Jackson Hole Economic Symposium, 27 August 2022
Monetary Policy Post-Pandemic: Balancing between Science and Art,
Predictability and Reactivity
Speech by François Villeroy de Galhau,
Governor of the Banque de France
Ladies and Gentlemen,
This is the first time I have been able to attend the Jackson Hole symposium,
but this renowned event epitomizes something I have always found of great
value in the daily practice of central banking: the continuing conversation
between policy makers and economic researchers. In this respect, the central
banking world is a remarkable exception relative to most public policy making.
This unique culture brings with it the recurring debate of how much of monetary
policy amounts to science or art. This is especially the case at the end of a very
uncertain summer: for Europe at least, growth prospects for next year have
receded, and inflation prospects increased, due to energy and gas price
pressures and additionally to the evolution of the exchange rate. Today I would
like to briefly look back at how useful science has been in the past (I). I will then
offer suggestions on how to balance art and science in the current policy
environment: in finding a "new predictability" despite the weakening of forward
guidance (II), and in facing the unprecedented challenge of the positive
remuneration of massive excess liquidity (III).
I. Science did well both before and during the pandemic
The view that monetary policy consists of science was perhaps most prominent
during the Great Moderation.
But what about the Great Financial Crisis, the Pandemic and the Russian war?
If, as Olivier Blanchard said in 2006, "monetary policy must be closer to art when
it is frequently confronted to new, poorly anticipated and poorly understood,
contingencies", the economic shocks of the past 15 years must surely have
shifted the pendulum back to art.i
I would actually argue that, even then, science served us well. Let me here cite
Olivier Garnier, chief economist of Banque de France.ii I believe we central
bankers can be proud of the joint achievements of policy and research in dealing
with the Global Financial Crisis and its aftermath: acknowledging common
mistakes in forecasts on the current level of inflation doesn't imply becoming
self-critical on policies. In the euro area, thanks to our "new conventional" tools,
inflation is estimated in 2019 to have been around 75 basis points higher, and
GDP growth 110 basis points higher than it would have been in the
counterfactual.iii Furthermore, nobody can seriously pretend that past
accommodative policy is the primary factor to blame for the current return of
inflation. This would be forgetting how deep the deflation risk was in 2020 and
the pandemic, and being mistaken about the present inflation surge: it finds its
origins not in excessive liquidity but in supply bottlenecks arising from the faster-
than-expected rebound from the pandemic, and the sharp increase in energy
and food prices, much aggravated by the war in Ukraine.
The core principles of the science's consensus remain valid today.
In particular the two first principles-central bank independence and the primacy
of price stability-remain essential for the credibility of the central bank. We are
benefiting from it today through the-so far-relatively firm anchoring of long-
term inflation expectations despite the surge in current inflation.
This being said, we should acknowledge that new questions have arisen with
the unexpected return of high inflation. Let me highlight three.
A first question is the slope of the Phillips curve. To the enduring debate of
whether it had flattened since the 1970s we must now add the question of
whether it could be steepening again in the current inflationary environment. The
question is central to assess how to quell inflation without engineering a harder
than necessary landing of economic activity.
Second, we still have to understand better how inflation expectations influence
actual inflation. In recent years, we have made considerable progress -including
at the Banque de France-in measuring the expectations of firms and
households, which are the ones that matter for price-setting and spending
decisions.iv But there is still relatively little empirical work on how their inflation
expectations map into their actual pricing and spending decisions.v What the
extent of pass-through from inflation expectations to inflation is, or whether past
inflation plays a role beyond inflation expectations remain open questions.vi
Third, what about forward guidance? It was a decisive input of science, thanks
to Eggertsson and Woodford. But at present, in a very uncertain situation, we
all tend to move away from it, and even to distrust it because it would tie our
hands. Does it mean that we also abandon predictability? I will here come to my
second part, and focus the art/science nexus on the reactivity/predictability
trade-off, if you allow me to assimilate the former to intuition and art, and the
latter to rationality and science.
