By Luke Jeffs

Euronext hosted in January a European Markets Insights conference in Paris that considered the main factors affecting the European trading landscape in 2023.

Setting the scene for the later discussions was Jean-Claude Trichet, the chairman of the French Academy of Moral and Political Sciences for the year 2023, the honorary governor of the Banque de France and the former president of the European Central Bank.

Having led the ECB for eight years from 2003 to 2011 and through the European debt crisis that started in 2009, Trichet is perfectly positioned to comment on the current challenges facing the ECB and its counterparts in the US and beyond.

Trichet started by setting the scene, taking the delegation back to 2021 as the world’s main economies started to think about life after Covid-19 in the context of rising inflation. The US was the first to see the signs of what was to come as inflation in the world’s largest economy doubled in the early part of the year to hit 5% by the middle of 2021.

Trichet told the Euronext conference: “I consider it is not totally negligible that even after it was visible that we had the start of an inflationary episode, for a number of reasons, the authorities and the private sector thought that it was fully transitory and there was no case for being as active as possible.

“The rhetoric changed in the United States in November when the Fed said it is not transitory, there is a real issue there but the first augmentation of interest rates took place much later, five months later so we see pretty well there was a delay, which is part of the issue.”

Trichet said that the benefit of hindsight allows us to understand that many of the fiscal policies introduced by governments to support businesses and households through the pandemic had elements that were inflationary.

Central bankers wouldn’t have known this at the time because most of these measures were unprecedented which also exposed some problems with the macro-economic models they were using, Trichet added.

“It is important to understand why there was a delay because there are lessons to be taken from that. The issue is that the models are not good, the models that are utilised namely the dynamic stochastic general equilibrium models are not … capturing what is really happening.”

He said: “I experienced that myself as the president of the central bank in the time of the Great Financial Crisis when the economy was falling like a stone but the models were not suggesting that it would fall as dramatically as it was.”

Trichet continued: “There was also hesitation on the qualification of the phenomenon. Is it a pure supply-shock or is it a complex supply and demand shock? If it is a supply shock maybe it is better to go through rather than aggravating the situation through managing demand which the central banks have the instruments to do.

“Secondly there was a belief that the structural low inflation pressures would continue and it was not absurd to think that, though this is changing. The conventional wisdom at the time of the authorities and the markets was that there was no particular problem.”

Another issue, according to Trichet, is that central banks were faced in 2021 with the twin challenges of unwinding the programmes they had introduced to support their economies through Covid against the backdrop of rising inflation.

Trichet said: “It is always difficult to engage in a U-turn when you had promised the market that you will continue to do something for a long period of time whatever happens. Forward guidance was useful in times of deflationary pressures but when you have to change course, the U-turn is difficult.”

The Federal Reserve, for example, issued in 2020 forward guidance that it would not increase rates until the signs were that the US economy had seen off the worst of the pandemic and was moving towards the Fed’s monetary objectives, including maximum employment.

Trichet told the delegation: “There was additional delay due to the link set up by forward guidance between conventional monetary policy on one hand and non-conventional monetary policy on the other. All major central banks said we will increase rates only when we interrupt our net purchases of tradeable securities.

“I was not in agreement with this idea of creating a close link, a correlation between the conventional and non-conventional. My own perception was that you had conventional on the one hand and that was very important, but the conventional should not depend on the non-conventional and the reverse would also be a mistake.”

Coming up to date, Trichet said the outlook for Europe at the start of 2023 is mixed. “Firstly, we live in an environment that is extremely uncertain. There is war in Europe and it looks like it will last a long time now. We also have tensions in the rest of the world and, from time-to-time, they become very tense. The negative impact on confidence is generalised in this environment.”

He added: “The risk of financial disruption remains quite elevated. We know that in the non-bank financial institutions there are elements that are much more vulnerable than we see with the banks. And this is for simple reasons – a lot has been done with the banks after the great financial crisis but we cannot say the same in the non-bank universe.”

Regulators are currently focusing on non-bank institutions. The Bank of England said in November it is looking at the counterparty risk associated with highly leveraged positions held by non-bank firms such as funds.

Trichet continued: “I would mention also as concluding remarks, there is a number of contradictions between monetary and fiscal policies at the moment. Normally fiscal policy should not contradict monetary policy.”

Much has been made of the fact that governments are still running programmes to support businesses and households through the current energy crisis while central banks are raising rates to control inflation.

Trichet said: “Continuing to be extremely accommodating in fiscal policy when the central banks on both sides of the Atlantic have changed their courses of action is something that is not appropriate of course.

“In Europe, all the fiscal support that has been given to the European economies is unfortunately much more untargeted than targeted. The figure for 2022 is that we have non-targeted fiscal support for households of 53% of this support, non-targeted fiscal support for firms 37% and targeted support for low income households only 10%. This is very abnormal.”

Trichet said that, while there are parallels, Europe and the ECB find themselves in a different situation to the US where inflation has been falling for months now. Europe is “much more affected”, Trichet said.

The central banker continued: “This justifies that the ECB is more cautious because part of the job that it has to do has been done by the situation, by the fact that energy and food are touching us much more than they are touching the US.”

But, looking ahead, Trichet told the Euronext delegation he sees some normalisation of inflation and rates over time. “Apart from food and energy, both the US and Europe have relatively high levels of inflation so 2.5x the 2% target of inflation. I think it is important that the two central banks have said that they maintain their target in the medium term and we will go down to 2% in the medium term which I interpret as over three years. It seems that the market stands ready to trust the central banks on that promise,” Trichet concluded.