A big week for central banks worldwide
Monetary policy is taking center-stage amid concerning inflation numbers - and will be in the spotlight for the weeks to come
Woah! This was a rather big week for central banks. We saw once again how essential central banking communication today is and how it steers markets and expectations in one direction or the other. The week had two main acts – the historic Federal Reserve Press Conference with the first 0.5 interest rate increase since 2000 amid concerning US inflation data; and the heated arena of ongoing discussions and comments by leading European central bankers on how the ECB should move in the coming months. The first one started as expected but then got an unexpectedly nasty turn, while the European act was a dynamic back-and-forth of comments, which left us not much wiser than a week before. Let’s explore each of them to see what we are in for in the coming months.
The Wednesday press conference by the US Fed was highly anticipated. The opening sentences of the introductory statement by Chair Powell put a clear focus: We know and hear the suffering of American people from heightened inflation. It is interesting that this was also the opening sentence of Isabel Schnabel’s interview, discussed below. It is an important pivot since the public sees some economists as being too numb to the pain and hardship that heightened inflation is causing to households, even more so about the worries it causes over possible future price increases. I think the Federal Reserve is doing well in using all its social media to convey this message. A journalist asked me this week whether central banks are losing credibility if they admit inflation became much too high; I believe they actually gain credibility if they are humble and admit to developments that are not in line with their previous expectations, but are broadly out of their control (such as the terrible geopolitical situation). So this message on the Federal Reserve twitter page was a constructive one:
The Federal Reserve raised interest rates by 50 basis points for the first time since 2000 and flagged that similar moves were on the table for June and July, as well as some specifics on the beginning of Quantitative Tightening (QT). Chair Powell guided the FOMC press conference on Wednesday pretty much as expected and managed very well to come out of difficult questions. Most importantly, he pushed back against a larger 75-basis point increase for the coming meetings. Stocks rejoiced on that assurance and this dovish tone. Markets ended in the positive and many commentators were quite astounded of this fact given that we were just given the most aggressive rate increase in 22 years.
By neglecting the possibility of a 75-basis points hike, at first it seemed Powell managed to persuade market participants of the soft-landing scenario and that the Fed will not push the economy into a recession. However on Thursday, markets imploded in a cataclysmic fashion. The S&P 500 Index lost 3.6%, while Nasdaq 100 dropped 5.1%, the most since September 2020. This turn-around was explained with the market angst that the Fed is not serious enough about calming down inflation if that would require too much damage to employment. The story goes that Chair Powell is not willing to risk the economy and is not going to go full hawky hawk if needed. The bearish bet is therefore that inflation will spiral out of hand. It is popular especially in financial circles. This was further spurred by comments such as the one by Jamie Dimon that the Federal Reserve is too late to the party and much behind the curve.
However I prefer this nice story reported by Nick Timiraos from Bloomberg. It was the Hoover Monetary Policy Conference on Friday and the Fed was the main point of discussion. Ex-Vice Chair Randy Quarles was asked whether he thinks the Fed will not be able to stomach a rapid increase in unemployment if that is needed for inflation to calm down. He told a rather long story about the Eccles building of the Fed Board, a security guard and a piece of art, which you can read for yourself. The morale of the story boils down to this - everybody remembers Fed Chair Arthur Burns because he is perceived as the Chair who lost control of inflation in the 70s. No Fed Chair wants to go down in history like this. So Chair Powell will do whatever necessary not to let inflation spiral out of control. I can definitely believe this story - and it will be put to the test in the months to come.
And a short wink to team transitory - the FOMC press conference was in person for the first time in two years. A symbolic reminder that the unusual circumstances through which we have lived since March 2020 are hopefully receding, we hope forever.
