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MARIA DEMERTZIS: Good morning, ladies and gentlemen. Welcome. Also, a very warm welcome from my side.
My name is Maria Demertzis. I am the deputy director of Bruegel, which is a think tank—an economic think tank based in Brussels, and I’m delighted to be here. Thank you to the organizers for including me in the program. And of course, I am delighted to host President Lagarde, who needs no introduction.
President Lagarde, there’s a lot to talk about. If I may start with just the title, as you see, the Frankfurt Forum is a forum that is a conference that concentrates on the US-European economic and geoeconomics relations. We’re here to talk, I’m sure, about inflation. Inflation is a problem. And I wanted to quote Chair Powell, who said that inflation is a global phenomenon even though the sources and the way that it’s felt in different parts of the world are actually quite different. Do you share his view in this respect?
CHRISTINE LAGARDE: Well, first of all, good morning. Good morning to all of you in the audience. And my great thanks to you, Fred, for a flattering introduction, but for standing as a leader in the European-Atlantic relationship, which matters so much. And I’d like to extend a special thank you to Josh and Julia. They’re in the back of the room and they have been instrumental in getting us all together.
So back to Jay’s—to Chairman Powell’s—view. It is a fact that we have inflation pretty much across the world—including in Japan, where it was so low for so long. Even there, we are seeing it. But we’re seeing inflation in different shape, form, and levels, and I think it has a lot to do with the roots of that inflation.
So if I—if I concentrate only on Europe—and I will say “Europe,” but it’s obviously the euro area, where we are welcoming our twentieth member on the first of January because Croatia will be joining the euro area and will become a full-time member of the European Central Bank—if I compare Europe with the United States, the roots of inflation are different. And I think it matters to understand where it is coming from so that we can adjust the monetary policy response accordingly.
So the two key differences that I would—I would see is—have to do with energy and labor.
If you look at energy, it is the key driver and has been the key driver of inflation in Europe. Rough speaking, if you take the direct impact of energy—and by energy I mean, you know, electricity, gas, all petrol-related products—if I look at that plus the indirect impact of energy costs, you’re talking about roughly 60 percent. So 60 percent of the drivers behind inflation here are related to energy. If you look at the United States, it’s about half of it. If you put food on the top, we are more impacted as well by food because of the way we are organized. The US is less impacted. So the drivers are predominantly energy-related in Europe and not as much in the United States.
The second factor which also has an impact is that when you look at wage progression, you see that wages in the United States progress anywhere between 5 and 7 percent at the moment. When we look at wages negotiated in the last few months, we are between 2.5 and 3 percent. So that’s also a major difference in terms of second-round effect that we have to be very attentive to.
Those are the two key differences. And if you add to that the economic analysis of is it supply-driven/is it demand-driven, clearly our inflation is strongly supply-driven. So we have shortage of supply for various reasons—you know, the supply-chain bottlenecks that have affected us critically at a time when the recovery was, you know, taking its full flight and at a much faster pace than expected. When you look at the United States, because of the wage point that I was making it is much more so demand-driven.
And that has—that has consequences to how we deal with it. And in a way, when you have predominantly or purely demand-driven inflation, I wouldn’t say that it’s fairly simple but you have to hammer demand, reduce it, so that it realigns with supply. When you are predominantly supply-driven, it’s far more complicated because monetary policy cannot in and of itself reduce the price of gas, cannot stop the war as much as I would love for us to be able to do that. So we need to be attentive to—
MARIA DEMERTZIS: If I may—I mean, I suppose my question is, it took a little while before action came in this respect, right? I mean, at Bruegel, we started monitoring the fiscal health that people were—that countries were giving to, both to companies, as well as to households, back in September of last year.
CHRISTINE LAGARDE: Mmm hmm.
MARIA DEMERTZIS: And so, we knew that the inflation was going to be a problem. Yet it took a long time to get there. Why did it take so long to come here?
