Speech by François Villeroy de Galhau,
Governor of the Banque de France,
Centre des professions financières
Paris, 17 February 2023
How monetary policy will defeat inflation:
channels and locks
Introduction
Inflation is currently the number one concern for our fellow citizens and for us.
Admittedly it has started to fall back slightly, to around 8.5% in the euro area, and it
could have halved by the end of this year. But that will still be too high. Inflation that
becomes entrenched at above 2% would be the worst enemy of confidence and
therefore growth.
The initial causes of this return of inflation are well known, and are primarily external
to the euro area: disruptions to global supply chains with the exit from the pandemic,
energy prices, Russia's war against Ukraine...
Their indirect repercussions have been
felt gradually, first in manufactured goods prices, then in services prices. To sum up,
inflation has not only become higher but also more widespread; not just imported but
also domestic; not just linked to a transitory supply shock but also potentially
persistent. In light of this, no one can seriously deny that monetary policy must
respond.
Today, therefore, I shall not talk about why the central bank must combat inflation but
about how, in the current context, it needs to act to be effective.
First we need to clear up the misconception that has become widespread, particularly
-
in our country that the weapon to achieve lasting victory over inflation is not fiscal: it
is primarily monetary, and then structural, so as to increase the supply of goods and
services. Tariff and fiscal shields can be useful in the short term, but they do not lead
to a durable reduction in inflation. And, as we strongly emphasised following our last
Governing Council meeting, it is time for national governments to start reducing their
support measures rapidly, by making them more targeted, as soon as energy prices
start to recede.
I shall therefore focus on two subjects here today: (I) what are the channels of
transmission of monetary policy today? (II) what are the pointers for our future
monetary policy and, to continue with the image of channels and waterways, what
navigation locks do we need to go through?
I. The channels of transmission of monetary policy today
One "historical" channel is less relevant today: monetary aggregates.
The monetary aggregates channel is based on the idea that strong money growth
fuels inflation: we have all more or less learned Irving Fisher's money quantity
equation (1911)1 and the monetarist theories that have dominated since Milton
Friedman (1956).2 However, this channel has gradually become less relevant. Indeed,
because of the volatility in the speed at which money circulates, the relationship
between money growth and inflation fluctuates over time; it is neither causal nor
automatic.3 That said, since its creation, the Eurosystem has always monitored
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monetary aggregates, even if their relative importance has gradually declined a
change that was confirmed in our last strategic review in 2021. Since the start of the
asset purchases in 2014, money growth has remained contained. During the Covid
crisis, however, the exceptional fiscal and monetary support measures led temporarily
to an expansion of household and corporate bank deposits: M3 growth reached 12.5%
in January 2021.4 But since then, growth in monetary aggregates has fallen steadily,
"monetarist"
reaching 4.1% in December 2022. A simplistic interpretation of the
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approach could therefore, paradoxically, prove reassuring today but artificially so.
The expectations channel
While the steering of monetary aggregates has become less important, the steering
of inflation expectations has gained significant ground in modern monetary theory,
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especially since the work of Michael Woodford.5 These expectations play a key role
be they those of the financial markets in determining the level of interest rates, or
those of economic agents (businesses and households) in guiding decisions on future
prices and wages. I shall come back to the expectations of households and
businesses later on, as they are more difficult to measure and influence. At this stage
I would like to concentrate on market expectations, and the way in which the central
bank should guide them.
The essential variable here is the of its communication and action. This
credibility
credibility is underpinned first by a solid institutional foundation: I would just like to
point out that this year marks the 30th anniversary of the law of August 1993 granting
the Banque de France its independence. Secondly, it requires unwavering
determination and capacity to act: let me reiterate firmly here today, not just our
forecast but also our commitment, alongside Christine Lagarde, to bring inflation back
towards 2% in the euro area and France by end-2024/2025. Credibility ultimately
means renewing our communication: since last year, like all other major central
banks, we have stopped giving the markets "forward guidance"
in the form of a
commitment to a path of key rates that is unconditional and/or extended over time, as
today's highly uncertain
this no longer appears suited to environment.
However, market expectations of the future path of key interest rates are an essential
determinant of medium and long-term interest rates, those that matter the most for
investment and spending decisions. We therefore need to aim, with humility, for a
"new predictability" in our communication.6
To do this we need to overcome at least
one challenge, which relates to the overly strict interpretation of what "deciding
meeting-by-meeting" means. As witnessed with our meetings at the end of last
October and in December, this would lead to surprises and excessive volatility.
