France’s central bank head has warned that the recent turmoil in the UK’s bond markets illustrates the “vicious loop” governments face if they undermine efforts by rate-setters to curb soaring inflation.
François Villeroy de Galhau, who sits on the European Central Bank’s rate-setting governing council, said in an interview that the sharp rise in the British government’s cost of borrowing after it unveiled £45bn worth of unfunded tax cuts last month highlighted the importance of “a consistent policy mix” between central banks and lawmakers.
Underlining the risks of fiscal expansion at a time of rapidly rising interest rates, the Banque de France governor said: “If you have a monetary policy with an anti-inflationary stance and there are doubts about whether your fiscal policy will fuel inflation, then you really risk nurturing a vicious loop.”
The sell-off in gilts forced the Bank of England to intervene to halt the collapse of parts of the UK’s pensions industry, which the Banque de France governor cautioned was the latest example of the non-bank financial sector’s vulnerability to cash crunches.
He urged global regulators at the Financial Stability Board to “deliver now on clearer and stricter rules” to ensure funds and traders build up stronger liquidity buffers. “We need more data and in each jurisdiction we need some kind of liquidity stress testing,” he said.
Comparing the UK turmoil with the money market fund panic after the Covid-19 pandemic hit in 2020 and a collateral shortage at energy traders after Russia invaded Ukraine in February, Villeroy said: “They have one thing in common and it is about the liquidity of non-banks.”
The UK government concluded an about-turn on Monday after new chancellor Jeremy Hunt announced he would ditch two-thirds of the tax cuts announced by his predecessor Kwasi Kwarteng, who was sacked on Friday.
Laughing with disbelief at recent events in the UK, which he said had dominated the IMF and World Bank annual meetings in Washington last week, Villeroy declined to comment on the specifics of the UK case but said he did not anticipate major euro area governments repeating the mistake.
While governments in the currency bloc are yet to encounter the turmoil seen in the UK over recent weeks, they are spending big to cushion the blow of surging energy prices on businesses and households. Economists, including those at the IMF, believe the energy packages raise the risk high inflation becomes entrenched.
Villeroy said the measures were “understandable”, however. France’s energy price cap, which has limited electricity price increases at 4 per cent this year and frozen domestic gas prices, had helped to keep inflation at a more manageable 6.2 per cent — the lowest in the eurozone — up until now. “As far as these measures remain targeted and temporary — and time will tell — they are rather helpful.”
The ECB raised rates by 1.25 percentage points over the summer to combat record-high inflation of 10 per cent — five times its 2 per cent goal — and is set to increase its deposit rate by 0.75 percentage points to 1.5 per cent next Thursday.
France’s president, Emmanuel Macron, told Les Echos in an interview published on Monday that he was concerned by the view that demand needed to “be shattered” through aggressive monetary tightening “to better contain inflation”.
Villeroy declined to comment on Macron’s concerns. But he expressed irritation at the idea the ECB risked pushing the economy into recession, saying this “misses the point”. The “predominant” risk was not higher rates, but the energy crisis.
The ECB would continue to “go quickly” until its deposit rate reached 2 per cent — the so-called neutral rate of interest at which it neither stimulates nor restricts the economy — at the end of the year. Any increases beyond that point would be at “a more flexible and slower pace”, he said.
The ECB aims to start shrinking the €9tn balance sheet that ballooned during the pandemic once rates are at neutral. Villeroy said from the end of this year the bank could stop replacing some of the bonds maturing under its €3.26tn asset purchase programme.
Before that, private lenders should be encouraged to repay the €2.1tn of ultra-cheap loans made by the ECB under its targeted longer-term refinancing operations (Tltro), he said.
The Tltros were designed to encourage lenders to keep lending during the pandemic by providing them with financing at minus 1 per cent. However, rising rates mean lenders are now in line for a risk-free profit of more than €25bn.
Shrinking the balance sheet would be handled with care, he said. “Let us start clearly but cautiously, and then accelerate gradually.”