Letter to the President of the Republic : How France and Europe will defeat inflation

Domestic inflation is also being fuelled by the recovery in demand after the lifting of health restrictions and by “second round effects” linked to the gradual catching up of wages, driving up inflation in services. While the decrease in inflation in the euro area can now be attributed to the decline in energy and imported commodity prices, domestic inflation continues to rise in France and the euro area (see Chart 3).

Inflation is therefore not only higher but also more broad based, and has spread to all prices. Food prices rose by 15% in March and became the main driver of inflation, taking over from energy inflation (5.2%). These two components, the most keenly perceived by most of our citizens, account for about 30% of our average consumer basket and therefore of the price index. However, their rise should be temporary : energy prices have already started to slow down significantly, and food prices should start to decelerate in the second half of the year, in the wake of the turnaround in global agricultural prices. The other components excluding energy and food, which account for around the remaining 70% of inflation, are less spectacular but are likely to prove more persistent : manufactured goods prices have accelerated to 5.6% as have services prices, although they are rising more moderately (4%).

This change in the nature of inflation can be seen in the “underlying” inflation indicators, which give us more information about the medium-term outlook. They aim to remove temporary shocks from headline inflation in order to capture the underlying trend. The most common of these indicators is inflation excluding energy and food² which therefore removes these consumption items whose prices are traditionally very volatile because they are dependent on international markets. Inflation excluding energy and food has increased significantly since 2021 (see Chart 4 below) and continues to stand at a level that is too high (4.6% in France and 5.7% in the euro area in March 2023).

therefore removes these consumption items whose prices are traditionally very volatile because they are dependent on international markets. Inflation excluding energy and food has increased significantly since 2021 (see Chart 4 below) and continues to stand at a level that is too high (4.6% in France and 5.7% in the euro area in March 2023).

At this stage, neither inflation excluding energy and food, nor a broader set of underlying inflation indicators monitored by the Eurosystem (see Box 1) are showing clear and converging signs of a trend reversal. This warrants us pursuing our monetary policy action (see 2.2)

According to our projections for France, headline inflation should peak in the first half of the year. At the end of the year, it is expected to recede to around 4%, with core inflation remaining high. In 2024, due to falling energy and food prices and the effects of monetary policy (see Part 2), headline inflation should decrease more sharply to around 2.5%, before gradually converging towards the 2% target by end-2024 to end-2025.

From actual to expected inflation

The spread of inflation entails an additional risk: too high inflation today could “contaminate” the future inflation expectations of economic agents (consumers, employees, business leaders, etc.), thus interfering with their consumption and production decisions, wage negotiations, investments and, more generally, the price-setting process. In this situation, inflation would become self-sustained with the risk of becoming entrenched. It is this scenario that we must absolutely avoid, and that is why it is crucial to anchor inflation expectations around our 2% target (see 2.2 below).

Expected rates in the financial markets (five-year forward) increased significantly above 3% in the spring of 2022, but have fallen since (see Chart 5a). They traditionally fluctuate in line with energy prices. Household and business leaders’ expectations are usually for their part more closely correlated with the actual level of inflation. According to the ECB’s Consumer Expectations Survey, household inflation expectations three years ahead in France rose in early 2022 to 3% (see Chart 5b) before stabilising, and appear to be showing signs of abating in the first quarter of 2023.

For its part, inflation expectations at the 3-5 year horizon of the 1,700 business leaders in France, surveyed each quarter by the Banque de France, increased in 2022 to 3% and have since stabilised at this level. Overall, there has not been a massive and greater “de-anchoring” of inflation expectations; but it is still important to bring them down towards 2%, in line with the central bank’s objective.

The Banque de France is more than ever mobilised to help people in difficult situations: the number of cases of overindebtedness in particular, while remaining significantly lower than in 2019 (the pre-Covid reference year), has risen in the first quarter of 2023 (up 6% compared to last year).

At the aggregate level, however, household purchasing power was preserved on average in 2022, with a decline limited to -0.1% in France, which followed a sharp rise of 2% in 2021.

This almost stable situation is obviously not perceived as such, but the lower inflation compared to our European neighbours, combined with a robust labour market (rise in the employment rate) and fiscal measures (price shields, revision of pensions and welfare benefits), have on average largely mitigated the decline in household disposable income. Average per capita purchasing power is expected to be almost stable again in 2023 (-0.1%), before picking up again in 2024 and 2025 on the back of an economic recovery (see Chart 7).

The risks of a runaway price-wage spiral

Given the magnitude of the inflation shock, it is normal for wages to undergo a catch-up process to prevent an excessive loss of purchasing power. But by increasing production costs, the rise in wages itself fuels the rise in prices : this phenomenon is known as the “price-wage feedback loop”.

This normal adjustment process must be set apart from a runaway spiral, which would push up inflation over the long run. This is the pattern that was observed in the 1970s, where households and companies
all suffered ultimately.