Monetary policy deserves better than a "live"
prediction contest, or an
overinterpretation of statements by different individuals. On 2 February, on the
contrary, we made it clear that we intended to raise our key rates by another
50 basis points on 16 March, and that we would then evaluate the subsequent path of
and unconditional "guidance" does
our monetary policy. Refusing to give long-term
not preclude providing some short-term visibility, today or tomorrow. The main thing
is that our future decisions shall remain dependent, first and foremost, on the
economic data. Amidst the uncertainty, I am calling, more than ever, for pragmatism.
What is the current level of market inflation expectations? After remaining fairly stable
for a long period below the 2% inflation target, expectations initially increased
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markedly in the recent period including five-year ahead expectations which are the
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most important for us and rose to over 3% in spring 2022.
But these expectations have since improved spectacularly as energy prices have
subsided; swap markets are now expecting inflation to fall rapidly towards 2%,
including in one year's time. This can also be seen in
five-year options markets.
These expectations can be regarded as too volatile, or a little too premature when it
comes to the inflation decline. But they still have a significant impact on the rise in
expected real rates, and this leads me to the channel of financial conditions.
The channel of financial conditions and demand
The fact that an expectations channel exists does not mean that monetary policy only
works like a magical incantation. It has a direct impact on financing conditions; and in
keeps demand in line with the economy's supply capacity, at a
doing so it indirectly
time when this capacity has been squeezed by external shocks.
We need to banish one false suspicion that tends to arise in this context: the idea that
monetary policy aims to create a recession, and that a choice has to be made between
growth and controlling inflation. This is wrong, first because persistent inflation would
mean higher risk premiums and price distortions which, in the longer term, would
curtail growth. Second, from a more cyclical viewpoint, euro area activity and
employment have proved resilient over recent quarters. There is therefore room to act
and I want to make this clear: our achieving of disinflation will not lead to a recession.
The goal now is to avoid a faster re-acceleration of demand than supply in the
expected 2024-25 recovery. To achieve this, financing conditions obviously cannot
remain the same today as they were when there was a demand shortfall, as in the
past decade when inflation was too low for too long. Technically, we are talking about
monetary tightening or "restrictive" financing conditions: these words obviously sound
less appealing, but what do they mean in reality?
We are first aiming, through monetary tightening, for an increase in real interest rates
at different maturities. These are interest rates (OIS7) adjusted for inflation
expectations (ILS8) and not for current inflation.9 It is real rates rather than nominal
rates that reflect the true financing conditions faced by economic agents; they stem
from our decisions, but also from the aforementioned expectations channel combining
the rise in expected interest rates and the fall in expected inflation. Since the start of
2022, the real yield curve has risen significantly; we are pleased that it is now in slightly
positive territory for all maturities.
We also look at credit aggregates, which are much more meaningful than monetary
aggregates.10 The credit channel is especially important in the euro area since, unlike
in the United States, the majority of investment here is financed through bank credit.
The cost of credit has risen markedly, from levels that were exceptionally
accommodative. We are seeing a deceleration in volumes, although growth in
outstanding credit remains strong [+6.3% in the euro area for business loans and
+4.4% for loans for house purchases]. In both categories, credit is cheapest in France
and is growing at above the average rate for Europe.

This slowdown in credit supply is justified after the sharp rise in private debt ratios in
recent years.
Interest rates also influence the foreign exchange channel. The past depreciation of
the euro has amplified the rise in imported prices, particularly those of commodities
which are global and set in dollars. The 16% fall in the euro against the dollar between
mid-2021 and mid-2022 would, if it had stayed at this level, have had an estimated
impact of roughly +0.6 percentage points on the level of consumer prices over the
long term. The monetary policy conducted since then by the Eurosystem has
contributed to the recent re-appreciation of around 8% in the euro, which should
gradually have the opposite effect. Do I need to say it again? We do not have an
exchange rate target, but we closely monitor the effects of the exchange rate on
inflation; it is good to see that they have become more favourable again since last
summer.
