Europe is under high tension. The war in Ukraine is raging in full force. Governments are taking emergency measures to protect citizens from skyrocketing energy prices. Meanwhile, inflation continues to rise. In the eurozone, it was 10 percent on an annual basis last month, it was announced on Friday. In the Netherlands inflation is extremely high at 17.1 percent . That puts the European Central Bank (ECB), which must keep prices stable in the eurozone, under heavy pressure to tame inflation. And so interest rates, which have been negative for years, have been hastily raised since this summer. Higher interest rates curb consumption and investment – ​​and so ultimately price increases should slow down. The big question within the 25-member Governing Council of the ECB is how far interest rates should rise. The Frenchman François Villeroy de Galhau is one of the most influential members of that board. The governor of the Banque de France, the French central bank, enforces authority in the boardroom in Frankfurt. And not just because he comes from the second largest euro country. His methodical way of arguing and his independent positions also make Villeroy someone to be listened to in the ECB tower. His flexible manners and his cheerful character help in this regard. In decisive moments, Villeroy recently voted in favor of tightening the ECB’s monetary policy. For a long time, this was characterized by ultra-low interest rates, a reflection of inflation that had been very low for a long time. With his positions, the Frenchman is often an ally of Klaas Knot, his Dutch counterpart. Within the ECB board, the president of De Nederlandsche Bank is regarded as a ‘hawk’, a central banker who advocates tight monetary policy and therefore higher interest rates. Their counterparts, the ‘pigeons’, are in favor of looser monetary policy. NRC spoke to Villeroy, who visited Amsterdam for a conference last week, in the office of De Nederlandsche Bank. There he consulted with Knot. European citizens are very concerned about inflation. Many people wonder: is the ECB still in control of inflation? “It is indeed the main concern of the citizens, including ours. Our mandate is to ensure price stability. We must and will reduce inflation to 2 percent within the next two or three years. “And do we have it in hand? We need to look at the nature of inflation in Europe. About half of this is due to price increases of energy and raw materials. If no new shocks materialize, hopefully this part of inflation will be close to its peak and will gradually subside. We’ve already seen that happen with oil prices, and we’ll probably see it in the next few quarters for other energy sources. This part of inflation is outside the sphere of influence of monetary policy. The other half is core inflation, the inflation rate without energy and food.” This last figure, ie adjusted for volatile energy and food prices, is an important indicator for the ECB. It shows underlying inflation and says something about consumer demand for goods and services. Villeroy: “That [core inflation] is far too widespread and too high, about 4.8 percent for the euro area. This part of inflation is our responsibility as a central bank. That is why we are raising the interest rate. And we will do whatever it takes to bring core inflation in line with our 2 percent target.” Also read: Central banks are showing their teeth in the fight against inflation Compared to other central banks, the ECB was slow to act. The central bank gradually stopped buying government and corporate bonds between December last year and June this year, thereby pushing down long-term interest rates. And from July, short-term interest rates for banks went up. The ECB rate that is now most important, the deposit rate, went from minus 0.5 percent in July to plus 0.75 percent in September. Further rate hikes are in the offing. The US Federal Reserve (‘Fed’) has already raised its key rate above 3 percent. The Fed expects interest rates of more than 4 percent by the end of this year. Critics say the ECB started raising interest rates too late and was also late in analyzing that inflation was not temporary, but structural. “No, this is not specific to the ECB. What happened worldwide, including in the US, is that inflation was unexpectedly much higher than expected. This has two causes: the strength of the recovery last year after corona and the war in Ukraine. It is true that the inflation estimates were wrong, but no one saw this unprecedented build-up of shocks coming. “When we saw core inflation in Europe rise above 2 percent, it was clear that we had to act. And we did. People may have forgotten that in December last year we decided to stop the emergency loan purchases due to the corona pandemic. That was a very important step. We stopped the last remaining buyback programs in June. And in July we had the first rate hike.” No one saw this unprecedented buildup of shocks coming But the ECB was relatively late with the first rate hike, compared to the Fed, for example. “Yes, but the nature of inflation is not the same on both sides of the Atlantic. The headline inflation rate in the US is now somewhat lower than in the euro area, but core inflation in the US is higher. And the US job market is tighter, putting pressure on wages higher. We are definitely moving in the same direction in Europe, but not necessarily at the same speed and towards the same interest rate level.” France has an inflation rate that fell to 6.2 percent in September, while the Netherlands is at 17.1 percent and still sees inflation rising. Where do these big differences come from? And does that make it more difficult for the ECB to conduct unambiguous monetary policy? “The main explanation is the timing and effectiveness of the fiscal measures that governments are taking to tackle the energy crisis. France was previously with a price cap on gas and electricity for households, and with discounts on fuel prices. That is now happening in the Netherlands, and also in Germany. I therefore assume that these inflation differentials diminish over time. In any case, we are basing ourselves on inflation in the euro area as a whole and therefore do not look at national differences in monetary policy.” This raises the question of how far interest rates in the eurozone will rise. Many market participants assume that the ECB will raise interest