Central Banks' Exit from the Garden
of Eden

Published on 28 June 2024

Global Interdependence Center Paris - 28 June 2024
Speech by Francois Villeroy de Galhau, Governor of the Banque de
France

Ladies and Gentlemen,

Welcome to Paris for the latest edition of the GIC conference. For many
of the past forty years central banks have lived in a sort of economic
Garden of Eden: an apparently peaceful life with easy choices. I will first
describe this paradise of stable inflation (I). I will then describe the
shocks that have ruptured this tranquility - the Great Volatility -
presaging a world of heightened uncertainty: the Exit of the title (II). I will
then outline strategies to respond to this more challenging world,
emphasizing the importance of our independence and price stability
mandate (Ill).

I. A world of stable inflation and the
rise of central bank credibility

The Great Moderation from the mid-1980s to the Global Financial Crisis
(GFC) was a period of moderate inflation and steady growth in output,

employment and living standards. This macroeconomic stability, after
the turmoil of the 1970s, created great confidence on the part of
researchers and policymakers in our capacity to smooth the business
cycle, although there was a lively debate about whether this long period
was due to 'good luck' or 'good policies'. Indeed, economic supply was
augmented by the integration of Central and Eastern European
economies and the further acceleration of globalization when China
started to fully open up in the early 2000s. Moreover, political risks were
generally low and technological innovation vibrant.

This period was interrupted by the GFC in 2008 and the European Debt
Crisis of 2010-2012. But central banks understood the nature of the
shock relatively quickly and responded decisively with new tools
targeting the provision of liquidity that prevented crisis-amplifying asset
fire sales. What followed was a period of lowflation from 2012 to 2020
associated with very low global real interest rates. Falling r* reflected a
global savings glut due to increased pension savings, trade imbalances
and a motive for emerging market economies to self-insure.

Certainly, there was an element of "good luck" in a sense that shocks
that hit the economies before the pandemic were relatively well
understood.' Also, most shocks have been on the demand side, which
makes policy less contentious due to a 'divine coincidence' between
stabilizing output and inflation. However, over the whole period,
policymakers reacted with "good stabilization policies" in real time. This
good policy was no coincidence but reflected a payoff from investment
in institutional credibility. With the disinflationary process that started in
the mid-1980s and transitioned over to the Great Moderation, central
banks gained the independence necessary to make the tough decisions
and act symmetrically. They were given clear price stability mandates
(which in practice became inflation targeting frameworks with a
gradual convergence towards the 2% target common amongst major
central banks). Importantly also, they vastly improved their
communication, transparency and accountability to steer expectations
about future policy. These three improvements were self-reinforcing
because enhanced credibility enabled central banks to stabilise inflation
with relatively modest adjustments in policy, which in turn helped anchor
expectations and improve credibility.

ll. The current period of « Great
Volatility »

This relatively favorable environment for central bankers came to a
sudden end with the Covid pandemic over 2020-22, which from an
economic point of view was a sequence of unexpected demand and
supply shocks, which considerably reinforced disinflationary dynamics.
Yet, while the world was exiting from the pandemic, supply chain
disruptions arising from bottlenecks in transportation services or the
availability of highly specific intermediate goods operated like cost-push
shocks for non-energy industrial goods.

A SEQUENCE OF SUPPLY CHAIN DISRUPTIONS

FIGURE 1: PRICE OF SEA FREIGHT (LEVEL)

- Baltic Dry Index

4000 - China Containerized Freight Index 4000

~--Harpex Index

Source: Refinitiv, Datastream. F BANQUE DE FRANCE
Note: Last observation May 2024.

A sequence of supply chain disruptions

The resulting supply-side constraints occurred during a time when
contact-intense services consumption was constrained, encouraging a
shift towards durable goods, a sector already under strain. Following the
re-opening, the sudden rise in energy prices following Russia's invasion
of Ukraine drastically accelerated inflation, particularly in the euro area,
creating the very real danger of a regime with entrenched high inflation.

A REVERSAL OF ENERGY PRICE SHOCKS

FIGURE 2: BRENT PRICE AND EURO AREA INFLATION (HICP)

--Brent $/BBI (LHS)
20 --Inflation EA, p.p (RHS)

0K ooo rt S-2%
o ort at et Ht NNN NOM M OM tT
SS<segssegesgegggegeegeaRa
oovuUcpwmwUC CUCOUCOCUCOCUCcCOCUCBOClCUcCOCUCOUCOUlUCUCOCUCOlUCS
Fy F ggg gsg eg sg gg 8
age. eases eesseé&es#y ss
®o 2 &§ 5 ¢ &©@ S&S 5 FOS ZS FEHB SE
$a ss & 6 Ss BK AS 3B 46S

Source: Eurostat, Refinitiv Datastream, Banque de France calculations.
Note: Oil prices in USD/b, HICP inflation eurozone year-on-year. Last point 05/2024.
2 BANQUE DE FRANCE

eunosystit

A reversal of energy price shocks

Tight labour markets amplified inflationary pressure, a problem
exacerbated by very loose fiscal policy (particularly in the US).