Things were not easier in Europe this week. Wednesday and Thursday brought attention back to the upcoming big decision days for the ECB Governing Council meetings on the 9. June (to take place in the Netherlands) and 21. July. A feast of central bank interventions started with Isabel Schnabel’s interview with Handelsblatt, taking a more hawkish tone than before to state clearly what is on the mind of many German speaking commentators. A pointed statement that the ECB does not only need to recognize heightened inflation and talk about it, but needs to show already its willingness to fight it by acting:
Schnabel seems to have positioned herself clearly on the side of a July interest rate increase. Her main arguments are clear and hold true - the central bank is risking a lot if inflation expectations de-anchor in the Euro area. The ECB will then need to act more aggressively ex-post if that happens, and would therefore need to inflict more pain to the economy than if it acts timely. We are not at de-anchoring yet, but it is clear how much attention inflation is gaining for the European public - news begin almost daily with the inflation numbers and policy discussions on measures how to handle them. The graph below shows how Google searches in Germany for the word inflation compare in the last 5 years and is pretty self-explaining. Doom-and-gloom experts rejoice in making grandiose assertions how they foresaw these developments for years. We should therefore not underestimate this situation and how it might change the public perception of the central bank and its credibility to calm inflation down. In the end, much of the power of central banks stem from their credibility. So if the European public is losing faith in the decisiveness of the ECB to fight inflation, this is a problem on its own, no matter whether it is fundamentally true or not. The ECB might therefore be forced to act sooner or later and it is a powerful argument that given you will need to act, it is better to do it soon.
On Thursday, one of the more dovish GC members Fabio Panetta came up with his view in La Stampa, and it could not have been more contrasting to that of Schnabel. His appeal is that the ECB should be prudent - it should wait and see how the geopolitical risks materialize for the Euro area economy, how much this might slow-down the economy, before moving to tightening interest rates. For him this would protect the ECB from the risk of acting to further weaken aggregate demand in a situation with already weak GDP numbers.
The interview brings many correct and crucial points in assessing where the ECB and the Euro area economy is. First, the Euro area has never been close to overheating like the US economy and has never had the very hot recovery the US experienced (remember the analysis by Laurence Boone at the beginning of the year - most of its arguments still hold; the US recovery was stronger due to stronger stimulus). This means that inflation is less demand-driven and much more due to other factors. Second, Panetta sounded much more worried than other GC members that the Euro area economy is already stagnating as a consequence of the war: “The European economy is de facto stagnating. Growth in the first quarter was 0.2%, and would have essentially been zero without what may have partly been one-off spikes in growth in certain countries. The major economies are suffering“
His interview appeals (rightly so) to the fact that we are amidst a very uncertain situation - and it might be wiser to see how the economy responds to the combination of geopolitical problems, supply chain disruptions (both from Eastern Europe and China), further sanctions and overall uncertainty affecting business and household confidence. The ECB has committed to making data-driven decisions, which in this situation is a practical argument to wait longer. Panetta implies the ECB should wait to see Q2 GDP data and only then decide on the interest rate increase. Q2 GDP data will be published at the end of July, only after the July 21. meeting so that is an implicit appeal by him to wait with the interest rate hike for September. The main message of this interview reminds of the Draghi statement from 2019: “In a dark room you move with tiny steps“, and I would not be surprised if it was inspired by it. From today’s point of view however 2019 were times of precious calmness in the world economy in which one could more easily argue to wait with decisions. Not to mention that if the economic situation worsens enough and Q2 GDP numbers are bad, the window for policy normalisation might close, as the optics of raising rates in a recession might be too hard to stomach. Both the hawks and the doves know that of course.
Panetta’s dovish tone was however later in the day counteracted by two further Governors sounding the alarm on fast rates rise. First, Austrian Governor Holzmann pointed out that he would even consider a June rate hike feasible, whereas it was left unclear whether he meant an actual hike in June or some form of commitment in June for a hike in July. Even though it sounded like the former, most commentators took it as the latter, as we know clearly the decision has been made to start hikes after the end of APP. Robert Holzmann is one of the most hawkish current Governing Council members, so his comments were not a surprise, and also give a good strategy for hawks to try to signal in June the increase in July and thereby move to policy normalization before the data starts prohibiting this.