rates by at least 0.5 percent in October – and perhaps even by 0.75, as happened in September. But where do those increases stop? In the discussion about this, ECB board members are focusing on the ‘neutral interest rate’, an interest rate level that neither slows down nor boosts the economy. Once that neutral interest rate has been reached, the central bank can still choose to raise interest rates to further slow down the economy. How high should the next rate hike be and what is the neutral level of interest rates in the eurozone? “I think open speculation about the next interest rate step is premature and too limited. We will make a decision at the meeting on 27 October, which will include looking at the financial conditions for businesses and households. These have recently become less favorable due to negative developments in the markets.” Villeroy is referring to rising market interest rates. “Instead of looking at the upcoming interest rate step, it is better to use the neutral rate as a benchmark. That is impossible to determine precisely, but my estimate is that it is below or close to 2 percent in the eurozone. We should go there without hesitation, by the end of the year. Then we can start the second phase, which is a bit more flexible and possibly also a bit slower. I’m not saying that rate hikes will stop there, but we need to look closely at how inflation and the economic outlook develop.” Photo Bruno Levy The main interest rate at the moment, the deposit rate, is 0.75 percent. This means that the ECB’s policy is still ‘accommodative’: it is not the brake you would like to have on inflation. In fact, the ECB is still boosting the economy. “We are shifting the course very quickly and very significantly. We raised interest rates by 0.5 percentage point in July and by another 0.75 in September. Those are no longer small steps. But even then it is very important to remain orderly and predictable. That way you don’t surprise markets, and you don’t make the financial conditions for households and companies too tight too quickly.” If you, as a central bank, want to reduce economic demand to combat inflation, are you consciously aiming for a recession? And does this mean unemployment will rise? “Fortunately, unemployment in Europe is now quite favourable. Especially in the Netherlands, but also in many other countries, unemployment is at a historically low level. We cannot rule out a recession for the euro area, but we are not counting on it either. Rather, we expect a significant slowdown in growth. Our goal is not to trigger a recession, it is our goal to return to 2 percent inflation.” How would you describe your own position within the board, on the scale from dove to hawk? “I don’t like this ornithological scale. If I have to give a definition, I see myself mainly as a pragmatist. I sometimes read that ‘the hawks have taken over power in the board’. I don’t recognize that. The situation has changed, we have to adapt monetary policy to rising inflation, but no one should follow an ideologically pre-programmed path. As good old Keynes said, when circumstances change, I change my mind.” Dove or hawk? I don’t like this ornithological scale, I see myself mainly as a pragmatist The current juncture, with high inflation and energy prices, leads to complex considerations for governments. They also see inflation as a major problem and want to compensate citizens for the increased cost of living. But that carries the risk that this support will further fuel inflation. In the United Kingdom, this led to an unprecedented clash last week between the fiscal policy of the Truss administration and the monetary policy of the British central bank. The support that the government wanted to give the population went hand in hand with tax cuts. As a result, investors lost confidence in the financeability of the British government debt. The Bank of England had to step in to prevent government debt rates from rising too fast. And that while the central bank is also raising interest rates with a view to inflation. Also read: Pound crisis is not exclusively British What can the eurozone learn from what is happening in the UK now? “It is mainly about the way in which it is operated. You should not pile uncertainty on top of other uncertainties, especially in the very turbulent environment in which we now live. You must maintain a predictable monetary and budgetary course. “Second, if monetary policy focuses on fighting inflation and fiscal policy carries the risk of fueling it, you can create a vicious circle. So you have to organize trust between monetary and fiscal authorities. In this case, confidence was damaged by undue criticism of the Bank of England.” He is referring to Truss’s criticism of the central bank’s loose money policy during her campaign to become prime minister. In the eurozone, governments also help citizens to pay their energy bills. On the other hand, the ECB is trying to curb inflation. How is that different from the British situation? “I would distinguish between targeted and temporary measures in this energy crisis, aimed at households and small and medium-sized enterprises, and permanent higher spending or tax cuts. The latter increase budget deficits in the long run. In the case of the United Kingdom, the markets apparently reacted much more to the structural measures.” And do you not see that permanent higher expenditure anywhere in the budgetary policies of euro countries? “Not yet. But we must remain vigilant. Let me put it this way: Europe must show boldness with reforms that boost economic growth, but this cannot be tantamount to lazy and unjust tax cuts.” Resume Distinguished Family François Villeroy de Galhau (Strasbourg, 1959) has been governor of the Banque de France, the French central bank, since 2015 . He attended the prestigious ENA administrative school and initially made a career with the French government. He was, among other things, chief of staff to Secretary of the Treasury Dominique Strauss-Kahn and headed the tax authorities. Between 2003 and 2015, he worked in the private sector, including as operational director of the bank BNP Paribas. The descendant of a distinguished family with roots in Lorraine and the Saarland, he speaks fluent German. One of Villeroy’s ancestors founded the porcelain and ceramics firm Villeroy & Boch in 1836, in which his family still owns shares.