CHRISTINE LAGARDE: Well, first of all, we started that journey of normalizing monetary policy in December. So, yes, it could have been September, but we started the journey in December. In December, we decided that we were going to reduce net asset purchases, stop net asset purchases, whether it was under the normal asset purchase program, or under the pandemic emergency program that we put in place—rightly so, in my view—in order to deal with the phenomenal crisis that we faced. But we decided to stop net asset purchases, and as soon as net asset purchases had stopped, then we decided to move out of negative interest rates—in which we had been since 2014—and then to hike again.
So, we decided in a matter of two monetary policy meetings, six weeks apart, 125 basis point increases. So, you know, I’m not—I’m not challenging that we made some projection errors—like everybody else who was doing projections, maybe because many of us are using the same models. But no one understood—I’ll take you back a little bit further. You mentioned September of that year. I’ll take you to December. So, eighteen months ago, roughly, eighteen months ago, I’m sure that very few in this room remember where inflation was. It was in negative territory, December 2020, minus three [percent]. Now, we are at plus 9.1 [percent], the last reading of October. Minus-0.3 [percent], sorry.
MARIA DEMERTZIS: Minus-0.3 [percent].
CHRISTINE LAGARDE: Minus-0.3 [percent]. But negative. We are now—last reading, at 9.1 [percent]. And our forecast for this year is a little north of 8 [percent], for the whole year, and moving towards 5.5 [percent] next year.
So, yes, I think there was a general sense for a period of time that this inflation, that was generated by the rotation of demand that we observed right after the recovery, from, you know, massive purchases of goods, to pent-up demand in services, in particular, we—many of us, I would say, pretty much all projectionists assumed that it was going to be transitory, because in the textbook, supply bottlenecks eventually fade out. Energy prices eventually return. Well, this didn’t happen. And what we are seeing and have been seeing for the last few months, and accelerated by the war in Ukraine, has been more persistent and of a magnitude that nobody had expected. But we started that journey in December.
MARIA DEMERTZIS: With the normalization, yeah.
Well, we are here now.
CHRISTINE LAGARDE: Yup.
MARIA DEMERTZIS: And the inflation is a projected 5.5 [percent], as you said, next year. I’m not going to comment on the forecast. I think that—I mean, there are—there are so many things we can say about forecasting, but in any case we have to deal with the tools that we have.
CHRISTINE LAGARDE: Yeah.
MARIA DEMERTZIS: But one thing we do know is that whatever we do now is not going to come into effect for another year and a half.
CHRISTINE LAGARDE: Yeah.
MARIA DEMERTZIS: It’s going to take a long time to get—to see the effects of the decisions that we take now. That’s why it was important to ask the question where we lay in starting, you see.
CHRISTINE LAGARDE: Yeah.
MARIA DEMERTZIS: But so my question to you now is—and given that now we have to wait for another eighteen months to see the effects—and now you are, actually—I think you are decisively increasing interest rates –
CHRISTINE LAGARDE: Mmm hmm.
MARIA DEMERTZIS:—are you afraid that maybe there will be stifled growth? Because you know, in a year and a half from now, maybe this war is over—I hope this war is over. Maybe the energy issue has normalized. Is it correct to now increase rates at quite the speed that we think is—increases are going to happen?
CHRISTINE LAGARDE: Returning stability of prices is the mission of the ECB. This is our primary objective, stated in the treaties as I have just said, and this is what we have to do, returning inflation to 2 percent in the medium term.
And we will do what we have to do, which is to continue hiking interest rates in the next several meetings, as I have said at our last monetary policy meeting. We have to deliver on that.
So, our primary goal is not to, you know, to reduce growth. Our primary goal is not to put people on the dole. Our primary goal is not to create a recession. Our primary objective is price stability, and we have to deliver on that. If we were not delivering, it would hurt the economy far more than if we do deliver on that point.
MARIA DEMERTZIS: So, if I may, you are trying to, so, ensure that the inflation that we see is not entrenched.
CHRISTINE LAGARDE: Yeah.
MARIA DEMERTZIS: You say 60 percent is supply-driven; the rest is, if I may call, demand or other things that are happening.
CHRISTINE LAGARDE: Yeah.
MARIA DEMERTZIS: So your hikes are there to prevent inflation from being entrenched, I think.
