Börsen-Zeitung : “US monetary policy should not affect our own monetary policy that much"

Francois Villeroy de Galhau photographie

François Villeroy de Galhau, Governor of the Banque de France

Published on 28 May 2024

François Villeroy de Galhau intervention

Interview of François Villeroy de Galhau, Governor of the Banque de France, 

Paris, 28 May 2024

Mr. Villeroy de Galhau, wage growth in the Eurozone is still relatively high. How important is the risk that high wage growth will keep inflation above 2% for longer than expected?

We clearly avoided a wage-price spiral in the euro zone. There is some catching up on real wages, which now increase. But during the first two years of the inflationary surge, real wages decreased significantly. The latest Q1 wage figures showed some temporary nominal acceleration, but originating from Germany and due mainly to one-off payments. In all other large European economies, nominal wages are decelerating. When looking at France, we expect annual increases of the average wage to be slightly above 3% in 2024-2026, compared to an inflation rate of 2.5% this year and less than 2% in the next years. These figures are not alarming. And prices are not only about wages, but also about productivity and profit margins. So we shouldn’t assess only one of those three elements:  in our future decisions, we should rather look directly at the outcome, especially services inflation. 

Another upside risk to inflation is the situation in the Middle East. How likely is an escalation that will drive energy prices significantly higher?

Obviously there are geopolitical risks. So far tensions in the Middle East did not affect the oil price that much: it’s still below its October 7 level. Let us nevertheless suppose there would be an oil price shock. There should be no automatic monetary policy reaction because we would have to look whether this shock is transmitted or not to underlying inflation, and to inflation expectations. If not, monetary policy should not react. We would anyway have the capacity to adapt the pace of our future rate cuts. Barring a surprise, the first rate cut in June is a done deal, but afterwards we have several degrees of freedom.

We discussed possible upside risks. What downside risks to inflation do you see?

One of the obvious risks is a subdued economic growth. In some regards monetary policy decisions in the Eurozone are currently easier than in the US because the business cycle is weaker. Beside the risk of easing prematurely and missing our inflation target “from above”, the risk of cutting too late and missing the target “from below” is now at least as significant: Europeans would then pay a too high price in terms of economic activity and employment. 

It seems likely that you and your fellow council members will decide to cut interest rates in June. This could be the start of a decoupling of ECB and Fed monetary policy. How would this affect the Eurozone?

What the Fed presently communicates is that the probability of a rate hike remains remote. Hence if a decoupling happened, it would not last forever. It could have two consequences. First, although this delay is already discounted by markets, there might be some pressures on the foreign exchange rate. But one of the big advantages of the euro area is to have a large economy: the single market has the same size as the US market, and is hence less influenced by the exchange rate. Its pass-through on consumer prices is less than 10%. If the dollar strengthens about 1% against the euro, it increases the euro area price index by less than 0.1%. According to a study of the Banque de France the pass-through could even be smaller, around 0.05 pp.

And the second consequence?

Long-term interest rates could remain higher in the US. Here the spillover effects to financial markets would be more significant, with a tightening of financial conditions spreading to the euro area. So the exchange rate channel could be inflationary and the long-term interest rate channel disinflationary for Europe. I draw two conclusions from that. US monetary policy should not affect our own monetary policy that much. And US fiscal policy is the elephant in the room: it is not in the hands of the Fed, and could significantly affect the level of long-term interest rates. A large US fiscal deficit tightens financial conditions and fuels inflation.

What do you think about fiscal policy in the euro area? Is it too expansive?
We have a single monetary policy, but not a single fiscal one. Hence each national central bank expresses its voice there about. I welcome the revised framework for the fiscal rules, even if it is complex. I will not comment on the German fiscal policy:  the Bundesbank does it. For France conversely, we should tighten at a reasonable pace. We have a level of public debt which is now above euro area average. During Covid the “whatever it costs” was warranted, but no longer. Monetary easing to come is not a bad time for fiscal consolidation in France.

There are different opinions in the ECB Council on what pace should be adopted for the cuts of the interest rate. What do you think?

I plead for maximum optionality and “agile gradualism” after our first June cut. I sometimes read that we should cut rates only once a quarter when new economic projections are available, and hence exclude July. Why so, if we are meeting-by-meeting and data-driven? I don't say that we should commit already on July, but let us keep our freedom on the timing and pace. 

And what about the amount of rate cuts?

I am also sometimes surprised to hear that the first 50 basis points would be easy and that it would be more difficult beyond that. Well, after the first two rate cuts, our monetary policy will remain restrictive. We are still actively fighting inflation until we reach the neutral rate.

What is the current level of the neutral rate in the Eurozone?

By most estimates it ranges in nominal terms between 2 and 2.5%. This doesn’t mean that we should go to this rate, but that with a deposit facility rate of 4%, we have significant room for rate cuts. By the way, from today’s perspective, my feeling is that present market expectations for our terminal rate are not unreasonable.

Do markets need forward guidance of the ECB?