Unlike in the 1970s, wages other than the minimum wage are no longer indexed to inflation, but freely negotiated. As a result, wages have not adjusted uniformly to the inflationary shock. Workers on the lowest incomes have rightly been the most protected from inflation. The minimum wage was automatically raised five times between October 2021 and January 2023, representing a cumulative increase of almost 10%. These raises led a number of industries to increase their wage floors at the start of 2022, followed by a new round of wage negotiations during the year in several industries.⁸ This resulted in 2022 in higher growth in the base wages of blue-collar and white-collar workers (4.5%) than in those of managerial staff (3%).⁹ The growth of overall compensation has also been bolstered by the payment of bonuses, which make it possible to offset the loss of employees’ purchasing power on an ad hoc basis.¹⁰

Average per capita wages – which include notably these bonuses – grew less quickly than inflation in 2022 (see Chart 8), but are expected to rise by 6% in 2023, temporarily outpacing inflation at 5.4%, before returning to a more moderate rate as of 2024. The wage catch-up process should thus occur with a slight lag vis-à-vis inflation.

The sensitive matter of margins

As regards businesses, the rise in the input costs of theirproducts was on the whole at least partly passed on to their selling prices. At the aggregate level, the corporate margin rate thus fell less than expected, unlike what was observed in the 1970s: after reaching a peak of 34% in 2021, the margin rate stood at 32% in 2022, close to its pre-Covid level. In 2023 and 2024, corporate margins are expected to decline slightly and temporarily as a result of economic conditions, before starting to rise again in 2025. The margin rate would then be close to its 2018 level.¹¹

Therefore, these developments in France do not overall appear to corroborate the assumption of a “price-profit spiral”, which is currently part of the public debate due to the margin behaviour of some companies, notably the largest ones. Indeed, these developments differ greatly across sectors (see Chart 9), and require a case-by-case analysis. Particular attention should be paid to developments in the energy sector and transport services (especially in the maritime freight sector). In the agri-food industry, after declines in 2020 and 2021, the margin rate has risen sharply in 2022 to a level close to that of 2018. In all events, it is hoped that competition and a degree of vigilance will lead firms to moderate their prices for the benefit of consumers. In the other sectors, however, the margin rate declined between 2018 and 2022, due in particular to the drop in productivity observed since 2019.

The situation in France thus differs from that of the euro area,¹² especially in Germany and Spain, where margins have contributed significantly to the rise in inflation in 2022.

Uncertainty and loss of confidence

If the illness of inflation were to become chronic, it would ultimately become the main enemy of confidence, and therefore of growth. High inflation is often more volatile and harder to predict. Faced with this uncertainty, households and businesses may adopt a wait-and-see attitude and choose to postpone their consumption or investment decisions. Moreover, contrary to popular belief, inflation sustainably raises the cost of borrowing on the financial markets, both in nominal and real terms. Uncertainty about future inflation dynamics leads to an increase in the “term premium”, which is a key component of actual interest rates and directly linked to inflationary risk. If there were doubts about the ability to return towards 2% inflation in the medium term, or even worse, if – according to an idea sometimes put forward – central banks increased their inflation target, this “term premium” would structurally increase.

If the loss of confidence is too great, citizens may no longer accept their currency. In 2022, extreme inflation rates (above 70%) in Turkey and Argentina severely eroded the real value of their currencies. Citizens then shunned their national currency in favour of other stronger and more stable currencies: the Argentine peso and the Turkish lira lost almost three-quarters of their value against the dollar in 2022.

To a lesser extent, within the European Union but outside the euro area, Hungary experienced an inflation rate of 25.8% in February 2023. Of course, inflation rates in the euro area have never reached these extremes and Europeans’ confidence in the euro remains very high, with 73% and 79% respectively of favourable opinions in France and the euro area at the beginning of 2023;¹³ but these counter-examples show the key value of confidence in the currency.

A sharp drop in purchasing power, a price-wage or pricemargin spiral, a loss of economic confidence: thanks to the actions already taken, the French economy fortunately does not show any signs of these symptoms of persistent inflation. This is all the more reason to treat the disease in order to prevent it from becoming chronic.

Monetary policy transmission channels

The “traditional transmission channel”, via monetary aggregates, has become less relevant. This channel was predicated on the idea that strong money growth would fuel inflation. But this relationship between money growth and inflation varies over time and is neither causal nor automatic.

Since the start of the asset purchase programmes in 2014, monetary growth has been contained, as the liquidity provided by the ECB was partly redeposited by the banks. During the Covid crisis, nevertheless, the exceptional fiscal and monetary support measures temporarily led to a surge in corporate and household loans and deposits. But since then, the growth of monetary aggregates in the euro area has fallen steadily to 2.9% in February 2023.¹⁵

A simplistic view of the “monetarist” approach could therefore today, paradoxically, turn out to reassuring, but artificially so. Moreover, this diminishing importance of monetary aggregates rules out the role of past accommodative monetary policies in current inflation, as is sometimes argued. There have been numerous supply shocks (see 1.1), but no serious economic explanation attributes current inflation to excess liquidity. Indeed, monetary policy nowadays acts on inflation mainly through two channels :

• The expectations channel, which has become much more important

Whether inflation expectations are those of financial markets to determine the level of interest rates, or of other economic agents (firms and households) to guide their decisions on future prices and wages, they play a key role in the transmission of monetary policy (see 1.1). By enabling the different economic players to coordinate their decisions based on a common and credible inflation target (2% in the medium term) central banks contribute directly to ensuring price stability.

