10 January 2019

Bank of France's Villeroy de Galhau: Twenty years after the introduction of the euro, what are the economic prospects for Europe?

François Villeroy de Galhau, Governor of the Bank of France, outlines the three principles on which Europeans have built success of the euro - price stability, independence and general European interest, - which must guide us in addressing Europe's challenges in the face of 2019's uncertainties.

I. The euro's success was built on three principles that are now more vital than ever

As to whether the euro has been a success; there are few among us this evening who would have any doubts. It is more interesting to look back on the reasons for this success, which, to my mind, was built on three founding principles: the Eurosystem's mandate of maintaining price stability; the means employed to carry out this mandate, i.e. independence; and the spirit that drives its action - general European interest. [...]

II. Our challenges in the face of 2019's uncertainties

A - A slowdown rather than a downturn, in a more fragile environment

A word first on the economic environment. At both the global and European level, activity is decelerating, but we are still a long way from experiencing a downturn. In 2019, global growth should at best be in line with 2018's level - 3.7% according to the IMF - subject to a downside risk. In the euro area,5 according to our latest projections, growth should come out at 1.7% compared with 1.9% in 2018. Although revised downwards, our baseline scenario remains relatively favourable. That said, at the start of 2019, we face three challenges: uncertainty, impatience and isolationism.

The most immediate one is the uncertainty over the outcome of the Brexit vote. Even if we don't want it, prudence requires that we prepare ourselves for the possibility of a no-deal Brexit, the impact of which would be more significant for the United Kingdom than for the euro area. However, any consequences for financial stability must and can be managed. But there are also considerable uncertainties outside Europe. The US cycle appears to be reaching maturity after an expansionary phase that began in mid-2009, but it is still far too early to worry about a recession. Growth should remain robust at around 2.3% compared with 3% in 2018, although at the expense of an ill-timed fiscal stimulus. There are greater uncertainties overshadowing the Chinese economy. The latest activity indicators have been weak. An escalation in trade tensions could lower Chinese GDP growth by up to 1.5 percentage points6 over a two year horizon. The slowdown could also encourage authorities to stimulate the economy, leading to increases in already high levels of corporate debt (155% of GDP compared with 106% in the euro area)7 and in the risks to financial stability.

Our second challenge is impatience. Thirty years ago, independence was conceived as a response to the temptation to make trade-offs between growth and price stability. But the real temptation, which is even stronger today, is to trade off long-term interests in favour of the short term. Financial markets are frequently characterised by short-termism and bouts of extreme volatility. But, more importantly, there is a political pressure towards it, driven by populist impatience that would like to have a lot, right away. For a number of years this impatience has been hindering long-term efforts in the form of fiscal consolidation and structural reforms, and these have unfortunately slowed in G20 countries. When we compare the performances of our different European Member States, it is clear that debt and public spending are not the engines of growth. There is a need today for fiscal stimulus in those countries that have surpluses, and for structural reforms across the board: without this there can be no sustainable growth. On this issue, I would just like to say a word on France, which has stood out as a positive exception over the past two years: the gilets jaunes (yellow vest) crisis provided justification for an emergency "package" to bolster purchasing power; but I do not think it should or even could halt the transformation efforts already underway.

Lastly, and this is our third challenge, isolationism, characterised by the escalation of trade tensions, constitutes the biggest short-term threat to global growth. Even before the tariff hikes, the uncertainty caused by protectionist stances, essentially on the part of the United States, already appears to be threatening growth via its impact on business investment. More broadly, uncooperative economic strategies - including within Europe - are on the rise. If each country seeks only to protect its own national interests, then everyone risks losing out - a phenomenon economists call "the prisoner's dilemma". According to a Banque de France study, a more collective fiscal and structural strategy could have boosted euro area GDP growth by between 2 and 3 percentage points in the 2011-13 period.

B - Achieving a gradual normalisation of our monetary policy, based on our three fundamental principles

Against this backdrop, I am convinced that the normalisation of our monetary policy - which has already begun - remains desirable. But it must be gradual, and consistent with the three principles that have sustained us for the past 20 years.

1 - We need to keep our options open in the face of the current uncertainty: we are predictable, but not precommitted. This is also an aspect of our independence, at a time when many are pressing us to provide further details 

For the past 3 years, we have published guidance roughly every 9 months on how we intend to conduct our net purchases over the subsequent 12 months, and we have always stuck to this forward guidance. As a result, the end of our net purchases at the start of January, despite being a major decision, caused no negative reaction whatsoever in the financial markets. Our past credibility gives us a certain amount of freedom with regard to the future. 