We shouldn’t come back to forward guidance. It was useful when there was a much more predictable environment and we were at the lower bound. But optionality shouldn’t mean excessive volatility: we could give some indications about our reaction function to data. Personally, I would set three compasses. First, European data on inflation are much more important for our decisions than the US ones. Second, the inflation outlook and our forecasts are now again at least as important as actual monthly data. Two years ago, our models were not very helpful because we had the unprecedented succession of two unpredictable shocks, with Covid and the Russian war on Ukraine. Now we have regained more trust in our models and forecasting tools, while we could see some increased volatility in the monthly inflation data during the rest of this year.

And the third guideline?

For me services inflation matters more than wages or margins. As you know, we focus on underlying inflation - excluding energy and food -, whose most important component is services inflation. It could be a bit stickier, although it has already decreased from a peak at around 5.5% in the summer 2023 to 3.7% in April 2024. I don’t think the last kilometer of disinflation is more difficult in nature, but it could be somewhat slower. 

Economic growth in the euro area is getting stronger, but is still quite low.

Growth should accelerate next year. Disinflation will bolster economic recovery, in supporting purchasing power and consumption:  fighting inflation and fostering economic growth are not contradictory but convergent. That said, potential growth in the euro area remains too weak at slightly more than 1%, especially compared to the US. As the inflationary emergency is receding, we should seriously deal with structural reforms: innovation and digital transformation, climate change, increased public sector efficiency 

What do you think about demands to stimulate investments by low interest rates?

We have one primary objective, which is our mandate given by democracy - and inherited by the way from the German Bundesbank: price stability. But I see no contradiction at all. Why are short-term interest rates, which the ECB decides on, higher at present? Because we had to fight a higher inflation. If you look at inflation expectations and long-term interest rates, they remained rather well anchored on the 2% inflation target thanks to the credibility of the central bank. So this credibility is the best way to fund investments at moderate long-term interest rates on the long run.

How to stimulate structural growth in the Eurozone?

If Europe unites and puts its strengths together, especially France and Germany, it has the ways and means to accelerate. I hope two priorities will be high on the agenda of the new European commission and the new European Parliament. Firstly deepening the single market as suggested by Enrico Letta in his report. According to the IMF, if internal obstacles were diminished by 10%, it could raise real GDP by 7%. We can see unfortunately the negative proof in UK with Brexit. Secondly: the Capital Markets Union (CMU) to enhance our financial power.      

Could you develop a bit more on the Capital Markets Union?

We have significant investments needs of more than € 500 bn yearly, but a hidden resource: if you look at the European excess of savings over domestic investment it amounts to about 2% of our GDP or more than €300 bn each year. Today those private savings finance investments in the US or in emerging markets. The CMU is seen so far as a very technical project with too many items. We should instead rebrand it “Savings and Investment Union”, and concentrate on four to five major topics, including green securitisation and European venture capital. 

French president Emmanuel Macron suggested that the ECB should also take into account economic growth and possibly even climate policy for its mandate. What do you think about that?

I cherish the independence of the central bank, which is another German virtue. So I never comment on political statements, starting with those made by the President himself. Our duty at the ECB is to implement our mandate as given to us by democracy. And within our mandate, we are indeed pioneers in incorporating climate change in our monetary policy around Christine Lagarde.

You said you had regained confidence in the ECB's forecasts. But compared to the long run, uncertainty is still quite high.

We have for sure to live with a more uncertain and more fragmented world, where supply-side shocks are more frequent. I think a clear commitment on price stability is more decisive than ever, because we give at least one key anchor to our fellow citizens and to economic players.

Could geo-economic tensions lead to a higher structural inflation in the Eurozone?

I would rather say there could be increased volatility of inflation. Not all shocks are necessarily inflationary. Climate change has for instance significant economic effects, but their magnitude and direction are still unclear. This is why we created the NGFS in Paris, the Network for Greening the Financial System. We publish scenarios. The necessary green transition is probably on average, but I say it very cautiously, moderately inflationary and moderately restrictive on activity. But the longer we would wait, the higher the costs.

So climate change should play a bigger role in the forecasts of the ECB?

Yes, as it plays a stronger role on economic developments. However it's not easy to forecast and we have to make progress on what I'll call the macroeconomics of climate. It's what we try to do at the NGFS.

From September onwards, the gap between the main refinancing operation rate and the deposit facility rate will reduce to 15 basis points. Will this have an impact on monetary policy? 

Not in the short to medium-term. Our aim was to provide clarity in advance to the financial system and to markets about what would come after the situation of excess liquidity we are in till at least 2026. The aim is obviously not to go afterwards to a situation of scarce liquidity, because we could then create problems for financial stability and for the economy as well, with possibly the risk of a credit crunch. Our purpose will be rather to provide adequate liquidity to individual financial institutions. Market reaction to our announcement in March was muted, which is probably the best possible sign that it was well designed and understood.

Updated on 24 June 2024