Christine Lagarde: Policymaking in a new risk environment
Speech by Ms Christine Lagarde, President of the European Central Bank, at the 30th
Dubrovnik Economic Conference, Dubrovnik , 14 June 2024.
* * *
It is a pleasure to be here in Dubrovnik.
To this day, the stunning beauty of this city evokes the words of one of its most famous
poets, Ivan Gunduli: "O lijepa, o draga, o slatka slobodo".1
These words may be centuries old, but they remain as fresh as ever for those who have
the good fortune to experience Dubrovnik first-hand.
The programme for the 30th Dubrovnik Economic Conference offers a snapshot of
policymaking in a world of transition. And this world of transition is, increasingly, a world
of profound uncertainty for economic policymakers.
If you look back at the speeches of former central bankers - as I'm sure many of you
enjoy doing - policymakers in every era claim that the world has never been more
uncertain.
And indeed the world is not necessarily more tumultuous than in the past, but the
nature of the risks we are facing is unusual.
Increasingly, volatility in growth and inflation will not only be driven by the business
cycle, which we understand relatively well, or even by the financial cycle, which we
understand less well but can at least try to pre-empt.
It will also be driven by a pair of major structural forces that we have next to no
experience of: geopolitical fragmentation and climate change.
The fragmenting of a previously highly globalised world is a type of risk that advanced
economies have not faced since the period after the First World War. And a rapidly
changing climate is a risk that we have not seen for millennia.
The unusual risk environment
Three factors make these risks special for policymakers.
First, they are particularly difficult to quantify and forecast.
We saw this in Europe after the Russian invasion of Ukraine, but more generally
geopolitical risks create various types of spillovers that are hard to map out ex ante.
That said, there are some recent studies that try to quantify the impact of conflicts. One
study, for example, estimates that for countries that are geographically close to a war
zone, output falls by more than 10% over five years and inflation rises by 5 percentage
points on average. Another finds that firms with greater exposure to geopolitical risk
experience an increased probability of default, lower market valuations and higher
financing costs.3
Climate change is similarly hard to forecast, as is visible for example in the struggles
the insurance industry is facing to accurately price climate risks.
An increasing frequency of extreme weather events means that claims costs no longer
correspond to the historical data used to price risk. Last year set a record for the
highest number of insured natural catastrophes yet.4
And climate change increases uncertainty about inflation, too: ECB research finds that
extreme summer heat could ultimately push up food inflation in the euro area by
between one and two percentage points.5
The second factor that makes these risks special is that they reinforce each other.
A weakening multilateral order not only makes it more difficult to agree on collective
climate action, but it also increasingly threatens to disrupt the flow of clean technology
that is necessary to lower the cost and accelerate the speed of the green transition
globally.
With China now becoming the dominant supplier of solar panels, battery cells and
electric vehicles, we are seeing an increasing trade-off between faster decarbonisation
and greater economic security as countries seek to reduce their dependencies.
In turn, unmitigated climate change could strengthen fragmentary forces. For instance,
an uneven distribution of extreme weather events may induce disorderly migration
flows, straining international relations and encouraging policymakers to establish more
barriers.
One recent paper estimates that a changing climate could impel significant numbers of
working-age people to migrate over the course of this century.6
The third factor is that both risks are characterised by potential "tipping points" - that is,
non-linearities - beyond which it would be very difficult to turn back.
If the multilateral order were to break down, history suggests that the opportunity to
rebuild it again may be a long time coming. Indeed, every major overhaul of the
international order, be it the Congress of Vienna in the nineteenth century or the Bretton
Woods Conference in the twentieth, was typically preceded and enabled by a major war.
And were global heating to reach a certain level, we may see irreversible
transformations. For example, as warmer weather causes permafrost in polar regions to
thaw, stored methane is released into the atmosphere. This causes further heating, and
a self-reinforcing feedback loop emerges.
Policymaking in an uncertain world
So what can we do to make our policies robust in this environment?
Certainly, the best-case scenario would be for countries to "carve out" areas that will be
spared from geopolitical rivalry, such as working together towards net zero, and to find
ways to increase mutual economic security without fragmenting world trade.
But if we are realistic, we must admit that with each passing day this scenario looks less
likely. The World Bank finds that almost 3,000 trade restrictions were imposed last year
7 8
- five times the amount in 2015. And 2023 was the hottest year on record.
So policymakers need to be prepared for a "second-best" scenario in which these risks
do start to reinforce each other and tipping points draw closer. This scenario is likely to
create two tensions for central banks that we will need to address.
The first tension is between what we can observe and what we can project.
The last few years have shown that making policy based on projections alone is likely to
be misleading. For instance, there were certain periods when recent inflation was the
most informative signal about future inflation, and so the best policy was to overweigh
recent data relative to a necessarily uncertain forecast.
But as major shocks passed we saw forecasts becoming more accurate. In 2023, for
example, we saw a reduction of about 70% in the average absolute error in our staff
projections relative to 2022, one quarter ahead. Relying too much on current data in this
setting would have been equally misguided and led to policy falling behind the curve.
The challenge for policymakers is that it is not always easy to know in real-time which
regime you are in, especially around turning points. And we cannot be changing our
mind from one day to the next on what kinds of data are most important to us.
