aM.
BANQUE DE FRANCE
"a

EUROSYSTEME

Speech

Monetary policy

Monetary Policy in Perspective (Il):
Three landmarks for a future of
"Great Volatility"

Published on 30 October 2024

The London School of Economics - London, 30 October 2024

Ladies and Gentlemen,

I am delighted to be in London and I wish to warmly thank Professor lain
Begg for the invitation. The current decade has been remarkable for
central banks, characterized by an unprecedented and highly implausible
sequence of shocks: a deflationary one with Covid, followed by an
inflationary one with the unwarranted Russian invasion of Ukraine. In a
speech I gave last week in New York,! I looked back on the critical role
and success of credible monetary policies in the recent disinflation
episode. Today, I will look forward and discuss how central banks can
navigate this new environment of "Great volatility" that sharply contrasts
with the stability of the past "Great Moderation". Expect more supply
shocks, while analysing that not all of them are alike (I). Anchor even
more our inflation objective, with some adjustments (Il). And be ready to
support louder and clearer structural reforms (Ill).

I. Standing ready to face greater
volatility and supply shocks

Some argue that the next years will see more inflationary forces, with
deglobalisation, decarbonisation and demographics. Maybe... but for
sure the near future will be shaped by more uncertainty. Supply shocks
are likely to occur more frequently, as stressed by president Lagarde ina
widely noted speech in Jackson Hole last year". This will contribute to
greater volatility and less predictability in inflation. Political
fragmentation, beyond extreme events such as wars, is already inducing
a decoupling of trade!' along geopolitical blocs, particularly for energy
and selected high-tech products (mobile phones, laptops and computer
chips).

TRADE FRAGMENTATION

Chart 1: The Fragmentation of World Trade according to geopolitical blocs
(year-on-year trade growth rates)

Source: Carluccio, Gaulier, Smagghue and Stumpner (2024).

Purple line : between countries in the same bloc (relative to trade with neutral countries) pacdieuce

Blue line : between countries of opposing blocs (relative to trade with neutral countries)

Trade Fragmentation

With fewer and more specialized suppliers, supply chains turn less
flexible, which reduces their capacity to absorb shocks". Climate change
is already increasing physical risks with their associated supply
disruptions: the number of extreme floods, storms and climatological
events such as heatwaves or wildfires has more than doubled over the
past forty years'. The transition to an ecologically sustainable global
economy will also be bumpy as the adjustment costs are large and
unevenly spread. Yet, these are not the only challenges the world
economy is facing going forward. Demographic change is weighting on
labour supply and will affect migrations, as well as the composition of
peoples' consumption baskets. Technological shocks are also likely to be
more pervasive, starting with Al.

1. Not all supply shocks are alike

These multiple supply-side shocks will have different implications for
inflation. Adverse supply shocks, while usually contractionary, need not
be inflationary at all horizons. As a consequence, there is no 'one-size-
fits all' policy response. The starting point is a thorough analysis of the
anatomy of supply shocks, with a corresponding cartography". Five
key characteristics of the shock matter for monetary policy.

The first one is the degree of shock reversibility. This is why central
banks may want to "look through" supply shocks, since the inflationary
effect of a transitory shock might dissipate before monetary policy
reaches its full effect (after 18 to 24 months). Symmetrically, as central
banks can be uncertain about the transitory nature of supply shocks,
they may want to react early to avoid spillovers to core inflation.

A CARTOGRAPHY OF SUPPLY SHOCKS

1. Possibility of reversal:

sS= >
#9 22
= @ 2. o
5 S
© a)
x ~.

BANQUE DE FRANCE

A cartography of supply shocks - 1

The second characteristic is between the domestic or external origin of
the disruption. When the shock is imported from the rest of the world
(e.g. an oil-price shock for an importing country), the impact on
domestic inflation may be later mitigated by the negative impact of the
terms-of-trade shock on aggregate demand. The same shock can be an
external supply shock and an internal demand shock. Such mitigation of
inflation is absent if the shock is domestic (e.g. a drought leading to an
increase in local food prices).

A CARTOGRAPHY OF SUPPLY SHOCKS

1. Possibility of reversal:

= =r
=} = 2. Source/Terms of trade: =. (4)
oa o "
= @ nal = O
s shock in Europe » {e)
ey 5
x <

BANQUEDE FRANCE

A cartography of supply shocks - 2

I also have to mention that domestic or external disruptions can be
policy-induced.

