By Elwin de Groot, head of macro strategy at Rabobank
And now the end [to monetary tightening] is near … And so I face that final curtain …
My friend I'll say it clear … I'll state my case, of which I'm certain [– Christine Lagarde]
As we head into the weekend and gold prices just reached their highest level ever and the euro has slipped below 1.07 for the first time since November last year (perhaps also as some market participants worry about an imminent attack on Israel by Iran or its proxies), we may conclude that this week has proved to be the final nail in the coffin of synchronized central bank policy actions.
Not so long ago ‘June’ appeared to be the month for the two major global central banks. But in the last few weeks the Fed got it’s ‘itchy fingers’ slapped by stronger-than-expected labor market and sticky (services) CPI data. It is now fairly clear that ‘June’ is no longer the month of truth for the Fed, as our own Philip Marey explained earlier this week in his post Fed-minutes comment – we have moved the goalpost for the Fed to September. The Fed’s Collins said yesterday at an event in New York that recent data had eased concerns about “an imminent need” to adjust interest rates. Well, that’s one way to say it! WSJ’s Nick Timiraos put it more starkly, noting that that “Fed Rate Cuts Are Now a Matter of If, Not When”, which kind of captures the sentiment.
But over to Europe then, where the ECB yesterday gave some strong hints that a June cut is forthcoming. Although persistent price pressures in services remain somewhat of a concern, this doesn’t appear to be in the way of a first cut at the next policy meeting. As we explain here, the Council seems to have made up its mind now that i) the data (in the form of a weak economy and disinflationary forces) have continued to move in the right direction and that ii) a few cuts (let’s start with one) would still keep policy sufficiently restrictive so as to not derail the disinflation process. Despite its mantra of ‘data dependence’ and inflation not having reached its target yet, the Council seems pretty convinced that a cut would be appropriate. “We will not wait for everything to be 2% before we cut”, captures the idea that ECB is now more concerned of falling behind the curve at some point than making an policy error by easing too quickly and sustaining the stickiness services inflation and/or tightness in the labor market. But by emphasizing its data dependence and that it is not pre-committing to any kind of easing trajectory, it probably believes that it can keep the risk of that second scenario materializing at an acceptable level.
But what of course stands out from this development is that the ECB has increasing confidence that it can go its own (European) way. Some observers, including ourselves, note it is a great opportunity for the ECB to demonstrate its ‘independence’, by taking the lead instead of being influenced by what is happening in the US. This shouldn’t be an issue if there is a more fundamental gap opening up between the Eurozone and the US that -indeed- warrants an independent and divergent policy stance. The biggest risk is actually when this perceived gap is not ‘structural’ but sufficiently persistent to push both central banks in different directions when actually that is not really warranted.
A weakening of the Euro on the back of this divergence could of course warrant a slower easing cycle on the part of the ECB at some point. But, to be fair, any model will tell you that you need a pretty significant drop in the euro before this has a material impact on inflation. As a rule of thumb, a 1% drop in EUR/USD – associated with a 0.5% drop in the effective exchange rate – would raise domestic inflation by 0.05% in the first year and 0.15% after three years. Conversely, one could even argue that higher US rates could spill over to Europe dampening the effectiveness of ECB easing and thus warranting even a slightly faster cutting cycle.
But the biggest risk, arguably, is that the ECB simply has it wrong on fundamental grounds. That (global) inflationary forces are more persistent (or will return with a vengeance) and that the recent US inflation data are a harbinger of global trends rather than some statistical aberration. On that note, it is interesting to point out that Ms. Lagarde yesterday clearly did not want to be drawn too much into a comparative analysis between Europe and the US, although she noted that the ‘nature’ of US inflation was different from the perspective of fiscal stimulus and investment (more of both in the US). While that may be true, we would also argue that most of the disinflation so far has come from (global) ‘supply-driven’ factors: lower energy prices, lower tradable goods inflation and (more recently) lower food prices. Not services inflation! And there is obviously a parallel with the US data, albeit, perhaps, on a different level and persistence. So although the ECB is increasingly confident that it can diverge from the Fed – since its domestic data and trends take precedence over global developments – it is actually on the domestic inflation front where that divergence is the least convincing!
Turning briefly to another ‘front’, namely the geopolitical, we also observe a hardening stance from all the parties involved, but in Europe this comes with, well, European characteristics. This week we saw both the release of a 700+ European Commission report on ‘state-induced distortions in China’s economy’, a report that will likely open the door to far more EU trade actions against China, and subsidies to counteract it. This immediately drew a stinging rebuke from China, which “strongly opposes the European Commission’s subjective, one-sided and erroneous assessment of China’s socialist market economy to create an excuse for its discriminatory anti-dumping practices”, the Ministry of Commerce said, according to Xinhua news. A German Kiel Institute report released recently notes that “[…] even according to a very conservative estimate, counting only the more easily quantifiable subsidy instruments, industrial subsidies add up to about Euro 221 bn or 1.73% of Chinese GDP in 2019.” This contrasts with some 0.4-0.7% in most other economies with which it compares China.
That said, we should also mention the recent visit by German Chancellor Scholz to China and now also Italian PM Meloni planning to visit Beijing to strengthen economic/trade ties after ditching Italy’s support for China’s Belt and Road initiative.
Meanwhile, the Commission also published a discussion paper on the economic impact of defense spending, arguably, to stimulate and support the discussion of how to do this in the most effective way. It notes that “[…] the literature on the existence of a causal relationship between defence spending and economic growth is not unanimous. Although favourable impacts are more frequently reported in advanced economies than in less developed ones, the outcomes are dependent on the time horizon and on the methodology used.”
More signs of the hardening stance came via German defense minister Boris Pistorius, who warned yesterday that Europe should prepare for a Russian attack as he compared Russia invasion of Ukraine to Hitler’s annexation of Czechoslovak territory in 1938. Last week Pistorius called for easing Germany’s debt rules.
It’s hard to summarize all this into a single sentence. Is it strategic ambiguity? Perhaps, but it is definitely the European Way…
