ECB’s Villeroy: Interest Rates Should Peak by September; Need Core Inflation Turnaround To Stop Hiking

17 February 2023

By David Barwick – FRANKFURT (Econostream) – European Central Bank Governing Council member François Villeroy de Galhau on Friday said that the ECB should hit the terminal rate by the end of September, and left open the size of any rate hikes beyond March’s likely 50bp increase.

In a speech in Paris, Villeroy, who heads Banque de France, said that even if headline inflation subsided to half of its current level by year’s end, ‘that will still be too high.’ Given its broad base, its domestic component and its potential persistence, ‘no one can seriously deny that monetary policy must respond’, he said.

According to a Banque de France estimate, the nominal neutral rate of the euro area is around 2%, he said. ‘Clearly we have gone beyond that today, and as a result have entered “restrictive” territory in the technical sense’, he said.

‘We are now entering a new, slower, longer and more open phase’, he said. ‘After the sprint comes the long-distance run. Expectations are continuing to focus, excessively in my view, on our speed: are we going to continue our 50bp hikes after March?’

That would depend on the data, he said. As well, he added, ‘there are two more important variables in this new phase: the level of interest rates that we reach, and the duration for which we stay there.’

Whilst now wishing to impose ‘any strict time limit’ for achieving the terminal rate, ‘it is possible’ that this will occur by summer, ‘which officially ends in September.’ The Governing Council would thus have four meetings left after the March gathering, ‘where we will have reached 3%’, he said.

‘We shall probably go beyond this 3%, but there will be no obligation to act automatically at each Council meeting, and we are not ruling out acting subsequently if new elements justify it’, he said. ‘This gives a sufficiently broad scope of action to be serene, open: after March there will be less monetary urgency as we will need to analyse the economic evidence more closely.’

To declare the terminal rate reached, he said, ‘the central criterion is a turnaround in the trajectory of inflation, not just headline inflation – we are very probably close to that point – but above all underlying inflation, notably excluding energy prices – which may lag the headline measure by several months.’

Being on the safe side, he said, would mean defining the turnaround as actually observed declines in core inflation, rather than merely ‘a sufficiently solid forecast of an expected fall in the very near term’, which standard would be more in line with transmission lags.

Therefore, he said, ‘the Governing Council will have to use its judgement.’

As for how long the terminal rate would need maintaining, ‘[i]t is our duty to repeat that the fight against inflation cannot be won without perseverance, and without keeping interest rates high for as long as necessary’, he said. ‘We need to be wary of declaring victory too soon: the final kilometres of a long distance race are often the most decisive.’

In any case, this question is ‘definitely not for this year’, he said. Still, when the ECB is ‘sufficiently confident that we have reached the right rate level, it might be a good idea to give guidance on the criteria determining how long we stay there.’

Of key importance would be a clear and sustainable return to an outlook consistent with price stability, he said, meaning that headline and core inflation data corroborate this, and the return is ‘well ahead of the end of our projection horizon, and including, in my view, a decline towards 2% of households’ and businesses’ inflation expectations.’

There are various measures of underlying price pressure, but currently ‘no clear and convergent signs in all of these indicators that would allow us to assert that underlying inflation has indeed reached a turning point’, he said.

Wage growth, whilst picking up, is still undershooting inflation, and there is no wage-price spiral in excess of what the ECB already accounted for in its forecasts, he said.

Meanwhile, household and company inflation expectations ‘are giving more mixed signals’, he said, and although there is no clear disanchoring, the ECB has to bring these durably back to 2%.

Guiding market expectations ‘requires unwavering determination and capacity to act’, he said. ‘Let me reiterate firmly here today, not just our forecast but also our commitment, alongside [ECB President] Christine Lagarde, to bring inflation back towards 2% in the euro area and France by end-2024/2025.’

That commitment is not new; new is at most the time frame for its fulfilment, which Villeroy has shifted out as it has become progressively more evident that previous versions of the commitment were unlikely to be fulfilled.

For example, on 15 February of last year, he declared that ‘our commitment is crystal clear: we will do what is necessary to bring inflation back firmly and durably to around 2% within our projection horizon.’

Last 17 March, he said that inflation ‘will return to 2% between now and 2024. … That is also based on the commitment … of the European Central Bank and Banque de France to sustainably return inflation to around 2%. It’s our mission and we will fulfil it. … That’s between now and 2024; it could happen before, in function of the evolution of energy prices.’

Villeroy today suggested that ECB communication strive for a ‘new predictability’ that would overcome the problem of too-stringent an understanding of the Council’s ‘meeting-by-meeting’ approach.

‘Monetary policy deserves better than a “live” prediction contest, or an overinterpretation of statements by different individuals’, he said. Still, short-term guidance is possible even where the longer-term unconditional sort is not, he said.

‘The main thing is that our future decisions shall remain dependent, first and foremost, on the economic data’, he said. ‘Amidst the uncertainty, I am calling, more than ever, for pragmatism.’

The notion that the ECB wanted or needed to induce recession was false, he said. Indeed, persistent inflation would ultimately dampen growth, he said.

Moreover, the euro area economy had been holding up well lately, he noted. ‘There is therefore room to act and I want to make this clear: our achieving of disinflation will not lead to a recession’, he said.

The objective had to be preventing demand from outstripping supply in the recovery anticipated for next year, he said. This implied that financing conditions had to be more restrictive than they were when demand was too subdued, he said.

That in turn meant higher real borrowing costs across the curve, he said. ‘Since the start of 2022, the real yield curve has risen significantly; we are pleased that it is now in slightly positive territory for all maturities’, he said.

Moreover, credit had become significantly more expensive, and the renewed strengthening of the common currency should dampen import prices, he said.

‘We do not have an exchange rate target, but we closely monitor the effects of the exchange rate on inflation; it is good to see that they have become more favourable again since last summer’, he remarked.

He called on national governments ‘to start reducing their support measures rapidly, by making them more targeted, as soon as energy prices start to recede.’