Think about tariffs. Who bears the cost of higher tariffs depends on
which firms can pass the increase in costs to its buyers. The imposition
of US tariffs on Chinese imports is a case in point of a policy-induced
shock: its impact is almost fully passed through to importer prices in the
USvi_ and in that case a persistent price level shock.

The third characteristic is the centrality of the affected sectors.

A CARTOGRAPHY OF SUPPLY SHOCKS

1. Possibility of reversal:

;

Aseuoneyul

2. Source/Terms of trade:

nal
PR Scene:

3. Centrality of the affected sectors:

aJOW
sso7

Ayeuoneyul

stream

I

BANQUE DE FRANCE

A cartography of supply shocks - 3

It determines how far shocks can ripple through the supply chain. The
semiconductors shortage in 2021 is an example of an upstream shock
leading to significant production losses in the downstream production of

automobile around the globe.

The fourth factor to consider is the degree of price stickiness in the
affected industries.

A CARTOGRAPHY OF SUPPLY SHOCKS

1. Possibility of reversal:

2. Source/Terms of trade:

nal
hock in Europe »

3. Centrality of the affected sectors:

oJOW
sso7

Aseuoneyul
AseuoreIjul

4. Degree of price stickiness:

BANQUEDE FRANCE

A cartography of supply shocks - 4

Differences here interact with the sector centrality I just mentioned.
Recent energy price shocks originated in a sector with fairly flexible
prices. But energy is an upstream sector and shocks here are cost-push
shocks for downstream sectors with overall stickier prices, including
services. While inflation initially rises only in a limited way in sectors with
sticky prices, it persists for longer. ¥!

Finally, the fifth characteristic of supply shocks is their predictability.

A CARTOGRAPHY OF SUPPLY SHOCKS

1. Possibility of reversal:

2. Source/Terms of trade:

al
I

3. Centrality of the affected sectors:

sJOW
sso

Ayeuoneyul
Ayeuoneyul

4. Degree of price stickness:

5. Ability to plan ahead?:
ictable BANQUE DE FRANCE
on tax » ieee

A cartography of supply shocks - 5

Disruptions do not need to be sudden and unexpected, they can be
anticipated well-ahead. The more predictable a supply shock, the more
manageable it will be. For instance, a preannounced steadily rising
carbon tax will have more manageable effects than an unexpected one-
off jump.

Bottom line: there is no longer one textbook answer to supply shocks.
Central banks will have to analyse more granular data, and exert their
judgment. Most shocks to come could be expected to be external for the
euro area and on more flexible prices like commodities or critical raw
materials, and hence have less persistent inflationary effects if inflation
expectations are kept well anchored. But their centrality in the economy,
and their intricacy with more sticky services prices should keep central
banks in alert.

While climate-related and natural disasters are often unpredictable, risk
scenarios help us to identify the worst possible outcomes and mitigate
them (by reacting ahead of time). These could be useful input to a risk-
management approach to policy setting.

That said, expect all of us to live with increased uncertainty. Frank
Knight (1921) famously coined the difference between risks, which are
measurable and hence hedgeable, and uncertainty, with unknown
probabilities and outcome. Today's world is more and more "Knightean".
And uncertainty negatively impacts investment decisions as shown by
Bloom et al."', as well as household consumption: see the recent increase
in the savings rate in Europe, at least partially explained by a lowering
confidence. Central banks themselves won't fully escape this increased
uncertainty; but they must do their best, as "uncertainty absorbers", to
reduce it for economic agents: this brings me to our inflation objective.

ll. Anchoring while adjusting our
inflation objective

Responding to supply shocks poses a greater challenge for central
banks compared to the demand shocks faced in the 2010s. Unlike
demand shocks, supply shocks create a trade-off, as higher inflation is
accompanied by a negative hit on output. Moreover, monetary policy
primarily influences demand, has no direct effect on supply. A further
clarification is important: monetary policy does not target specific
sectors and relative prices, as price signals play a key role in the market
economy to enable an efficient allocation of resources. Nevertheless, we
must remain vigilant as households and firms are very sensitive to
specific prices in forming perceptions of inflation.

