William De Vijlder

Group Chief Economist BNP Paribas

US: the sobering record of real GDP forecasts during recessions

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Emploi

Eurozone: the surprising resilience of the labour market, will it last?

Since the start of this year, the European Commission’s industry sentiment survey has seen a significant decline, yet companies continue to report that labour remains a key factor limiting production. This is probably due to order books that remain at record high levels in terms of duration of assured production. Through their impact on the growth of employment and wages, labour market bottlenecks should provide some resilience to consumer spending when the economy is turning down. This support will probably not last however. Hiring intentions of companies have started to  decline, which should ease the bottlenecks through a slowdown of employment growth.

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Household wealth

Gone with the wind: the erosion of real household wealth

Household wealth -the difference between assets (property, financial) and financial liabilities- matters because in the longer run, it should allow to finance expenditures post retirement. During the pandemic, we have seen in the euro area a big jump in the savings rate as well as an above-trend increase in property prices whereas financial assets suffered from negative valuation effects. The European Commission estimates that, on balance, between the onset of the pandemic and the end of 2021, households accumulated around EUR 2.7 trillion of new wealth in excess of the normal trend. This was considered as a factor of resilience for household spending. Households could save less than normal in case of a weaker economic environment because they had saved more than normal during the pandemic. However, according to the European Commission, by mid-2022 elevated inflation had already eroded the real value of additional wealth by almost 50%, implying a much thinner cushion to absorb shocks.

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United States of America

US: disinflation has started

The US consumer price data for October have reinforced the view that disinflation -the narrowing of the gap between observed inflation and the central bank’s inflation target- has started. That conclusion seems clear as far as headline inflation is concerned -it has peaked in June- but we need confirmation that the decline in core inflation from the September peak is not a one-off. Core goods inflation has been moving down but core services inflation  remains stubbornly high on the back of transportation services and shelter. What matters now for the economy and financial markets is the speed of disinflation because this will influence Fed policy, the level of the terminal rate and how long the federal funds rate will stay there. All this influences the perceived downside risks to growth.

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US Federal Reserve

Federal Reserve: how much is enough?

At which level will the Federal Reserve stop hiking the federal funds rate? The question is hugely important for activity and demand in the US economy as well as for financial markets. During his recent press conference, Fed Chair Jerome Powell remained vague about the reaction function of the FOMC but he did mention that they would be looking at real interest rates. This raises the question which inflation measure to use to move from nominal to real rates. A possible solution is to use the term structure of inflation expectations that is calculated by the Federal Reserve Bank of Cleveland. Despite its significant recent increase, the real one-year Treasury yield is still below that reached during previous tightening cycles, with the exception of 2018. Against the background of elevated inflation, it is clear the tightening cycle is not about to end. 

 

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Eurozone: the disinflation of 2023, between hope and uncertainty

The latest ECB survey of professional forecasters (SPF) shows a downward revision of the growth outlook and an upward adjustment of the inflation forecast. For next year, the real question is not about the direction of inflation but about the speed and extent of its decline. Slower than expected progress could convince the ECB of the need for more rate hikes than currently priced by markets, implying a bigger output cost of bringing down inflation. Disinflation could indeed take longer than expected. Over the past two years, a variety of factors have led to an exceptionally elevated but also broad-based inflation. Not all shocks have occurred simultaneously and it often takes time for them to work their way through the system, from the producer to the wholesaler to the retailer. This creates an inertia in the inflation dynamics.

 

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Politique monétaire

Synchronous rate hikes: a sum-of-the-parts analysis

A sum-of-the-parts analysis, which is popular in corporate finance, has made its way in the world of central banking, reflecting concern that the multitude of synchronous rate hikes could have a combined tightening effect that is larger than the sum of its parts. To the extent that inflation in a given country is largely a function of global slack, these hikes could cause an unexpectedly large decline in inflation. Rising import prices due to currency depreciation are another factor because they could force countries to tighten monetary policy. Confidence effects may also play a role, especially at the level of export-oriented companies. To address these risks, central banks could insist that synchronous rate hikes should moderate inflation expectations globally. They should also take into account the spillover effects of the actions of foreign central banks when designing their own course of action.

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Crise économique

Global: growth at risk

When growth is slowing, risks tend to be tilted to the downside because households and companies adopt a more cautious attitude in their spending and investment decisions. At the present juncture, it is also difficult to see what could create an upside surprise. To the contrary, according to the IMF, there are several downside risks: the cost of energy, the problems in Chinese real estate, persistent disruptions in the labour market. Financial conditions could deteriorate. Already today they create a discomforting environment, with the risk of a non-linear impact on growth. It illustrates the challenge of central banks with growth-at-risk being at the low end of historical ranges and inflation at the other extreme.

