative and will be
at least as patient as them. The Eurosystem balance sheet, in terms of GDP
ratio, is twice the size of the Fed's. We have also been able to extend it
significantly.
Among major economies worldwide, the euro area has the lowest interest rates,
be they nominal or real, short or long-term. And the ECB has developed a wide
range of tools. Quantitative Easing was not created in Europe, but corporate
bond purchases, the wide range of eligible collateral, TLTRO or negative rates
were developed here.
In calibrating our decisions, we look of course at both the stance (based on our
desired effect on future inflation) and the effective transmission of monetary
policy (is the stance having the intended effect for economic agents, including
SMEs and households?). These two considerations are evident in our recent
decisions about the PEPP. The purpose of the PEPP is to preserve favourable
financing conditions for all borrowers during the crisis phase of the pandemic
and thereby prevent inflation from falling even further below our objective. From
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the start in March 2020 and still more since December, we have included the
possibility to buy flexibly across time, jurisdictions and asset classes, to ensure
that all borrowers benefit from favourable financing conditions.
The recent evolution of long-term sovereign rates illustrates our consistency. In
January and February, long-term sovereign bond yields in the euro area began
to increase, largely reflecting transatlantic spillovers from US monetary and
fiscal policies.
So we decided in our Governing council on March 11th to conduct our purchases
"at a significantly higher pace", which was implemented promptly and efficiently
and limited the rates increase. From mid-April nevertheless, our action has been
hampered by unwarranted tapering fears. Let me be crystal-clear: any
hypothesis of a reduction of purchases partly for Q3 or the following quarters is
purely speculative. As Christine Lagarde has said, we did not even discuss
phasing out at our April Governing Council meeting. Our net purchase volumes
will be freely determined until at least March 2022 by our commitment to
preserve favorable financing conditions for all economic agents. Our monetary
policy can be patient, as the euro area inflation is well below other jurisdictions.
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III. Is the ECB efficient in its results?
Over the period 1999-2007, inflation averaged 2.1%. But the inflation rate has
dropped to only 1.0 % between 2013 and 2019. This is a substantial shortfall.
Headline inflation in the US (CPI) experienced a similar decline of 1.1%, having
dropped from 2.7% to 1.6% between the two periods, although the gap to the
target is smaller.
In the euro area, according to Banque de France's analysis, two factors explain
most of the gap between the observed level of inflation and our targetiii.
The first one is caused by the Great Recession and the sovereign debt
crisis.This set of crises has durably depressed demand and therefore prices,
through the Phillips curve; while the slope of the Phillips curve seems to have
decreased in recent decades, it is still positive. The Phillips curve remains well
alive: in the bad news of "missing inflation", this is the good news for monetary
policy. The second factor is the strong decrease of the price of oil after 2014
that lowered the inflation rate both directly, through the energy component of
consumption prices, and indirectly. It is estimated that these two factors have
led to a 1 pp decrease in the annual inflation rate. Unconventional monetary
policy was successful in mitigating these disinflationary effects. Absent this
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policy, in-house and ECB computations show that annual inflation would have
been around 0.3pp lower between 2014 and 2019 (on average per year).
After the onset of the pandemic, our monetary policy measures have also
stabilized and then reversed the fall in inflation expectations. According to
estimates from the ECB, all the measures taken since the beginning of the
pandemic should contribute cumulatively around 1pp to the annual inflation rate
over 2020-2022iv. Inflation expectations have picked up and long-term market
based inflation expectations are currently above their pre-Covid levels (market-
based inflation expectations 5y/5y are close to 1.6% today).
B. Beyond Covid, the ECB has a powerful "quartet of tools" to keep its
monetary policy as accommodative for as long as necessary.
Euro area HICP inflation increased to 1.6% in April 2021, from -0.3% in
December 2020, while core inflation remained subdued at 0.7% in April and
0.2% at the end of last year. However, this rebound is primarily due to transitory
factors and base effects, which are expected to fade out of annual inflation rates
early next year. Underlying price pressures are expected to increase somewhat
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this year, owing to short-term supply constraints and the recovery in domestic
demand, although they remain subdued overall, in part reflecting low wage
pressures. This assessment is broadly reflected in the baseline scenario of last
March ECB staff projections for the Euro Area. It foresees annual inflation at
1.4% in 2023. There is today in the Euro Area no risk of lasting return of inflation.
We will continue PEPP net asset purchases "until at least the end of March 2022
and, in any case, until [we] judge that the coronavirus crisis phase is over". We
still have ample time to judge and decide, well beyond our June meeting, as
Christine Lagarde said last Friday.