Do we then need to modify our price stability framework? Increased
volatility, even well managed, means that we could likely deviate from
our inflation target more frequently. Maintaining inflation precisely on
target 2,0 at all times is neither realistic, nor necessary. Instead, our
focus must remain forward-looking, as monetary policy affects the
economy with considerable lags.

1. Keeping the 2% target

Central banks have converged on a 2% target and there are good
reasons for it. It is low enough to make inflation barely noticeable when it
is at target. But it also provides a buffer to avoid deflation and a margin
on nominal interest rates to reduce the risk of hitting the effective lower
bound. The 2% target has proven effective in anchoring expectations, as
historical evidence demonstrates. It has now become a global standard
in advanced economies. Revisiting it is not on the table for our Strategy
Review next year, as the ECB President already made it clear. That said,
facing greater volatility, should central banks have more flexibility around
this inflation target?

2. Flexibility in space: 'control' bands?

Without changing the point target, some argue that we may want to
make it more flexible thanks to inflation bands. Facing greater
volatility, inflation bands could reduce the risk of fine tuning and
overreacting to small changes in inflation. Several advanced economies'
central banks today follow a target with an explicit tolerance band.
However, the explicit numerically defined band can play different roles.
Most of those central banks pursue a point target, with a tolerance band
that serves as a communication device: being off the target does not
immediately call for activism on the side of the central bank. The central
banks of the UK and Canada fall into this category. New Zealand, also,
added a focal point to the inflation target band in 2012.

EXAMPLES OF CENTRAL BANKS PRICE STABILITY DEFINITION

Numerical
target/definition

Bank of Canada 2% with a control Point with control 6-8 quarters, on average
range of 1-3% range
Bank of England 2% Point with triggers* Applies at all times; for

deviation or +/- 1%, the BoE
needs to indicate the horizon
of the return to target

Reserve Bank of New Zealand 1-3% with 2% Range with focal Medium-term

midpoint point

Reserve Bank of Australia Between 2 and Range « Appropriate timeframe »**
3%

Swiss National Bank 0-2%*** Range Medium-term, specified as

around 3 years

'Source: "The ECB's price stability framework: past experience, current and future challenges". Work stream on the price stability objective, Occasional Papers Series n* 269, September 2021. (*) If
moves away from the target by more than 1 percentage point in either direction, the Governor is required, to send an open letter to the Chancellor explaining why inflation has moved away BANQUEDE FRANCE

from target and what action the Bank is taking to bring inflation back to target". ("?) "The appropriate timeframe for this depends on economic circumstances" (**) ) "The Swiss National Bank

'equates price stability with 2 rise in the Swiss consumer price index (CPI) of less then 2% per annum, Deflation, e. a protracted decline in the price level, is also regarded as @ breach of the

objective of price stability."

Examples of centrale banks price stability definition

In contrast, some central banks like the Swiss National Bank target an
inflation band, for which they express to be indifferent, as long as
inflation materializes within that band or zone. There are however some
drawbacks of such target zones in my opinion. One consequence of the
implied nonlinearity of central bank policies in the presence of inflation
target zones could be higher output volatility, as central banks need to
take more forceful actions outside of a band.*" In practice, there is a risk
that explicit inflation tolerance bands, even if augmented with a focal
point and intended as a communication device only, can be
misunderstood as non-intervention zones, thereby undermining the
expectation channel of monetary policy.

3. Flexibility in time: medium-term orientation

An alternative and possibly preferable approach in my view is to maintain
our medium-term orientation around the symmetry of our objective. As
with tolerance bands, under a medium-term orientation a central bank
does not have to react to short-term point deviations, but rather respond
to inflation dynamics that risk pushing it off target. What matters is not
so much the /eve/ of deviation from target at one point in time, but the
trend and persistence of expected deviations, in other words, whether
this deviation is more likely to increase or to decrease. In concrete terms,
if inflation is above target, but converging at a sufficient pace, this may
not call for action. Nevertheless, a too vague medium-term objective
without a clear roadmap is a blurred signal that can ultimately undermine
credibility. Hence, the counterpart of such flexibility is that it implies a
clear communication about the horizon and the journey back to target.

