Fiscal deficit concerns overblown, not out of control: Banque de France deputy governor

By Harry Wu, 21st Century Business Herald, SFC

In the 1970s, two oil crises swept through the United States, Europe and other economies. Soaring oil prices pushed many economies into the stagflation trap of high inflation and high unemployment. Faced with supply shocks, monetary policy in many parts of the world failed to adjust course in time, and inflation expectations became unanchored.

About half a century later, although the COVID-19 pandemic and the Russia-Ukraine conflict triggered another inflation storm, the crisis did not repeat itself. Agnès Bénassy-Quéré, Deputy Governor of the Banque de France (the French central bank), said in an interview with 21st Century Business Herald at the 2026 Bund Summit that inflation in the past cycle rose very fast but then receded very fast with limited impact on the real economy. This is a good example showing that the disinflation process owed much to central bank credibility—well-anchored inflation expectations greatly helped the central bank cope with inflation.

From the two oil crises to the COVID-19 shock, and now to renewed inflation concerns arising from the Middle East conflict, supply shocks have not gone away. Bénassy-Quéré acknowledged that policymakers today are not dealing with a demand shock but with successive supply shocks. As a result, the mix of fiscal and monetary policy is harder to coordinate, and the two can more easily get in each other’s way.

In her view, under a supply shock, inflation rises while output falls. Monetary policy tightens because of inflation, while fiscal policy tries to support households and firms that have lost purchasing power because of the energy crisis and other shocks. If fiscal support affects aggregate demand too much, it will push up prices and make the job of monetary policy harder. She stressed that fiscal policy should follow the “TTT” principle—Temporary, Targeted and Timely—precisely affecting specific households or firms without making the job of monetary policy harder.

As for the current new round of inflation pressure, Bénassy-Quéré believes that as long as inflation expectations are well anchored and second-round effects are not evident, monetary policy may delay tightening and try to look through a temporary shock. But this requires strong credibility and depends on what fiscal policy is doing. She also warned that if supply shocks such as geopolitical tensions and extreme weather keep piling up, inflation volatility may increase. Even if the average reaches the 2% target, household and firm expectations may become less anchored, and the central bank needs to pay attention to the stability of expectations.

The lessons of the two oil crises of the 1970s are still vivid: once inflation expectations become unanchored, recalibrating policy costs more. Today, as supply shocks arrive one after another, the real test is no longer whether a single shock can be handled, but whether fiscal and monetary policy can stay within their respective boundaries amid overlapping shocks and jointly safeguard policy credibility. 

The policy-mix logic behind “TTT”

Bénassy-Quéré once served as chief economist at the French Ministry of Finance and now works at the French central bank. This “finance ministry–central bank” dual perspective makes her especially attuned to the coordination of the policy mix.

The mix of fiscal and monetary policy has traditionally been seen as a means of responding to demand shocks. Monetary policy affects aggregate demand, and fiscal policy also affects aggregate demand in different ways. The core question is: what is the best mix when there is a positive or negative shock?

With the current succession of supply shocks, it is much harder to respond, and monetary and fiscal policy may come into conflict. Monetary policy tightens because of inflation, while fiscal policy tries to support households and firms that have lost some purchasing power because of supply shocks such as the energy crisis.

The mechanism of this conflict is that while fiscal policy supports households, it also exerts upward pressure on prices, making the job of monetary policy harder. Bénassy-Quéré believes that, for this reason, there is now a consensus: under this kind of negative supply shock, fiscal policy should follow the “TTT” principle—Temporary, Targeted and Timely.

She further explained that the “TTT” principle means having a very precise impact on certain households or firms without affecting aggregate demand and without making the job of monetary policy harder. Fiscal support is not off the table, but it must be precise, limited and temporary, avoiding turning support for those hurt into broad-based stimulus.

On monetary policy, her thinking is that as long as inflation expectations are well anchored and second-round inflation effects are not evident, tightening may be delayed and the central bank may try to look through the shock. The shock is temporary, but this requires strong policy credibility, so that everyone believes inflation will return to target; it also depends on what fiscal policy is doing.

Building the foundation of central bank credibility

Fiscal policy following the “TTT” principle can create room for monetary policy, but whether the central bank can truly look through a temporary shock still depends on whether inflation expectations are anchored and whether central bank credibility is sufficient. Bénassy-Quéré used the European Central Bank’s post-COVID experience to illustrate the important role credibility played in the inflation process.

She believes that the ECB’s post-COVID experience was actually quite good. The ECB began tightening somewhat later than other central banks, but she does not think this mattered much. Following monetary tightening, the disinflation process was fast. Above all, it had limited negative impact on the real economy, showing how central bank credibility – well-anchored inflation expectations – can greatly help the central bank to cope with inflation.

The initial phase of the disinflation process was related to energy price decline, but she stressed that the cooling in the second part did owe to monetary policy and its credibility: interest rates were tightened sharply by 450 basis points in just a few months, and had the expected, delayed effect on inflation; they could then be eased relatively quickly because disinflation had taken hold.

Now the energy price shock is recurring on a smaller scale, and credibility is still helping the central bank bring inflation down. No second-round effects have yet been seen. But she warned that looking ahead, the problem is that if such supply shocks keep piling up—for example, geopolitical pressures, climate change and extreme weather events—inflation volatility may increase.

Even if average inflation may reach the ECB’s 2% target, if volatility is high, household and firm expectations may become less anchored. This means the central bank cannot be satisfied merely with hitting the target on average; it must also pay attention to the stability of expectations amid volatility.