the "sprint"
II. A few pointers: from to monetary normalisation in 2022 to the
race" towards monetary stabilisation
"long-distance
As of the end of 2021, we responded to the inflationary shock with a rapid and clear
shift in monetary policy stance. After discontinuing its net asset purchases (as of the
announcement in December 2021 for the PEPP), the ECB Governing Council decided
to raise its key rates at an unprecedented rate, by a total of 250 basis points in five
months, between July and December 2022. Some felt that we started these rises too
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late: we can argue over whether it should have come a few weeks earlier which
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would not have changed much but I would just like to remind you of the initial doubts
voiced by many economists over the inflationary shock, which was still seen as
temporary a year ago, and notably concentrated in the energy supply. We needed to
analyse and form an opinion: as soon as inflation clearly became more widespread
and more persistent, we acted quickly and with force. At the end of 2022, monetary
policy reached what we call "the neutral rate"
zone, which is the theoretical equilibrium
rate at which there is neither monetary expansion nor contraction of inflation. The
Banque de France estimates that, in real terms, this neutral rate is currently just above
- -
0% in the euro area it is higher in the United States and hence around 2% in
nominal terms. It was a sprint race as we had to get to at least this neutral rate as fast
as possible. Clearly we have gone beyond that today, and as a result have entered
"restrictive" territory in the technical sense.
The long-distance run towards the stabilisation phase
We are now entering a new, slower, longer and more open phase. After the sprint
comes the long-distance run. Expectations are continuing to focus, excessively in my
view, on our speed: are we going to continue our 50-basis-point hikes after March? I
shall not answer that today, first because our decisions over the coming months will
be guided by the data. Above all, it is also because there are two more important
variables in this new phase: the level of interest rates that we reach, and the duration
for which we stay there.
The level of the "terminal rate"
the markets' estimate of the "terminal rate"
Regarding the level, was, until the last few
days, around 3.5% in the euro area. The fluctuations since yesterday may be
excessively volatile, but I shall just make one comment here on the calendar and
another on the substance.
Regarding the calendar, without setting ourselves any strict time limit, I think it is
possible that we will have reached this peak by summer... which officially ends in
September. That would leave us four Governing Council meetings, after the one in
March where we will have reached 3%. We shall probably go beyond this 3%, but
there will be no obligation to act automatically at each Council meeting, and we are
not ruling out acting subsequently if new elements justify it. This gives a sufficiently
broad scope of action to be serene, open: after March there will be less monetary
urgency as we will need to analyse the economic evidence more closely.
I do not believe it is possible to model "a
Regarding the substance and method, target-
compatible rate". It is appealing from an academic point of view, and such a model
was notably developed by the economist Lars Svensson who went on to become
Deputy Governor of the Swedish Riksbank from 2007 to 2013.11 But in practice this
method is ineffective. It relies heavily on having a very accurate model and clear
identification of the shocks hitting the economy. The substantial forecast revisions
over recent quarters underline just how difficult it is to calibrate policy based on
forecast targeting. As a consequence, this method gives highly volatile estimates of
the terminal rate, which can double depending on the assumptions and forecasts.
However, I do think we need some pointers, which brings me, regarding our channels
of transmission, to the first essential "navigation lock": that of the future
stabilisation of the level of rates. What economic data should guide us in deciding
whether or not to stop the rate hikes? In my view, the central criterion is a turnaround
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in the trajectory of inflation, not just headline inflation we are very probably close to
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that point but above all underlying inflation, notably excluding energy prices
which may lag the headline measure by several months. It is this underlying inflation
that monetary policy can best treat, and which provides the best indication of the
medium-term trajectory of headline inflation. Will this turnaround require actual and
duly observed falls in underlying inflation, or a sufficiently solid forecast of an expected
fall in the very near term? Prudence demands the first response, while the time taken
for monetary policy transmission justifies the latter, so the Governing Council will have
to use its judgement. The other bigger question on an economic level is how best to
define underlying inflation: I shall come back to this at the end.
The duration of the stabilisation phase
The other key variable is the duration the interest rate is kept at its so-called terminal
level. It is our duty to repeat that the fight against inflation cannot be won without
perseverance, and without keeping interest rates high for as long as necessary. We
need to be wary of declaring victory too soon: the final kilometres of a long distance
race are often the most decisive.
Here again I think we can give some pointers on this other essential "lock": what
economic data could guide us as to the length of this phase and lead us to one day
envisage a lowering of the level of rates? This issue is of course further off in the
future, and definitely not for this year. However, when the time comes, we will need to
find the optimal balance between the level at which rates are stabilised, and for how
long, as in a long distance race where you need to balance pace and distance. When
we are sufficiently confident that we have reached the right rate level, it might be a
good idea to give guidance on the criteria determining how long we stay there.