CHRISTINE LAGARDE: Yeah. Yeah, because what is—we are all seeing it. And thank you again, President, for hosting us at the chamber. It’s wonderful to be here in proximity of those who are in the trade, in the business, industrialists. In the business, there are wage negotiations taking place. There is anxiety on the part of those who see the bill at the end of the month, and with the electricity and the gas prices increasing. So, those who sit at the negotiation tables need to appreciate that in the medium term, inflation will be returned to 2 percent.
And that’s what I mean by working on the inflation expectations, because we are very attentive to that. We not only look at what the models tell us; we look at what our scenarios tell us. We do sensitivity analysis. We look at surveys. We try to understand exactly what is in investors’ minds, in consumers’ minds, to see where it’s heading. And we need to make sure that those inflation expectations stay anchored at 2 percent. But that’s really an important part of the job that we have to do at the moment, because we can impact second-round effects, more difficult to impact the first-round effects when they are, you know, predominantly energy-driven.
MARIA DEMERTZIS: President Lagarde, I want to ask you a question on communication. I know you care deeply about communication, and about direct and clear communication.
CHRISTINE LAGARDE: I try. No, absolutely.
MARIA DEMERTZIS: The issue of forward guidance, the issue of telling us what you’re going to do in the future—you also just told us right now—I was personally surprised to see that you had told us that you’re not going to tell us what you’re going to do, and then you told us, we will tell you what we are going to do.
At the same time, you put a lot of emphasis on the issue of uncertainty. We don’t know what’s going to happen; we don’t know where we’re going. And my question to you is, I mean, how should communication be adjusted? That quite well the degrees of uncertainty that we have out there are so, so big, when we don’t know where we’re going, can we not go there slower? Or should we go faster? And how should you adjust your communication, when actually the future is quite so uncertain?
CHRISTINE LAGARDE: You’re totally right that the future is extremely uncertain, and that’s the reason why we decided that we would decide, meeting by meeting, on the basis of the data that we receive. And I think that in such uncertain times, to rely exceedingly on forward guidance would be a constraint and would not be good communication, because if you communicate in terms of forward guidance that you are going to do this or that at such time, it will be state-dependent, it will—and uncertainty results in completely—in a completely different situation from what you had anticipated in your models, in your scenario analysis, in your sensitivities analysis.
Then, your forward guidance was wrong; you misguided those who carefully listened to you. So, we think that in those uncertain times, and as we are no longer at the effective lower bounds—so very, very low or close to that effective lower bound as we were—it’s probably much safer and much more accountable to our mission to be data-dependent, and to decide meeting by meeting.
Now, I gave a little bit of forward guidance by saying that—and I think it’s based on sufficient analysis and facts—when I said that after the 125-basis-point hikes of interest rates, that there will be more interest rate hikes in the next several meetings because we are—we are not at the neutral rate yet. We are—this is our first destination on the journey, but we are not there. And we have to move there first and then see what rate will deliver us the 2 percent inflation objective that we have for the medium term.
So there is a little bit of forward guidance. It doesn’t say by how much. It doesn’t say the number of meetings. But it’s a clear indication that we are on a—on a path the pace of which, the volume of which will be determined on the basis of data and meeting by meeting.
MARIA DEMERTZIS: If I may, I would like to move on to another topic, subject of conversation that has actually kept us busy for some time, and that is the new and different anti-fragmentation tool.
CHRISTINE LAGARDE: Uh-huh.
MARIA DEMERTZIS: I think that’s actually something that has created a lot of fans and a lot of those who are very critical about it. But I want to start by asking you: Why is there a need for a new tool? Don’t we have enough tools?… There are different ways of dealing with the fragmentation risk. Why is there a need for a new tool?
CHRISTINE LAGARDE: We believe that not only should we deliver on monetary policy, but we must ensure that monetary policy is delivered across all member states. So if there is—if our—if the reaction function applies predominantly in, I don’t know, you know, ten out of nineteen countries or twelve out of nineteen countries, we haven’t done our job. It has to apply throughout the entire euro area.