II. Four possible lights for a new predictability
Should art now play a bigger role? At a minimum we should acknowledge the
need for modesty, agility and nimbleness. But this is not an argument for
returning to the secrecy and unpredictability that characterized central banking
until the 1990s. There is no room for what Karl Brunner ironically described forty
years ago as "thriving on a pervasive impression that Central Banking is an
esoteric art, [whose] esoteric nature is revealed by an inherent impossibility to
articulate its insights in explicit and intelligible words and sentences."vii Instead,
we should aim to build a "new predictability", a different one suited for uncertain
times. Let me propose, with humility, four possible lights in approaching it.
II.A. Forward guidance on the path is today less important than
commitment on our end objective
First, in the current normalization phase, there is much less need and space for
detailed forward guidance: we are no longer at the effective lower bound and
are coming back to our more normal reaction function-all the more so in the
current uncertain environment. Accordingly, in our ECB July statement
President Christine Lagarde emphasized optionality dependent on economic
data, and taking decisions on a meeting-by-meeting basis. More importantly still,
we strongly reiterated our commitment to our end objective of bringing inflation
back to 2% in the medium-term, i.e. 2024 in our present forecasts. The more
open we are about the path, the more committed we must be about the
destination of the journey.
Don't get me wrong: market expectations of future policy rates remain a key
driver of long-term interest rates, which are what matters most for investment
and spending decisions. But forward-guidance-at least in the form of a
commitment to an unconditional and/or prolonged path for the policy rate-is
today an unadvisable way of steering market expectations. If you go to the
hospital, it is certainly unpleasant not knowing how long you will stay there. But
you certainly do not want a doctor who decides to keep you 7 days regardless
of how your health evolves. Without question, you would rather have a firm
commitment that he will cure you of your ailment!
II.B. Being gradual is less important than being orderly
As William Brainard famously argued more than 50 years ago, gradualism is
appropriate in a situation where we face large uncertainty.viii However, the
Brainard principle was formulated before monetary economics understood the
importance of inflation expectations. Research at Banque de France shows that
a central bank facing instrument uncertainty is bound to be overly cautious if it
fails to appreciate that being gradual runs the risk of moving inflation
expectations adversely.ix We can be gradual, but we should not be slow and
delay normalization until higher inflation expectations force us into aggressive
interest-rate hikes.
What remains essential however is to be orderly, in order to avoid undue market
volatility and ultimately economic volatility. Like a gradual normalization, an
orderly one has a time dimension, as we should avoid putting risks on financial
stability through unnecessarily brutal interest rate changes.x But it also has a
cross-country dimension, as it also implies avoiding within the euro area
unwarranted country-specific spikes in borrowing costs that only emerge from
the echo chamber of financial markets. In this respect, our new Transmission
Protection Instrument (TPI) is a very powerful tool for an orderly path forward.
II.C. How to deal with surprises: a reaction function
So far, so good about being orderly or predictable... but uncertainty means
surprises, and we have had to deal with many bad ones on inflation figures. In
such cases, we could not avoid reacting by surprising markets rather than being
behind the curve. This is what a sound risk-management approach calls for:
weighting seriously the long-term risks to price stability in the case of persistently
higher inflation.xi We rightly had to give priority to risk management on inflation,
over expectations management on interest rates.
It is paramount, nevertheless, that financial markets and economic actors
understand our reaction function in order to avoid unwarranted volatility: if
inflation-and especially core inflation-is higher than what we expected, we
are likely to raise rates more quickly, although never following a mechanical rule.
And we should preserve some short-term signaling-or guidance-in our new
"meeting-by- meeting" approach: this is somewhat new territory for us, where as
much as possible (i) guidance if any should come from explicit statements from
the top rather than from unsourced leaks, (ii) multiple and somewhat disorderly
expressions of personal wishes should be more restrained, and the silent period
should obviously be respected.