I would also add that we have now clearly outlined the sequencing of our normalisation: first a rise in key interest rates, which will not come until at least through the summer, and in any case for as long as necessary to ensure sustained convergence of inflation towards our target - I shall come back to this later; then, and only then, after an extended period, a gradual reduction in the reinvestment of the stock of acquired assets. In my view therefore, we do not need to give additional guidance on the timing or other details of the process until next spring, when we could be more precise about the sequencing according to the latest economic data. 

Nor do I see any need at present to review the future operational framework of our monetary policy: because this question will only arise once we have actually achieved normalisation, and because the tools of our monetary policy are already well known. The range of tools was expanded considerably over the course of the crisis; we will no longer use them all once we have reached the "new normal", but it is in our interest to keep them all to hand. Clearly, our monetary policy will remain accommodative for as long as necessary to achieve our inflation target.

2 - A better understanding of the path of inflation

Of course, our main focus remains price stability. In 2019, the fall in oil prices will have a significant downward impact on inflation. After peaking at 2.2% in October 2018, euro area inflation could fall to around 1% in some months of this year, before rising again gradually to 1.8% in 2021 according to the latest Eurosystem projections.

Beyond these temporary fluctuations, the key trend to watch is core inflation. The improvement in the labour market has already led to a substantial acceleration in wage inflation. Growth in average compensation in the euro area has thus risen from 1.2% in 2016 to 1.6% in 2017 and will probably reach 2.2% in 2018. However, this wage inflation has not yet been passed through to core inflation [slide 5]. Until now, the acceleration in the inflationary pressures linked to unit labour costs since the fourth quarter of 2017 has been offset by the improvement in terms of trade and the decline in corporate profit margins. In our forecasts, these downward factors have a temporary lagging effect: core inflation should gradually increase towards a rate of 1.8% in 2021 (after 1.0% in 2018, 1.4% in 2019 and 1.6% in 2020).

However, certain observers have stressed that this lagging effect appears to be durable, and has caused inflation to fall repeatedly short of Eurosystem projections. Inflation excluding energy and food remained subdued at 0.9% in November, as well as in December according to the Eurostat flash estimate. This possible weakening in the link between wage rises and price rises could be attributable to more structural factors, which are also being discussed in the United States: we shall pay close attention to how data on this issue evolve.

3 - Relentless efforts towards a stronger Europe

Monetary policy cannot be the only game in town. I understand and share German concerns on this... and that is why we need to push relentlessly for a strengthening of our Economic Union. Allow me to mention a great Luxembourger, Pierre Werner. At the end of the 1960s, he dared to suggest in his report that the monetary area needed a common budget, that its decisions should be endowed with democratic legitimacy or that unions should be given an active role. In this respect, the advances made by the Eurogroup in December 2018 constitute limited progress that needs to be extended. With regard to the Banking Union, its success will be predicated on the establishment of a solid and effective resolution mechanism, more than on the deposit insurance scheme. We need to pave the way for the backstop to be implemented as soon as possible. Moreover, in the interests of financial stability, we should consider extending the maturities on the credit lines and reach a definitive agreement on how to make emergency decisions. Unfortunately, there was almost no progress at all on the Capital Markets Union in the 4 December agreement. It is more important than ever that we make concrete headway, notably on harmonising bankruptcy regimes and strengthening the role of ESMA as a supervisory authority. More broadly, I can only express my regret that the reinforcement of the ESAs proposed by the Commission has been blocked by the Council.

The Banking Union and Capital Markets Union are the key components for a genuine "Financing Union for Investment and Innovation": I have put forward this idea as a way of better channelling our abundant resources - our EUR 350 billion private savings surplus - towards the concrete needs of the economy: the energy transition, SMEs or digital innovation. Jean-Claude Juncker's investment plan was a first successful step towards this. With regard to the ESM, it's not just about managing crises ex post, but about preventing them from happening in the first place by reinforcing our precautionary tools: the principle of ex ante criteria and the absence of an assistance programme are both welcome elements. However, we need to avoid having ex ante criteria that are so strict that in practice they prevent the ESM from being used preventively, as is the case today.

Beyond these institutional reforms, and with the United States and China increasingly asserting their dominance, it is vital that the European Union be given genuine strategic autonomy. Our currency, the euro, already plays a significant role at the international level, and this could be expanded even further [slide 6]. Despite being the world's second most important currency, it is still used to a far lesser extent than the dollar. It accounts for 20% of global currency reserves compared with 63% for the dollar; by contrast, 36% of the total value of payments (including intra-euro area payments) is settled in euro, compared with 40% for the dollar. This is why the European Commission's communiqué in December was particularly opportune. The initiatives promoting the role of the euro, notably in the energy sector, need to be examined carefully. Europe has built its monetary sovereignty thanks to the euro; it needs to preserve its sovereignty with regard to trade; and we still have a long way to go to build our economic sovereignty, so that we can meet the challenges of innovation in artificial intelligence or of the energy transition. [...]

Full speech

© BIS - Bank for International Settlements