So I think the Transmission Protection Instrument is precisely aimed at that. If we see—if we assess that because of market dynamics that are unwarranted our monetary policy is not transmitted throughout the euro area; and if the four criterias that we have put in place, which predominantly you can summarize as a well-behaved country by the rules of Europe; and if it is a proportionate instrument to use, in other words it will serve the purpose that we have of transmitting monetary policy; then the Governing Council, in its collective wisdom and of course borrowing the analysis of other institutes of quality and good standing, will trigger the Transmission Protection Instrument and will do so. It’s one more instrument that we have in the toolbox. And it’s intended for that specific purpose, unwarranted market dynamics.
We do have other tools. And you know, if the TPI has been used for the results for whatever cause that is, then there will be other tools that we can use. And they are completely alive and available as well, and we will use all instruments of monetary policy in the toolbox in order to deliver on the primary objective and make sure that it is transmitted across the euro area.
And it’s not intended for one country or the other. You know, the world turns and we have to be attentive to all nineteen member states.
MARIA DEMERTZIS: But if I may, the unwarranted part is, of course—how are you going to apply this? What is unwarranted? And how do you go about identifying what is unwarranted? I mean, this is—I mean, the tools that we have in our—in our hands, do you think they will give you the confidence to say something is warranted by fundamentals and something is not warranted? And with that—if you could comment on that, that would be interesting. But also, with that, a very important—one of the four criteria that you have there is that there is—the debt behind the countries is sustainable.
CHRISTINE LAGARDE: Mmm hmm.
MARIA DEMERTZIS: And you say that you are going to do your own analysis, but also do the analysis—look at the analysis of other institutions and come to a conclusion. If I may ask a little provocative question, but the debt sustainability of a country is as much economics as it is politics. And don’t you think it would be better, certainly for the reputation of the central bank, to let other institutions decide what is sustainable and what is not sustainable? Why did you have a need to decide on yourself to do that?
CHRISTINE LAGARDE: First of all, because a central bank in current times is an independent institution, and I have to respect the collective wisdom of twenty governors and the Executive Board members around the table whose job it is to deliver on the mission. So it is the independence of the central bank to use the appropriate tool on the basis of a process that we have identified in relation to TPI, the three-step assessment process and the four criterias, one of which is fiscal sustainability.
And that is intended not, you know, for us to suddenly become the ultimate judge of sustainability. Because we will, obviously, use the analysis produced by institutions like the IMF, like the ESM, like the Commission, to name a few because they do produce excellent analyses—not always on the same page, you’re right, and there is a political dimension to it, absolutely, but you can try to eliminate as much as possible the political biases when you use several institutions.
You know, I was—as an anecdote—and I have some former IMF colleagues in the room. They will remember those days when the Commission was publishing a debt-sustainability analysis, when the IMF was publishing an IMF debt-sustainability analysis for a country. And then we would go and visit the country, and that country would say, oh, I have a completely different analysis from yours and this is, you know, smoke and mirrors. Well, in all fairness to those who are technical experts, they can really reduce the uncertainty to a minimal portion. And the fact that we are cross-checking and cross-referencing our own understanding—because we do have quite a few good analysts ourselves—and those produced by other reputable institutions, I think, is the best guarantee we have of producing something that is independent because that’s clearly a necessity.
MARIA DEMERTZIS: Thank you very much, President Lagarde.
Given the time, if you’ll allow me I want to move into two more things, simply because they will be discussed very much today later in different sessions. One is the international role of the euro, exchange rates and how much you can see the euro becoming more of an international currency. And the other one is the digital euro. So let me take them one by one.
CHRISTINE LAGARDE: Mmm hmm.
MARIA DEMERTZIS: There is actually going to be a session later with—Martin here has—will present a very interesting paper on the international role of the euro. If you look at the international reserves, the euro reserves internationally have been about 20 percent for the longest time. So 60 percent the dollar, 20 percent the euro. Do you think that there is a scope for the euro to take a bigger role? And, in fact, should it?
CHRISTINE LAGARDE: You know, I can’t help saying that the euro is the second international currency of reference. So 60 percent for the dollar, 20 percent for the euro, and the rest—the other 20 percent are allocated differently. You know, you’ve got sterling, Swiss francs, renminbi of course, yen. So to remain the second is something that we should acknowledge.