Finally, the medium-term orientation provides some flexibility to deal
with supply shock trade-offs. In such situations, headline inflation may
not accurately foreshadow medium-term outcomes. Central banks can
then decide to put less weight on headline inflation data, and give more
weight to measures of underlying inflation. This has been the case since
2022 in the euro area, when underlying inflation became one of three
criteria of our reaction function. This issue is also covered in the chapter
2 of the latest WEO of the IMF, which shows in particular that, in the
recent period, policy rules targeting inflation in sectors with stickiest
prices would have delivered relatively faster disinflation®",

However, we should not abandon our reference to headline inflation in
the definition of our objective. This measure is well understood by the
general public and fits their inflation perception, and this is the inflation
that matters for expectations and second round effects.

lll. As structural policies play a larger
role facing supply shocks, how can
central banks help?

In an environment where supply matters more, structural policies also
matter more for price stability. To the extent that they raise the path of
potential growth, structural policies reduce the inflation rate for a given
growth rate of effective GDP. Furthermore, a more flexible economy will
reduce the reaction of prices to a given shock, because reallocations and
substitutions across sectors, technologies and geographies will be
faster. More than ever, monetary policies should not be "the only game in
town"; but they could even not be the "central game". As regularly
repeated - but not much noted? - in our Monetary Policy Statement,
"fiscal and structural policies should be aimed at making the economy

more productive, competitive and resilient'"".

Let me first emphasise the urgent need for action. Europe has a growth
and productivity problem. We had rather good news in the short term on
Q3 growth this morning, in the euro area (+0.4%), as well as in France
(+0.4%). But with a broader view, there is a widening gap in GDP growth
compared to the United States, with cumulated increase of GDP per
capita reaching 26% since 1999, compared with 39% in the US.

I
A WIDENING GDP GROWTH GAP WITH THE US

Chart 4: GDP growth per capita
(in %, average annual change (Ihs), cumulated change (rhs))

1999-2008 2009-2014 2015-2023 1999-2023

Eurozone mUnited States = UK

Sources : OECD.

BANQUE DE FRANCE

A widening GDP growth gap with the US

Given the tight fiscal space - at the end of the first quarter of 2024,
debt-to-GDP reached for example 111% in France -, fiscal policy should
be focused in many countries towards consolidation rather than
stimulus. We must escape the high debt / low growth trap.

Reassuringly, we have nevertheless two roadmaps with concrete
proposals to tackle these growth challenges, the Draghi report for
enhancing European competitiveness and the Letta report for
empowering the Single Market*'. They provide the structural reforms
agenda essential to foster innovation and productivity, while leveraging
the green and digital transitions. If we put aside the Eurobond part of the
Draghi report which could be disjoined, let me sum up this agenda with a
triple strengthening of the European economy: size, multiplied by
muscle, multiplied by speed.

I &
A TRIPLE STRENGTHENING FOR EUROPE

Size x Financial muscle x Speed

V Vv Y

Single Market Savings and Investments Union Innovation
intensification = Capital Market Union Simplification
+
Competition policy
at European Scale

+ Banking Union

BANQUE DE FRANCE

A triple strengthening for Europe

1. The supportive role of central banks

Central banks can help fiscal consolidation and structural reforms by
preserving stability in this volatile environment. Central banks can be the
anchors in the storm. By keeping long-term inflation expectations
anchored, they reduce long-term inflation risk premia, the cost of long-
term funding and ultimately improve macroeconomic stability.

2. Using our credibility, and inspiring good
governance practices?

Central bankers are naturally reluctant to address the structural
economic challenges and reforms, as these are often somewhat of
political nature; but the Bank of Spain by law or the Bank of Italy in
practice for instance often have to stress such topics. More generally,
central banks in Europe are more vocal there than say, the US Federal
Reserve. There are good economic reasons, as said, why central banks
have some legitimacy for providing help to governments in this field
while preserving their independence. Unfortunately, many of these
governments are at present politically weakened and face a difficult task,
under pressure of short-termism, conflicting objectives and national
biases. One key element of central banks' successes comparatively has
been credibility. This credibility on monetary policy was built through
decades of tenacious action and communication.