For inflation expectations to remain anchored in an environment of structural changes
and less quantifiable shocks, people need to be able to broadly predict our reaction
function and know what developments we will tolerate and what we will not.
That is why I have argued that, in the future, we will need to have ex ante policy
frameworks that combine both forward-looking and current-looking elements.
We need forecasts of the medium term, but we also need to be alert to the fact that
available models have been "educated" using data from previous structural regimes
that may no longer be valid. So, analysing current data and identifying persistent
components allows us to account for structural changes and forecast the future in a
more robust way.
This is essentially the approach the ECB has been using since March last year, when
we deployed a three-sided reaction function to make our decisions more robust: a
forward-looking component - our inflation projections - and two more current-looking
ones, the dynamics of underlying inflation and the strength of monetary policy
transmission.
We have also made more use of scenario analysis to help us understand the risks
around our projections if certain assumptions turn out differently.
This framework served us well in calibrating when to stop raising rates, how long to hold
them constant and, most recently, when to start cutting them. And for the time being,
we will continue to use it to set the rate path in an uncertain environment.
The second tension is between independence and interdependence.
Central banks make decisions independently, but those decisions are interdependent
with the actions of other authorities. When policies are well aligned, that
interdependence can lead to virtuous circles which help all authorities deliver on their
objectives.
For example, increasing government investment to reduce energy supply constraints
may make medium-term inflation lower and less volatile. That would, in turn, warrant
lower policy rates over time, encouraging more investment, and so on.
But faced with "existential" risks like geopolitical conflict and climate change, it is natural
for people to ask whether central banks can contribute more explicitly.
In my view, the answer to this question has two parts.
First, the evidence we have so far suggests that the new types of shocks we are facing
are likely to put upward pressure on prices, at least initially.
One recent study based on data since 1900 finds that geopolitical risks lead to high
9
inflation, lower economic activity and a fall in international trade. And climate change is
likely to initially appear as a negative supply shock - although over time investment in
renewables, grids and storage will lead to lower and more stable energy prices.
In this setting, it is important that we continue to focus on inflation and stabilise inflation
expectations at our target. We know that the public detests high inflation, and allowing it
to become embedded in the economy would disrupt our politics and undermine all other
geopolitical and climate goals.
However - and this is my second point - as a changing climate and geopolitical
fragmentation have implications for our mandate, there is scope for action within our
mandate. Let me give you a few examples.
The ECB now measures and monitors climate-related risks, and we have incorporated
climate change considerations into our collateral framework.
Currency swap lines are vital instruments in helping to reduce volatility, but they too
have a geopolitical impact as they can strengthen the dynamics of major international
currencies.10
And given the dominance of non-European digital payment firms, the launch of a digital
euro would protect the strategic autonomy of European payments and monetary
sovereignty, providing a fall-back solution if geopolitical tensions intensify.11
Conclusion
Let me conclude.
Policymakers today are grappling with new kinds of risks. While the best-case scenario
would be for policymakers to work together to prevent these risks from materialising, we
need to be prepared for a "second-best" world.
That will be a world marked by higher levels of uncertainty and volatility, and it will
create tensions for central banks that we will have to resolve.
But at the same time, I am reminded of the words of the Croatian poet Antun Branko
Šimi: "Man, be careful not to walk small under the stars." Policymakers are not
prisoners of fate, and there is scope for action.
We can find balanced ways to move forwards - ways that account for the new
environment, but that also allow us to continue delivering on our mandate.
1
From Ivan Gunduli's play "Dubravka". The phrase can be translated as "Oh beautiful,
oh dear, oh sweet freedom".
2
Federle, J. et al. (2024), " The Price of War ", Discussion Paper Series , No DP18834,
Centre for Economic Policy Research, 14 February.
3
D'Orazio, A., Ferriani, F. and Gazzani, A. (2024), "Geoeconomic fragmentation and
firms' financial performance ", VoxEU , 18 March.
4
Swiss Re Group (2024), "New record of 142 natural catastrophes accumulates to
USD 108 billion insured losses in 2023, finds Swiss Re Institute", press release, 26
March.
5
Kotz, M. et al. (2023), "The impact of global warming on inflation: averages,
Working Paper
seasonality and extremes ", Series, No 2821, ECB, Frankfurt am Main,
May.
6
Burzyski, M. et al. (2022), "Climate Change, Inequality, and Human Migration",
Journal of the European Economic Association , Vol. 20, Issue 3, June.
7
Kose, M.A. and Mulabdic, A. (2024), "Global trade has nearly flatlined. Populism is
taking a toll on growth ", World Bank Blogs, 22 February.
National Centers For Environmental Information (2024), "2023 was the warmest year
in the modern temperature record ", 17 January.
9
Caldara, D. et al. (2024), " Do Geopolitical Risks Raise or Lower Inflation? ", 22 April.
10
As I have argued in the past. See Lagarde, C. (2023), "Central banks in a
fragmenting world", speech at the Council on Foreign Relations' C. Peter McColough
Series on International Economics, 17 April.
11
The ECB
Lagarde, C. and Panetta, F. (2022), " Key objectives of the digital euro ",
Blog, 13 July.