LABOUR MARKET TIGHTNESS IS STARTING TO EASE FROM HIGH LEVELS

FIGURE 3: VACANCY RATE AND LABOR SHORTAGES

4 40
--Vacancy rate (Euro area)
3.5 --- Vacancy rate (France) " 35
, - Labour shortages: Industry (RHS) op
ig) .4I ae Labour shortages: Construction (RHS) 30
-- Labour shortages: Services (RHS)
2,5 25
2 20
1;5 15
1 10
0,5 5

0
SOE RE MEM EME MERE MEM EM EME MEME MEM EME Mees
SSSGGGGSEGSGSG5GGGS5GS5G5G5GGG5G5G5G55555
SERRASSSHASSHHAAHATITHSSSRNRASKSHSS HA AADDT
SSSSSSSSoS Ha Aae Saree oer rs ace RSNANNRARRAS
SSSSSSSSSSSSSSSSSSSSSSSSSSSSONSNSSSSSS
RRRRRRRRRRRRRRRRARRRRRRRRRRRARRRRRRRRAH

Source: Eurostat, European Commission.

Note: Fraction of firms reporting labour shortages constraining production, EC survey. Last observation 2024q2. mod Guna
a

Labour market tightness is starting to ease from high levels

The real question at this point is whether this presages a new regime
with a permanent increase in economic volatility or will it eventually
revert back to a more moderate environment? Like most "two-handed"
economists my answer is "both are partly right".

The fall in inflation and the success(es) of monetary policy

The good news and what supports the argument that the "Great
Volatility" may be temporary is that inflation has come down relatively
quickly in the euro area, as well as in the US, partly due to a reversal of
energy and food prices and partly due to our determined monetary
policy response. After the peak of headline inflation in October 2022 at
10.6%, inflation rates halved to 5.3% by September 2023, when the ECB
policy rates reached their peak, and has halved again to 2.6% in May. In
retrospect, the underlying shocks were transitory but monetary policy
played its role by preventing a lasting propagation to core inflation.

This successful disinflation reflected two key channels: the "traditional"
channel whereby higher real interest rates dampen credit and demand
(estimated to have contributed up to 2pp less inflation in 2024); and the
newer expectations channel, whereby inflation shocks die out because
of anchored inflation expectations.

ANCHORED INFLATION EXPECTATIONS OF MARKETS AND FIRMS

FIGURE 5: LONG-TERM MARKET INFLATION EXPECTATIONS. FIGURE 6: FIRMS' EXPECTATIONS OF THE ANNUAL INFLATION RATE

IN THE EURO ZONE (ILS EA) (FRANCE, IN PERCENTAGE)
S , First rate hike 3,2 : First rate hike
-ILS 2Y/2Y EA i July 2022 H July 2022

-ILS 5Y/5Y EA y 3

2,2 H inflation expectation,

3Y-5Y (median)
2
SS IH FP eS HP SO S
LM DM DM YM PP PR PR
0 ere PH HH PP

Jan-18 Jan-19 Jan-20 Jan-21 Jan-22 Jan-23 Jan-24

Source: Quarterly survey of inflation expectations, Banque de France. Last

Source: ILS in the eurozone refer to the Harmonised Index of Consumer Prices point: Q2 2024.

'excluding tobacco (HICPxT). 5-day moving average. Last point: 06/19/2024.
ing ( T). S-day 9 96 poi BANQUE DE FRANCE

Anchored inflation expectations of markets and firms

The power of this second channel can be traced directly to the virtuous
cycle of credibility I mentioned above.

Is the "Great Volatility" here to stay?

Unfortunately, there are also reasons to fear that the period of high
inflation volatility may endure. Some macro trends could make inflation

more erratic and less predictable. Let me elaborate:

Supply-side factors are turning less favorable. Here I list just a few:
Fertility rates in most European countries are trending down, reducing
the potential labor force; policies favoring carbon-free sources of energy,
while warranted, could weigh on the supply-side during the transition
period; and global trade fragmentation is becoming more likely and
supply chains more fragile, in the context of weaker multilateral
institutions. Commentators locate peak-globalization at the end of the
first decade of this millennium. I Much faith is placed on Al to improve
productivity but the impact on inflation is unclear.

At the same time, exogenous shocks may become more frequent and
larger in magnitude: Climate change is creating more frequent extreme-
weather events, as witnessed by the devastating flooding in southern
Germany and northern Italy earlier this month. Geopolitical rivalry and
political uncertainties are likely to intensify.

lll. Policy strategies to tackle periods
of high volatility

What adjustments are needed for a new inflation regime with higher
volatility?