Much more surprising were comments by Finnish Governor Olli Rehn, a more neutral voice in the GC, who also seemed to point to the direction for faster and more aggressive tightening movements.
On Friday, French Governor Francois Villeroy de Galhau argued that interest rates may be raised back above zero by the end of the year. By doing so, he did not push for an earlier increase, but rather for three rate increases this year, which is in line with market expectations right now. These could highly hypothetically all happen in the autumn.
These hawkish comments were partly mediated by Philip Lane’s intervention at Bruegel on Thursday. The most important chart in the intervention is a counter-argument to fears about a wage-price spiral developing in Europe. The ECB forward-looking indicator of wages does not seem to imply developments that would amplify the current inflation through an unbalanced developments of wages - with a mere 3% wage growth expected in 2022.
Saturday was the grand ending of this tumultuous week. ECB President Lagarde, in an interview with Delo, continued to hold a neutral tone and to mediate between the hawks and the doves. Her opinion favours gradualism and is still in line with a July hike. She also reiterated that European inflation is more dependent on imported energy prices, and that wages do not seem to imply a wage-price spiral still, which are both dovish arguments.
The coming weeks will see this split and this discussion deepen further. The ECB will be put under immense pressure to find the right balancing act between dampening inflation without hampering economic growth too much. The April inflation numbers coming mid-May will most probably see inflation year on year at similar levels as in March. This will make the hawks push further. However GDP data will most probably not be in their favor, as the effects of the war and the stagnation of the European economy, which Panetta mentioned, might start showing further and further. This is what we saw with pretty bad German industrial production data this week already (-3.5%).
In general, inflation will continue to be very difficult to assess and predict with any certainty. On one hand, there is definitely some part of inflation, which was pandemic-driven . This is the factor with a potential to normalize soon. Then there are supply chain disruptions, which were expected to be transitory, but would definitely stay for longer after the mother-of-all supply chain disruptions has been ongoing in the ports around Shanghai for the last weeks since the city went into full lockdown. These will be disruptions that are yet to materialize downstream for the world economy in the coming months and would have a further inflationary effect.
Then there are the geopolitical factors and energy prices for oil and gas, which at the current juncture are almost impossible to forecast, since they would depend on EU sanctions and Russian counter-reactions. There is also the question how aggregate demand will respond to all of this uncertainty - first numbers from Germany from this week showed already significant negative effects on production. And then finally, as Schnabel very rightly pointed out, inflation is broadening in the Euro area, so we cannot argue anymore that it is due only to the above mentioned, outside or one-off factors. While core-inflation, without food and energy, is still lower than the US, it is at an uncomfortable level of 3.5%, which is too far away from the 2% target. Another final debate is how this reflects on wages, and following Philip Lane’s view - wage pressure is still moderate and does not seem to favour a wage-price spiral. Here the role of European trade unions will be crucial in the coming months. They would need to play a very careful balancing act on one hand to protect their members, while not putting fuel in the inflation fire further. They would thus have to accept some real wage losses. The play there would be for trade unions to admit to wage adjustments lower than inflation during wage negotiations, but negotiate a one-off compensation for higher energy prices to be paid lump-sum by governments to households. This should enable them to say they defended the purchasing power of union members, without contributing to inflation on the macro front.
If all of this holds further, I think we are still looking into one interest rate hike in July, another one in the autumn, and only if the economy stays relatively mildly affected by this, a third one in December. The action in the June 9. meeting will be whether the ECB will already hint at the July hike and therefore all but sets it in up-front. The optimal strategy for hawks will definitely be to push for that - the incoming data of a slowing down economy and the second derivative of prices most probably flat-lining will not be in their favour at the July meeting. And if the decision is then left for September, who knows where the European economy will be by that point. Monetary policy will be in the spotlight for the rest of the year and both President Lagarde and Chair Powell will have to find a very delicate balance to ensure a consensus on the path forward in such disruptive times.