The key criterion here seems to me to be a return to an inflation outlook that is
compatible with our 2% target, firmly and durably. Firmly in the sense of being
supported by actual data on headline inflation but also on underlying inflation. Durably
in the sense of being well ahead of the end of our projection horizon, and including, in
and businesses' inflation
my view, a decline towards 2% of households' expectations.
Before concluding, however, we need to shed more light on two key elements of this
and economic agents' expectations.
economic narrative: underlying inflation
The different measures of underlying inflation
The aim of underlying inflation measures is to better estimate the change in the
persistent component of inflation, which corresponds to "trend" inflation.
measure of this is "core" inflation" (in other words excluding energy and
The standard
food which are the two most volatile components). Core inflation is estimated to have
stabilised in January, albeit tentatively, at the elevated rate of 5.2% year-on-year,
according to the Eurostat Flash estimate.
other indexes
There are "exclusion-based" that better strip out the effects of transient
shocks to items other than food and energy. These indexes are less volatile than the
"core" HICP
measure and can thus provide a better reflection of the fundamental
trends in inflation.12 However, in the current phase, these indicators are not best suited
for identifying real time shifts in the persistent component of inflation.
Compared with these exclusion-based indicators, the Persistent and Common
Component of Inflation (PCCI)13 constructed by the ECB has the merit of including the
impact of medium-term shocks to energy and food, to the extent that they have
common effects. By construction,14 the PCCI can also potentially provide earlier
signals of turning points in underlying inflation. For example, the PCCI was the first
indicator to signal the rise in inflationary pressures in 2021. Similarly, it reached a
turning point in mid-2022, when the other indicators were still rising. That said, the
PCCI is based on a complex statistical methodology and the signal provided by its
recent changes remains to be confirmed.
indicators that focus on "momentum" and on quarterly rather
Along the same lines,
than annual changes can provide useful additional information in the current phase.
At this stage, there are no clear and convergent signs in all of these indicators that
would allow us to assert that underlying inflation has indeed reached a turning point.
Lastly, we are closely monitoring the changes in wages, which are notably crucial for
services inflation. Nominal wage growth is still accelerating across the euro area,
although has so far remained below price growth; however, this is not leading to a
wage-price spiral beyond what is included in our projections.
The inflation expectations of households and businesses
As I mentioned in the first part of my speech, market expectations have clearly
improved, admittedly against a backdrop of falling energy prices. However, the
inflation expectations of economic agents (households and businesses), particularly
over the medium term, are also essential as they are the ones that determine the path
of prices and wages. These expectations, which traditionally change more slowly than
those of the markets, are giving more mixed signals.
The inflation expectations of euro area households rose at the start of 2022; they
have since stabilised but have not fallen to any significant extent: in December, the
ahead expectation was 3% according to the ECB's CES15
median three-year survey.
that households' responses on future price changes continue
The survey also shows
to be more widely dispersed.
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Regarding businesses' inflation expectations, the Banque de France after Banca
d'Italia -
is a pioneer in this field, having launched its own dedicated survey two years
ago. As in the case of households, this survey shows a rise in the median three to
five-year ahead expectation, which reached 3% by mid-2022 and has merely
stabilised since then.
of households' and businesses'
We have thus avoided a significant "unanchoring"
ensure they become lastingly
medium-term expectations; but we still need to "re-
anchored" towards the 2% target.
Conclusion
Today I have given no dates or figures: doing so would be meaningless and would
equate to coming back to unconditional and excessively binding guidance. But I think
it is useful and feasible to offer an economic narrative that is based on data and "state-
dependent". This is part of the "new predictability" that I would like to see. You can be
sure of our unwavering determination in bringing inflation back towards the target of
2% over the next two years. Our actions will be transmitted via two efficient channels:
that of expectations and that of financing conditions. And on these channels, our
interest rate trajectory could, in my view, go through two navigation locks: for a
stabilisation of interest rates, that of a clear turnaround in underlying inflation; and then
for a possible lowering of rates, that of a clear prospect of a durable return to the
inflation target.
"Don't talk unless you can improve the silence".
Jorge Luis Borges wisely wrote:
Forgive me for not following his advice, but I hope I have at least reduced the
sometimes confusing noise that surrounds our monetary policy. And thank you for
listening.