The starting point: mapping potential supply shocks

In order to define a proper starting point for the policy process, we need
to foster our analytical capabilities to take these new risks on board in
a comprehensive and evidence-based policy process. One lesson
learned from the recent inflation surge is that not all supply shocks are
alike. Indeed one of the challenges is how to map the multitude of
potential shocks into an analytically manageable cartography. Let me
propose 4 dimensions along which we should parse any potential
shocks:

A CARTOGRAPHY OF SUPPLY SHOCKS: FOUR KEY DIMENSIONS

1. Centrality of the affected sectors:

stream/Substitute
'cons. goods »

5 s
m 2. Degree of price stickness: 7)
ail lexible 2.
5 fresh food » =
= =
2. 3. Source/Terms of trade: o
g m= > §
sed) sed)
-4
< 4. Ability to plan ahead: <
>redictable
'carbon tax »

A cartography of supply shocks: four key dimensions

a) Which part of the production network is directly affected? Shocks
affecting upstream sectors of complementary goods or services (or
difficult to substitute) have greater effects than downstream and
highly substitutable goods or services

b) The degree of price stickiness of the affected sector. Persistent
shocks to sectors that change prices infrequently will have more
durable costs than temporary shocks to sectors with highly flexible
prices in both directions.

c) Internal versus external shocks. Shocks to imported goods with
no domestic substitute have a stronger immediate impact, while
afterwards a terms of trade effect can partly mitigate the overall
inflationary pressures. Changes to internal relative prices (Such as a
carbon tax) redistribute purchasing power between domestic
consumers.

d) The predictability of the effects (a preannounced steadily rising
carbon tax will have more manageable effects than an unexpected
one-off jump).

Central banks will need to invest in more granular models to analyse
these shocks. In particular, the integration of climate-related (physical)
risks, despite in its infancy, should feed into our risk assessment for the
inflation outlook. Since all supply shocks are not alike, one approach is to
use scenarios to explore complex interactions or low-probability/high
impact events. These could be useful input to a risk-management

approach to policy setting. In times of high uncertainty, we will not
always be able to identify all shocks in real time so a risk-management
approach leans against the most costly outcomes.

Two messages about the endpoint

About our endpoint, let me emphasise two key messages.

e First, whilst supply shocks can create complicated short term trade-
offs between output and inflation, they do not prevent us from
achieving our inflation target, which creates the most favorable
conditions for sustainable growth in the long run.

e Second, commitment on our inflation target is an efficient strategy
in boosting the expectation channel of monetary policy. " In this
regard, the symmetric target of 2% over the medium-term we
defined in 2021 has served us well over recent years. We should thus
refrain from changing this 2% level, but its adequate flexibility will be
part of our strategy review next year. A 2% symmetric medium-term
target does not mean strictly 2.0% at all times; some margin of
adjustment jn time is probably preferable to one in space. Our
medium-term horizon gives us sufficient flexibility to smooth the
adjustment to shocks, whereas a band could weaken the anchoring
of inflation expectations and may potentially be misunderstood as
policy inaction zone. 'Y

Let me switch from these longer term challenges to say one remark on
our current policy.

Our pragmatic gradualism is consistent with a gradually higher weight
given to the projected outlook - and giving gradually lower weight to the
inflow of data. This reflects time-varying uncertainty and risks. Data are
inherently noisy and there is a risk of overreacting to volatile news,
especially until the end of this year: so "data-driven" in the current
inflation environment does not mean "flash-driven". That said, French
inflation in June published this morning at 2.5% after 2.6% in May, is
encouraging news: disinflation is on track. As data surprises are now
smaller and revisions to the current assessment more minor compared to
two years ago, we are gaining more confidence in the forecast and more
scope to disregard smaller bumps in the disinflation process.

Let me conclude with a metaphor. The car racing at Le Mans this year
was particularly challenging in treacherous weather conditions and 10
cars abandoned because of mechanical failures. This underscores that
the more uncertain the journey, the more reliable the vehicle you need.
This equally applies to monetary policy and central banks: in uncertain
times, we need a reliable vehicle. We have solidity from our two pillars of
independence and our price stability mandates. Be assured that, through
the present uncertainties, the credibility of the Banque de France and
the ECB, and the trust they inspire, will be firmly anchored on these two
pillars.

iGarnier, O. (2023) « De la grande modération a la grande volatilité de
l'inflation ».

iNussbaum (2010) Peak globalization.

tliVilleroy de Galhau, Anatomy of a fall in inflation: from a successful first

phase to the conditions for a controlled landing, speech at Paris-Dauphine
University, 28 March 2024.

ivLe Bihan, Marx, Matheron (2021) Inflation tolerance ranges in the New
Keynesian model, and Grosse-Steffen (2021) Anchoring of inflation
expectations: Do inflation target formulations matter?

Updated on 3 July 2024