Using this credibility to soeak, beyond monetary policy, about structural
reforms and fiscal consolidation, is not without risks. We as Central
Banks should make clear that we are not the deciders there; that we
mention structural policies as far as these are relevant for price stability;
that our role is to bring independent data, expertise and explanation in
the public debate; that we accept our views to be discussed and even
contested. But in today's Europe and today's world, where non-monetary
action is both more necessary and more difficult than ever, this risk may
be worth taking for central banks. If we do not advocate the Draghi and
Letta reports, who will? Or if we do not defend open trade, with fair
rules, who will?

However, credibility did not come by chance: the architecture of the
ECB, as a central bank, was designed to counteract short-termism, and
to achieve the common goal of price stability. While our governance may
not be directly transferable to other institutions, I see three key
ingredients that can serve as an interesting example - and are by the
way also gathered for European successful competition policy: (i) clear
and precise objectives, the "mandate", conferred by democracy; (ii)
institutional independence with majority voting after an open and
confident discussion; (iii) full accountability on decisions and results. I
will sum up this way: if we were not efficient, we would not be fully
legitimate in being independent.

While this governance is obviously not universally applicable, and the
decision here belongs to political authorities, these could possibly
consider replicating it in some specific domains in Europe. As an
example, achieving the capital markets union, now adequately rebranded
as a broader "Savings and Investments Union", is vital for fostering
growth: as part of it, a unified and independent supervision of markets is
key. Regarding climate change, some have put forward innovative
reflections around a "central bank of carbon'*"!, which could steer the
climate agenda, with a clear mandate to reduce carbon emissions and
reach net neutrality in 2050.

Let me conclude with Bertrand Russell, the famous British philosopher
and mathematician who was awarded the Nobel Prize in Literature in
1950. He was also one of the founders of the London School of
Economics. In his History of Western philosophy, published in 1946, he
wrote: "To teach how to live without certainty, and yet without being
paralysed by hesitation, is perhaps the chief thing that philosophy, in our
age, can still do for those who study it." We, central bankers of the 21st
century, have started to learn how to manage uncertainty in an
unprecedented succession of shocks. We stand ready to adapt to this
new environment of Great Volatility and to act where needed, in order to
remain an anchor of stability. For our economies to show resilience,
structural policies have to follow suit: rest assured that we will do
everything in our remit to help Keep these fundamental issues front-
stage. Thank you for your attention.

Villeroy de Galhau (F.), A monetary policy perspective (I): three lessons
from the recent inflation surge, speech at New York University, 22
October 2024

iLagarde (C.), Policymaking in an age of shifts and breaks, speech at
Jackson Hole, 25 August 2023

iliMancini (M.) et al., Positioning in global value chains: A new dataset
available for global value chain analyses, VOXEU Column, 18 April 2024
iVMancini (M.) et al., ibid

"Drudi (F.) et al., Climate change and monetary policy in the euro area, ECB
Occasional Paper Series No 271, September 2021

vivilleroy de Galhau (F.), Central Banks' Exit from the Garden of Eden,
speech, 28 June 2024

viiCavallo (A.) et al., Tariff Pass-Through at the Border and at the Store:
Evidence from US Trade Policy, American Economic Review, Vol. 3, No. 1,
March 2021

viliafrouzi (H.) and Bhattarai (S.), Inflation and GDP dynamics in production
networks: A sufficient statistics approach, NBER Working Paper, February
2022 (updated in July 2024)

xDées (S.) et al., An analytical framework for assessing climate transition
risks: an application to France, Review of World Economics, 1-57, 17 July
2024

"Knight (F.), Risk, uncertainty and profit, published in 1921

xiBloom (N.), Bond (S.), Van Reenen (J.), "Uncertainty and Investment
Dynamics', The Review of Economic Studies, Vol. 74, Issue 2, April 2007
xli_Le Bihan (H.), Marx (M.) and Matheron (J.), /nflation tolerance ranges in
the New Keynesian Model, European Economic Review, Vol. 153, April
2023

xililnternational Monetary Fund, World Economic Outlook, Chapter 2,
October 2024

xivEuropean Central Bank, Combined monetary policy decisions and
statement, 17 October 2024

*VL_etta (E.), Much More than a Market - Speed, Security, Solidarity, report,
10 April 2024

xviDelpa (J.) and Gollier (C.), Pour une banque centrale du carbone (For a
central bank of carbon) (French only), October 2019

Download the full publication