• The financial conditions and demand channel

Monetary policy acts directly on financial conditions and thereby indirectly controls demand in line with the economy’s supply capacity, at a time when this capacity has been reduced by external shocks. Let us dispel a misconception at this point: unless there is another major external shock, the reduction in inflation achieved by the Eurosystem will not lead to a recession, given the resilience of activity and employment. The objective today is to prevent demand  from re-accelerating faster than supply during the expected recovery in 2024-25. To achieve this, financing conditions obviously cannot remain the same today as they were when there was a demand shortfall, as in the past decade when inflation was too low. Technically, we are talking about “monetary tightening” or “restrictive” financing conditions, since we are above neutral rates after the normalisation conducted in 2022, but what does this mean in reality?

Through monetary tightening, the Eurosystem is primarily seeking to achieve an increase in real interest rates at different maturities. These real interest rates, which correspond to nominal interest rates minus inflation expectations, reflect the true financing conditions of economic agents; they stem from monetary policy decisions, but also from the inflation expectations channel. The current rise in nominal interest rates, combined with inflation expectations better anchored at their target level of 2%, has led real interest rates in the economy to rise substantially and, in line with our objectives, to move back into positive territory, which had not happened for over ten years (see Chart 12).

Central banks also look at credit aggregates, which are much more meaningful than monetary aggregates. The credit channel is especially important in the euro area since, unlike in the United States, most of the economy (households and firms) is financed here through bank credit.

The impact on access to credit and the soundness of banks

Although volumes have slowed, growth in outstanding loans in France remains significant (up 6.9% year-on-year for loans to businesses and 5.1% in housing loans to individuals in February – see Chart 13) For these two loan categories, credit in France remains less expensive and is growing faster than the European average (see Chart 14). This slowdown in credit supply is justified after the sharp net rise in private debt ratios in recent years; so is the increase in interest rates, provided that it remains gradual and orderly.

Overall, access to credit is more costly than during the years of ultra-accommodative monetary policy, but credit remains widely accessible. For example, in the fourth quarter of 2022, 90% of VSEs, 96% of SMEs and 98% of ISEs that applied for an investment loan were granted it.¹⁶ This was made possible thanks to the soundness of French banks, whose solvency ratios are close to historical highs, having more than doubled their capital since 2008.

At the end of 2022, common equity tier one (CET1) solvency ratio of the six main French banking groups reached 14.9%, i.e. about five percentage points above the minimum capital requirements.
 

The recent banking crises, specific to US regional banks and Credit Suisse, highlight in contrast the strengths of European banks : they are strictly supervised in the framework of the Banking Union; and due to the application of Basel III to all banks in Europe, they are also subject to stringent liquidity rules. In the United States, to date only 13 banks are regulated in this way, following the authorities’ decision in 2019 to exempt the vast majority.

Consequently, French and European banks are well equipped to adapt to the monetary tightening, even if it results in a slight reduction in available liquidity – and the Eurosystem has the necessary instruments to ensure their liquidity if necessary. In general, French and European banks benefit from rising interest rates thanks to their diversified model, their broad deposit base and their large loan portfolio. They clearly do not
suffer from the weaknesses of some US regional banks such as Silicon Valley Bank in the face of rising interest rates.

As regards Credit Suisse, for years it had suffered from two well-known failings: an unprofitable business model and excessive risk-taking. These issues had started to be addressed, but all too slowly, and the wave of mistrust in March forced an accelerated takeover by UBS.

The lag in the effectiveness of monetary policy

Monetary policy is always and universally effective in controlling inflation, as long as it is no longer solely driven by an imported supply shock (see 1.1). We have started to see its efficacy in recent months in the United States and Canada where goods prices and wages have begun to slow down. In Canada in particular, rate hikes began in March 2022. Inflation peaked in June 2022 at 8.1% before gradually falling to 5.2% in February 2023. Inflation excluding energy and food, which stood at 4.8% in the same month, seems to have started to decline. As these favourable developments are broadly in line with its forecasts, the Bank of Canada has decided to keep its rates unchanged since the beginning of this year.

At the same time, the lags in the transmission of monetary policy mean that the full impact on inflation of the rate hikes already underway will only be seen in several quarters.

These lags are traditionally assessed at between one and two years. While some research suggests that they may have shortened in recent years, particularly in the United States,¹⁷ these lags must in all cases be better monitored in relation to the economic and financial factors specific to each currency area. At any rate, the differed effect of our past interest rate hikes will be greater than that of our future decisions.