Can we do better? I’m sure we can. But in my humble view and with tribute to Martin Mühleisen’s paper, which is really interesting and I would concur with him on many points, there are three key attributes for a currency to become THE international currency, if you will, or one of the main—that is, more than 20 percent.
First of all, you need a large, sizeable economy. That’s what I would call the weight. It has to be solid and large. I think, you know, Europe satisfies that criteria.
The second one is the stability of all its institutions, of its economic framework, which gives predictability to those who trade and invest. You could dispute that in a few corners, but I think in the main Europe also has to offer that stability.
The third one—on which, in my view, we are short—is the depth of its financial—of its capital market. And you know, many European leaders advocated—I don’t see many European countries actually moving forward with the project of really delivering on a European capital market that would be a union capital market. So we have good markets. Let’s get it right. There’s a good capital market in Germany. There’s a good capital market in France. There’s a good capital market in all those countries. But there is no Union capital market where you can, you know, move smoothly from one to the other. And I really hope that we can achieve that.
Now, of course, what do we deal with? The rivalries between places. We deal with the rivalry between authorities that supervise those markets. We deal with political sovereignty that is often associated with a member and not with the union. But we are not helping our cause of being stronger and more powerful as a currency if we keep on dealing with a fragmented market as we do. If you talk to investors, they say that very clearly. That, in and of itself, would not be enough to make us totally efficient, and the union would have to be deeper in other respects. But the capital markets union is really an element that is missing in the three pillars that I associate with a very strong international currency. The United States has all three, no question about it.
One more point about this. There is research now that really points in the—in the direction of the relationship between trade and reserves. In other words, the more you trade in dollars, the more dollar reserves you want to have. The more you trade in euros, the more euros you generally have in your reserves. So there is a linkage between trade and reserves.
By the way, we in the euro area, we benefit from the union in that respect because about 60 [percent]—and I stand to be corrected, President, because I’m sure you have the trade numbers better than I do. I used to have them well. But about 60 percent of the trade that we conduct is actually within and between members of the euro area, and we trade in euros. We don’t trade in alternative currencies at home within the euro area. So there is a portion of our trade that is exposed to FOREX risk, but 60 percent of it is within the euro area.
MARIA DEMERTZIS: So just to be clear, then, the reason why we might want for the euro area—for the euro to become a stronger and more popular currency is because it’s going to generate more trade and therefore more wealth.
CHRISTINE LAGARDE: I don’t want to jump to conclusion. I think the observation is that the more trade you have, the more reserve you have. But it’s obvious that the stronger the currency, the easier it is. You know, when you go and visit Vietnam or when you go and try to invest in, you know, whichever country, typically the relationship ends up with how much and then in what currency and who takes the exchange risk. Well, if we have a strong currency, we can negotiate in euro rather than have to go through either the local currency of the country in which you invest or with which you trade or the dollar, which is often referred to as the currency of reference because of its role as an international currency.
MARIA DEMERTZIS: If I may pick on one of the things you said on the—on the depth of the capital markets, I think, as one missing –
CHRISTINE LAGARDE: Yeah.
MARIA DEMERTZIS:—a slight diverging a little bit of the—of the role of the currency, but the creation of the depth of markets in the euro area is something that we have been at it for some time. We have been ten years—
CHRISTINE LAGARDE: Yeah. More than ten years, yeah.
MARIA DEMERTZIS: More than ten years. What, in your view, is the one thing that we need to do next in order to really create the conditions for capital markets to develop and thrive in Europe?
CHRISTINE LAGARDE: Well, what makes the strength of the—of the US capital market is, you know, Treasury bills, Treasury bonds. This is something that we have on a scattered—in a scattered way, not in a unified way. And you know, the only instrument that I can think of which is vaguely similar to that would be the European instrument that are issued by the Commission to finance NextGenerationEU. That is—but that has been defined and agreed as an ad-hoc instrument to deal with the pandemic.
Will we go further than that? It’s not for the central bank to decide. Would it help setting up a strong capital market with depth? Of course it would.
MARIA DEMERTZIS: Thank you for that.