II.D. R* remains useful to delineate normalization and tightening
To be sure, R* is unobservable and its estimation remains surrounded by
uncertainty. But I believe it remains a helpful concept in the current
normalization.
According to me, for the euro area, until we are around R*, the neutral rate-
which possibly lies between 1 and 2% in nominal terms-the road ahead is clear
and we can go in a sustained and determined way, including through some
guidance. Doing so is normalization, lifting our foot from the accelerator pedal.
In my view, we could be there before the end of the year, after another significant
step in September. Only beyond R* could tightening-actively pushing the
brakes-begin; we will then have to discuss and decide, based on our
assessment of actual inflation and the future outlook, focusing in particular on
its core part and on wage developments. The US is obviously closer to
tightening due to several differences in the nature of inflation there. But have no
doubt that we at the ECB would if needed raise rates further beyond
normalization: bringing inflation back to 2 % is our responsibility; our will and our
capacity to deliver on our mandate are unconditional.
III. How to remunerate massive excess liquidity when it coexists with
positive rates?
Let me come to another issue that we practitioners must now confront: how to
remunerate massive excess liquidity when it coexists with positive interest
rates? This will be a new situation for most of us, and especially for the euro
area. While excess liquidity was negligible until 2008, it currently stands at more
than €4 trillion, as a legacy of our APP and PEPP assets purchase programs,
but also, for one third, our TLTROs.
Yet, our reserve remuneration system was designed at a time of negligible
excess liquidity. The system already showed its limits in the past, when having
to coexist with negative interest rates. Left unchanged-without our tiering
system-it would have severely impaired the bank channel in the transmission
of our monetary policy. The return of policy rates to positive territory would this
time provide a sizeable risk free income to the banking system, and a similar
loss for the Eurosystem. The possible losses for central banks and the
Eurosystem may draw public attention, but the primary objective of monetary
policy is price stability, not central bank profitability; and the more relevant issue
in this regard, rather than our profit and loss statement, is the financial solidity
of central banks' balance sheets through their levels of capitalized reserves.
The effect on banks' net interest income nevertheless, if opposite in sign to the
one under negative rates, could also distort the transmission of our monetary
policy. Just as we did with the tiering scheme, we have to think about a reserve
remuneration system adapted to this new context, as the ECB announced it in
our July decisions. We will conduct this assessment in a swift and pragmatic
way, looking at various options having existed across history and across
jurisdictions.
**
The high uncertainty in which we must at present navigate the normalization of
monetary policy means that we will have to artfully deal with the unexpected.
Perhaps however, accepting this uncertainty is, if not what science is typically
associated with, at least what rationality commands. Voltaire said, "uncertainty
is not a pleasant condition, but certainty is absurd".xii Two hundred years later,
Bertrand Russell wrote that "not to be absolutely certain [is] one of the essential
things in rationality".xiii I am glad we still need science, including on the new
challenges I stressed, to reconcile uncertainty and rationality.
i
Blanchard (2006).
ii
Garnier (2022), Presidential Lecture at the French Economic Association.
iii
Rostagno et al. (2021).
iv
See Savignac, Gautier, Gorodnichenko and Coibion (2021) for first results on a new survey
conducted by the Banque de France on expectations of French firms.
v
See Coibion Gorodnichenko Kumar (2018), Coibion Gorodnichenko Ropele (2020), and Rosolia
(2021) for the few papers that seek to empirically assess the effect of inflation expectations on
pricesetting.
vi
See Werning (2022) for recent advances on these questions from a theoretical perspective.
vii
Brunner (1981).
viii
Brainard (1967).
ix
Dupraz Guilloux-Nefussi Penalver (2020).
x
See Cukierman (1991) and Stein and Sunderam (2018).
xi
See Weidmann (2022), Jacobsson Lecture, for a recent articulation of this idea.
xii
In a letter to Frederick II, King of Prussia, on April 6, 1767.
xiii
Russell (1947).