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Public debt

Eurozone: rising interest rates and public debt sustainability

Due to the recent significant increase in interest rates, Eurozone countries now have a borrowing cost on newly issued debt that, for an equivalent maturity, is higher than that of the existing debt. From a debt sustainability perspective, this necessitates a smaller primary deficit or a larger surplus, depending on whether the average interest cost is, respectively, lower or higher than the long-term nominal GDP growth rate. However, this effect will only be fully operational when the entire debt has been refinanced at the higher interest rate. Given the long average maturity of existing debt, the annual adjustment effort is small for the time being but it will grow over time. However, debt sustainability is about more than keeping the debt ratio stable under certain circumstances. It is also about the resilience to interest rate and growth shocks. The higher the debt ratio, the more important it is to do more than simply trying to stabilize it.

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Bank of England

UK: the ‘dash for cash’, leverage and the need for economic policy coordination

Financial markets in the UK have recently been confronted with a ‘dash for cash’, whereby investors sell off even safe assets such as long-term government bonds to obtain cash. The catalyst was the announcement of an expansionary fiscal policy, which might force the Bank of England to hike interest rates more aggressively given the potential inflationary consequences. Leverage and the ensuing margin calls acted as an accelerator of the jump in Gilt yields. The events show the necessity for a coordination of economic policy. In case of elevated supply side inflation, this means monetary tightening to trigger disinflation, targeted fiscal policy support to those who suffer most from inflation and macroprudential policy that address the consequences from market volatility and large increases in bond yields.

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Drapeau Réserve fédérale

US: vacancies, job turnover and disinflation

The tight US labour market plays a crucial role in the effort of the central bank of bringing inflation back to target. Slower growth in labour income should lead to slower demand growth, whereas smaller wage increases will ease pressure on corporate profit margins and reduce the need for companies to charge higher prices. The labour market is characterized by a dynamic interaction between job openings, unfilled vacancies, voluntary departures (quits) and layoffs. In the US, unfilled vacancies and the quits rate have started to decline and one should expect that this dynamic will gather pace, causing a slowdown in wage growth. The question remains to what extent this will bring down inflation, which is why the Federal Reserve’s policy is completely data-dependent.

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The struggle to find good news about the economy

Usually, during a period of sluggish growth and rising official rates, bad news about business activity and demand is often welcomed by the stock market, as it often causes central banks to take a more cautious approach during their monetary-tightening cycle.

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Monetary policy

The monetary cycle: from panic to perseverance to patience

In recent months, the huge and rising gap between observed and target inflation has confronted central banks with an urgency to act. It could be called the panic phase of the tightening cycle. What followed was a swift succession of significant rate increases. Tightening was frontloaded, rather than gradual, to avoid an unanchoring of inflation expectations. This perseverance phase will be followed by a long wait-and-see attitude once the terminal rate -the cyclical peak of the policy rate- will have been reached. During this patience phase of the monetary cycle, the central bank will monitor how inflation evolves. With the risk of further rate hikes having declined, the government bond market should stabilize, which can have positive spillovers to other asset classes. Likewise, the real economy may also sigh a breath of relief, given the reduction in interest rate risk, unless demand and activity would in the meantime have suffered a lot from higher interest rates.  

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Towards a frugal winter

 Recent economic data paint a picture of increasing concerns about the economic outlook. In the US, high inflation and rising interest rates play a key role. In the euro area, the same factors play a role -although interest rates are still below those in the US- but skyrocketing energy prices and gas supply disruption are additional forces that should drag down growth. Easing price pressures in business surveys are a hopeful development but selling price expectations remain nevertheless exceptionally high given the weakening of order books. This could point to input price pressures that force businesses to charge higher prices to protect their margins. It is to be feared that slowing demand will make this increasingly difficult, forcing companies to cut back on investments and new hirings.

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William De Vijlder

Monetary policy : from theory without end to the end of theory

The last twelve months, inflation has continued to surprise to the upside, due to a combination of a series of supply shocks (covid-19, disruption and shortages, the war in Ukraine, weather conditions) and the strength of demand, which had been underestimated.

Today, the broad-based nature of inflation and its persistence are the real issues, which reduce the visibility in terms of future inflation developments. Therefore, central banks have decided to change their approach. The theory of inflation and monetary policy has been put aside, the only thing that matters are the data.

The main worry of the ECB and the Fed is that inflation expectations become unanchored and influence pricing decision of companies as well as wage negotiations. Consequently, the central banks’ overriding objective is to slow down demand growth by hiking rates, hopefully helped by the absence of new supply shocks.