I’m looking at the time. I really want to talk also about one more last thing, the digital euro, this—and the—
CHRISTINE LAGARDE: Oh, we’re here for the rest of the day now.
MARIA DEMERTZIS: Exactly. I mean, first of all, I would like to commend the Atlantic Council because they have produced a wonderful database on where countries and central banks are with regards to digital currencies.
But again, talking about the euro area, I am—especially for the benefit of our audience, I am a bit puzzled why—don’t we already have a digital euro? I only pay—I never pay with cash. I only pay with digital money. What is a central bank digital currency?
CHRISTINE LAGARDE: All right. To keep it super simple, I would say that it’s a digital banknote with a little less anonymity than the paper banknote, OK, because it is issued/guaranteed by the central bank.
Am I saying that banknotes will disappear? Uh-uh. No. And, you know, that’s the beauty of Europe. You are fine paying with your plastic cards, or with your phone, or using whatever token you use. But in other countries, people are still very happy to hold bank notes in their pocket and to pay quite significant purchases with cash.
I happen to be one of those. I like—I like bank notes, I’m sorry. I use plastic cards, and my phone eventually, but yeah, there is an attachment to cash that exists in many countries. If you look from—at the moment, I think there is a referendum in Austria to argue with public opinion support against a directive by the commission to actually require that any payment north of ten thousand euros be made not in cash. Well, the Austrians are not happy with that, as I understand, because they want to be able to use cash. Now, there are multiple reasons why it is legitimate to not have those huge payments in cash, because you want traceability, you want to fight money laundering, you want to fight tax evasion, da, da, da, da, da, da.
But do you know what is the first thing that we found out when we did the first survey and sort of client testing? We found that all those who are interested in a digital euro that would be a central bank-guaranteed payment system, peer-to-peer and otherwise, they say that the one thing that we really care about is privacy.
And privacy, I think, has been—I mean there are countries in Europe which have suffered from lack of privacy, and these countries are particularly attached to their privacy. But second, I think there have been enough scandals in the last few years of companies that have collected data through payments, notably and otherwise, and that have monetized those data by selling databases, by producing artificial intelligence-produced in-depth analysis of you, me, and others. And they don’t want that.
So, you know, I think it’s—in addition to being the sort of central bank-guaranteed digital banknote, it’s also a digital payment that should be available, if people want it. You know, if Europeans don’t want it, then we shouldn’t go there. But we should be ready if they want it, because we provide the guarantee that those data will never be exploited for commercial purposes.
Whether people pay to buy their bread, or they pay to buy their cars, or what kind of medicine they purchase, what kind of frequency they go to a hospital, is none of our business as central banks. It can be the business of private sector data collectors, who happen to find out lots of interesting things about us. This is not the business of a central bank, and it should never be.
MARIA DEMERTZIS: Do you think—and also linking it to the previous question—maybe a digital euro will actually make it more popular outside the EU waters?
CHRISTINE LAGARDE: Could well be, could well be, but for that, and maybe we circle back to the Atlantic Council purpose and the trans-Atlantic relationship, and what the council has always aimed at and for. This has to be coordinated with others. We cannot—you know, a digital currency is borderless. It shouldn’t be borderline, and it should certainly cross the lines, which is why I think it should be regulated and properly supervised.
But it can facilitate cross-border payments, big way, which is why between the United States authorities, the European authorities, and others beyond that, we need to compare notes. We need to check what the imperatives are. We need to understand what is the ideal supervision and regulatory mechanism so that we have something that—you know, systems and currencies in digital form that can talk to each other, even at retail level and certainly more so at wholesale level.
So, I’m so pleased that the Atlantic Council is doing this CBDC tracker and is facilitating a dialogue between the authorities. I think it’s great. We need it.
MARIA DEMERTZIS: Absolutely.
President Lagarde, thank you very much. That’s all we have time for today. Thank you for your very frank and very clear answers, so thank you for taking the time to join us this morning.
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Image: Christine Lagarde speaks at the Frankfurt Forum Conference, IHK Frankfurt, on September 28, 2022. Copyright Stefan Krutsch Photographie.