Let me today stress one obvious but sometimes overlooked truth: whatever the
future decision on PEPP, we will still be able to play and enhance the full
"quartet" of our unconventional instruments: asset purchases, negative rates,
liquidity provision, and forward guidance. These unconventional instruments are
here to stay, beyond Covid and its crisis tools, meaning that our monetary policy
can remain as accommodative as necessary, for as long as necessary. And I
would like to share some thoughts on each instrument of the quartet.
Asset purchases are powerful and we still have room to do more if necessary.
Reinvestments under the PEPP will remain significant, and net purchases will
continue under the APP, possibly adapted. Based on our experience with the
PEPP, we could move towards some additional flexibilities, in terms of allocation
and/or volume.
The way negative rates are implemented continues to be effective. If needed,
the present level of the DFR is not a floor. In particular, the tiering system limits
the negative side effects on bank intermediation of low-for-long interest rates.
The tiering multiplier could be adapted flexibly to support the "low-for-longer"
policy. I would favor a more rule-based approach to adjust the level of the
multiplier. For instance, this multiplier could depend on the change in excess
liquidity (net of TLTROs).
As the third instrument of the quartet, our forward-guidance gives visibility to
the future path of interest rates and could be enhanced by stronger commitment
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and communication. A particular focal point is the present puzzle between the
date of anticipated lift-off and the expected inflation then, which at present
remains under our target. To strengthen the impact of our forward-guidance on
rates, we should clarify our state-dependent reaction function. Consistent with
the symmetry of our objective, our willingness to tolerate upside risks on inflation
has to be more widely understood. I would not go as far as embracing flexible
average inflation targeting as the Fed did in its new strategy framework: it raises
several complex questions and can create excessive constraint. But the forward
guidance is a more tactical and adequate tool, stating clearly that we are ready
to overshoot temporarily 2% before any rise in interest rates. Furthermore, our
forward guidance could be made more outcome-based by linking the path of
policy rates to realized inflation rather than with judgements and forecasts on
the expected future path of inflation.
Concerning our fourth instrument on liquidity provision, let me stress the
efficiency of TLTROs. This instrument is a specific feature of euro area
monetary policy and I believe we should keep it in place in some form for more
time. The embedded incentive scheme on pricing makes it attractive for banks
to extend credit to firms and households. Through TLTROIII, the ECB has
provided around 2.1 trillion euros in loans to banks at negative rates. According
to Eurosystem estimates, TLTROIII liquidity is expected to boost loan volumes
to real economy to the tune of 3pp cumulatively by 2022v. The April Euro Area
Bank Lending Survey indicates that around 45% of banks have reported and
expect an increase in bank lending to firms due to TLTRO's.
Implementing a rule-based tiering multiplier, as I proposed earlier, could make
it easier for us to get rid of some possibly excessive subsidies in the present
design of TLTRO, and also limit the room for carry trades. But such a "refocused
TLTRO" would remain crucial to provide the real economy with sufficient credit,
and banks a significant additional source of funding relief.
**
Let me conclude: we central bankers and policy makers must always deal with
uncertainty, but still more since March 2020 and the pandemic. Nevertheless,
we tried to give clarity - and successfully, according to most. Being predictable,
without being precommitted. Voltaire summed this up nicely as early as 1770:
"Doubt is an uncomfortable condition, but certainty is a ridiculous one."vi In these
promising but moving times beyond Covid, I aimed to give as much clarity as
possible; clarity, not certainty, which is neither possible nor desirable. Thank you
for your attention.
i
Panel discussion, presented at "Monetary Policy: A Journey from Theory to Practice. An ECB colloquium held in
honor of Otmar Issing, March 2006
ii
See "Past and future of the ECB monetary policy", V. Constâncio, Conference on "Central Banks in Historical
Perspective", Valletta, 4 May 2018, and "Inflation targeting", L. Svensson, The New Palgrave Dictionary of
Economics, 2008.
iii
Diev Pavel, Kalantzis Yannick, Lalliard Antoine, Mogliani Matteo, "Comment expliquer la faiblesse de l'inflation
en zone euro depuis 2013 ?", Le Bulletin de la Banque de France n°234 : article 7, April 2021. Comparison of the
average of real and nominal 10Y rates on the period Jan-Apr 2021, among EA, US, Japan, UK and Canada.
iv
Die Geldpolitik der EZB in der Corona-Krise, Isabel Schnabel Webinar von Sven Giegold mit der
Heinrich-BöllStiftung, April 2021
v
See "The ECB's monetary policy in the pandemic: meeting the challenge", speech by P. Lane, October 2020, and
references therein.
vi
Letter to Frederick William, Prince of Prussia (28 November 1770).