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Politique monétaire

The new meaning of ‘whatever it takes’

At the Jackson Hole symposium, Fed chair Powell and Banque de France governor Villeroy de Galhau have insisted that their responsibility to deliver price stability is unconditional. . It gives a new meaning to ‘whatever it takes’. Faced with uncertainty about the persistence of elevated inflation, the Federal Reserve and the ECB will increase their policy rates to bring inflation under control, whatever the short-run cost to the economy, because not doing enough now would entail an even bigger economic cost subsequently.  Equity markets declined and bond yields moved higher. Tighter financial conditions will help the monetary tightening in achieving the desired slowdown in growth. To what extent this is reflected in the inflation dynamics to a large degree will depend on what happens to the supply side, which is beyond the control of central banks.

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ECB

ECB: into a new era

The ECB Governing Council has surprised markets by a 50 bp rate hike and by dropping its forward guidance and moving to a data-dependent tightening cycle. This may reflect unease about how quickly the euro area economy might react to the policy moves and about the consequences of uncertainty about gas supply during the winter months. Another key decision was the introduction of the Transmission Protection Instrument (TPI), a tool to address unwarranted spread widening that would weigh on the effectiveness of monetary policy transmission. The data dependency of further rate hikes and the vagueness about the triggers for using the TPI may lead to an increase of the volatility in interest rates and sovereign spreads whereby investors try to understand the ECB’s reaction function.

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European Central Bank

ECB: addressing unwarranted spread widening

Next Thursday’s meeting of the ECB Governing Council is eagerly awaited. The rate hike decision has been pre-announced so the more important question is whether the new tool to address unwarranted sovereign spread widening will be unveiled. The rationale for such an instrument is well understood but its design and use raise several questions. One is easy to answer. To avoid a conflict with the monetary policy stance, bond purchases by the central bank would need to be sterilized. The others are more challenging. Where is the threshold to call a spread widening ‘unwarranted’? Should the ECB be clear or ambiguous on this threshold and on its reaction when it would be reached? The final question concerns moral hazard and, hence, conditionality. When the ECB intervenes to address unwarranted spread widening, what are governments supposed to do in return in terms of fiscal policy?

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American flag / capitole

US: an uneasy feeling (part 2)

Recent data send conflicting signals about the outlook for the US economy. A survey of chief financial officers shows they have become gloomier and the nowcast of the Federal Reserve Bank of Atlanta is forecasting a contraction of real GDP in the second quarter. This would mean two successive quarters of negative GDP growth, which corresponds to the popular definition of a recession. However, the labour market continues to be strong and the majority of indicators used by the NBER Business Cycle Dating Committee are still in an uptrend. This suggests there is no imminent risk of recession yet.

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Statut de la liberté

US: an uneasy feeling

The chief financial officers of US companies have become gloomier about the outlook for the US economy. The latest Duke University CFO survey shows that 20.8% of the participants expect negative GDP growth over the next 12 months. The assessment about the own-company prospects has declined far less, leading to a record high gap with the outlook for the economy as a whole. This is a source of concern: how long can own-company confidence remain high if the overall environment continues to deteriorate? Interest rate developments will play a key role in this respect. Of those US companies that plan to borrow, two-thirds would reduce their investments in case of an increase of borrowing costs of 3 percent. It is a sobering message considering the expected tightening of monetary policy.

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Unwarranted spread widening: measurement issues (part 2)

A lasting, unwarranted widening of sovereign spreads in the euro area would represent an excessive tightening of financial conditions and weigh on activity and demand. It would run into conflict with the objectives of the ECB in the context of its monetary policy normalisation. Spreads are influenced by various fundamental variables that are directly or indirectly related to debt sustainability issues. These tend to be slow-moving. Sovereign spreads also depend on the level of risk aversion, a variable that fluctuates a lot and which is influenced by global factors. This complicates the assessment of whether an observed spread widening is warranted or not.

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Unwarranted spread widening: measurement issues

In recent weeks, the prospect of several ECB rate hikes has caused an increase in Bund yields and, unexpectedly, several sovereign spreads. Beyond a certain point, higher spreads may become unwarranted. Under such circumstances, the ECB might consider stepping in to avoid that its policy transmission would be impacted. Determining whether sovereign spreads have increased too much is a real challenge. Historically, based on a 20-week moving window, the relationship (beta) between the BTP-Bund spread and Bund yields fluctuates a lot, so this calls for taking a longer perspective. Using data since 2013, the current spread is in line with an estimate based on current Bund yields. Clearly, other economic variables should be added to the analysis. It shows the complexity of the task should the ECB commit to address unwarranted spread widening.

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About William De Vijlder

Group Chief
Economist
BNP Paribas
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