On the modeling side, she said the Banque de France has a New Keynesian model for simulating monetary policy and couples it with a general equilibrium model that includes the energy sector, so that shocks such as climate change or the transition can be translated into cost-push shocks, productivity shocks and other shocks that the New Keynesian model can understand.

She pointed out that in doing so, they found some limitations of the standard New Keynesian framework, especially regarding forward-lookingness. In the New Keynesian framework, households and firms have perfect foresight and know what will happen. If there is a climate-related cost-push shock that weakens capital accumulation or productivity growth, people will expect long-run GDP to be somewhat lower, but under perfect foresight this would cause consumption to fall today, hence inflation to initially decline, which is sometimes unrealistic. For example, after a permanent increase in energy prices, a standard New Keynesian model sometimes simulates lower inflation, which is inconsistent with recent reality. Therefore, the model must be improved by limiting its forward-lookingness.

On communication, she analyzed the theoretical power and practical limits of forward guidance. In theory, statements about monetary policy five years out have effects today; forward guidance works through expectations and has a very powerful effect on today’s inflation. But the literature has shown that this is not how it works in practice—this is the so-called forward guidance puzzle. ECB President Lagarde has proposed the idea of framework guidance: rather than communicating future monetary policy, communicate the central bank’s reaction function. Some work by the Banque de France shows that market expectations of the central bank’s reaction function are fairly stable.

She also noted that the ECB now publishes scenario analysis, with a main scenario and different scenarios corresponding to different percentiles of the futures oil and gas markets. Different scenarios help guide the market in judging where it stands relative to the forecast and allow range adjustments to the forecast when needed.

On measuring expectations, she reminded that a distinction should be made between market expectations and household and firm surveys. Market expectations can be measured with indicators such as forward rates. Household and business surveys are relatively accurate for short-term expectations but are not necessarily reliable for the long term; they often simply parrot the central bank’s target. Households typically overestimate inflation because they give greater weight to items with higher inflation, such as food and energy. When food or energy prices surge, inflation expectations also surge; when inflation returns to the 2% target, expected inflation remains at a relatively high level—lower, but still above the level before the energy price surge.

She further pointed out that this has two implications. First, the central bank needs to be careful when talking about core inflation, because core inflation excludes this effect, while the central bank’s long-term target is headline inflation. Second, the surveys reveal that, because of the influence of salient prices, consumers tend to underestimate their purchasing power, because they overestimate inflation and also underestimate nominal income growth. The survey results are striking: when people were asked whether their nominal income increased between 2020 and 2025, most said no, even those with indexed income. This is a perception problem—when there is inflation, people tend not to perceive increases in nominal income, but perceive a higher inflation rate than statistical agencies actually calculate, and the result is an underestimation of purchasing power.

This underestimation of purchasing power will lead to weak consumption, and weak consumption will dampen inflation. She believes the central bank needs to anticipate this effect because monetary policy acts with a lag of about 18 months; because of these perception effects, the savings rate may rise after an inflation spike, which will push inflation down.

Deficit is not out of control

Recently, government bond yields have surged in many countries, especially long-term government bond yields, which also poses a real constraint on monetary and fiscal policy.

Bénassy-Quéré said bond yields are rising everywhere, partly because of the energy crisis, but only partly. In addition to government bond issuance, private-sector bond issuance has also increased sharply. These hyperscalers are raising funds not only in the dollar market but also in bond markets in Europe and other countries; in effect, they are borrowing long-term funds in Europe. There are also structural factors, such as the shift of pension funds from defined benefit to defined contribution, which reduces demand for ultra-long bonds. The AI investment boom is inflationary in the short term, and its long-term impact on inflation is still uncertain, but these hyperscalers will issue a large amount of long-term bonds in the future, with a notable impact on market rates and long-term rates.

Rising long-term interest rates will gradually increase interest costs for countries. She gave the example of France, where the increase in interest costs will be equivalent to 0.3% of GDP in 2026 and is expected to increase by another 0.3% in 2027. However, this is gradual because the average maturity of debt is more than eight years, so the impact is not immediate. But it means the government needs to make a larger structural adjustment to adjust the overall deficit.

She stressed that this is true worldwide, and debt levels are already high, which means some governments will have less room for maneuver in responding to future shocks. Rising long-term interest rates are not an abstract financial market change; they will gradually squeeze the fiscal space available when the next shock hits. 

Turning to France’s fiscal deficit, she believes caution is needed but there is no need to panic, as explained by the Governor of the Banque de France, Emmanuel Moulin. On the one hand, France has the willingness to adjust, and the government has committed to reducing the deficit; on closer inspection, this is feasible, and France has succeeded in doing so before. On the other hand, the French economy is relatively resilient and diversified; although growth is not very high, it is resilient to shocks. 

But she also warned that the deficit must be handled carefully, because cutting spending, raising taxes, or both will have a negative impact on the economy. Therefore, deficit reduction cannot be done overnight; it requires a credible path and a coherent government. Of course, one cannot expect all politicians before an election to understand and make statements about how to cut spending and raise taxes; they will try to avoid the issue because they know it will not win many votes. This is also the reality of political campaigns.

Looking ahead, she is not pessimistic: although France’s fiscal deficit problem is worrying, it is not out of control and can be solved. The priority is to pass the 2027 budget, which is extremely important, then enter the election, after which the dust will settle and reality will be presented to the elected French president.

The fiscal deficit is not out of control, but the bond market’s alarm cannot be ignored: the earlier a policy adjustment is made, the less future action will have to be rushed and reactive.