William De Vijlder

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.  

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.

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.

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?

Elevated inflation, if left unaddressed, could cause a de-anchoring of inflation expectations, an increase in risk premia, greater price distortion and hence longer-term costs for the economy. Although at first glance, central banks face a dilemma -hiking interest rates to lower inflation at the risk of causing an increase in unemployment or focusing on the labour market and accepting the risk that inflation stays high for longer-, they can only choose between acting swiftly or face an even bigger challenge later to bring inflation back under control. Recent statements by officials of the Federal Reserve, the ECB and the Bank of England acknowledge the need to act but their decisions and guidance are very different and reflect the differences in the macro environment.     

The FOMC has started a new tightening cycle and its members project 6 additional increases in the federal funds rate this year and 4 more in 2023. This hawkish stance is unsurprising. After all, the policy rate is very low, inflation is exceptionally high and the economy is strong. Given the Fed’s dual mandate, the pace and extent of rate hikes will depend on the evolution of inflation as well as the unemployment rate. Previous tightening cycles suggest that concerns about the risk of an increase in the unemployment rate have played an important role in the decision to stop hiking. The central bank will have to hope that inflation has dropped sufficiently by the time that this risk would re-emerge.

Since its launch, the ECB’s asset purchase programme has had, through various transmission channels, a significant impact on financial markets, activity and inflation. In recent months, doubts about the positive effects of additional purchases and concerns about possible negative consequences have increased. Against this background, the ECB has cut the link between the timing of the end of net asset purchases and the rate lift-off. This is a welcome decision that increases the governing council’s optionality. The new staff macroeconomic projections remind us of the pervasive uncertainty we are facing. In such an environment, monetary policy can be nothing else than data-dependent.  

Based on Christine Lagarde’s latest press conference, it is clear that the ECB’s Governing Council view on the inflation outlook has evolved quite significantly. Since the December meeting, upside risks to inflation have increased, raising unanimous concern within the Council. Financial markets interpreted this as a signal that the first rate hike might come earlier than previously expected and bond yields moved significantly higher. The ECB’s forward guidance, which can also be considered as a description of its reaction function, suggests a rule-based approach to setting interest rates with clear conditions in terms of inflation outlook and recent price developments. In reality, a lot of judgment will be used as well. This makes perfect sense given the many uncertainties surrounding the outlook, although it makes the outcome less predictable. With this caveat in mind, we expect a first 25bp rate hike in September, to be followed by a similar increase in December.

In his press conference last week, Fed chairman Jerome Powell was very clear. Based on the FOMC’s two objectives –inflation and maximum employment- the data warrant to start hiking interest rates in March and, probably, to move swiftly thereafter. In doing so, it will be “led by the incoming data and the evolving outlook”. This data-dependency reflects a concern of tightening too much and makes monetary policy harder to predict. The faster the Fed tightens, the higher the likelihood of having it take a pause to see how the economy reacts.

The minutes of the December meeting of the Federal Open Market Committee (FOMC) have shown a distinct and sudden shift towards a more hawkish stance. The reduction of the pace of net asset purchases (tapering) has been stepped up, the first rate hike is expected to come earlier and the FOMC participants favour an early start and a faster pace of quantitative tightening (QT). Although they are more relaxed about QT than in 2017, it remains a tricky operation. The challenge will be to find the right balance between QT and the number of rate hikes in order to bring inflation under control without jeopardizing growth. History shows that achieving a soft landing is difficult.

It was a rare coincidence that last week, four major central banks –the Federal Reserve, the ECB, the Bank of England and the Bank of Japan- held their monetary policy meeting. Considering that they all target 2% inflation, their decisions shed light on the role of differences in terms of approach as well as in the economic environment and outlook. However, they share a preparedness to react when circumstances require. Given the mounting concern about the Omicron variant, more than ever, monetary policy is data-dependent.

The list of factors that need to be taken into account when assessing the influence of monetary policy on growth and inflation has grown over the years. Long gone are the days that it was sufficient to look at interest rates against the background of the gap of inflation versus target and unemployment versus its natural rate. Forward guidance and management of the balance sheet (quantitative easing or tightening) are now part of the standard toolkit of central banks.

The ECB insists on the need for patience before considering a policy tightening, despite current elevated levels of inflation. It believes that inflation will decline next year and that a wage-price spiral is unlikely to develop. Moreover, inflation expectations remain well anchored. Demand in the euro area is suffering from the headwind created by the jump in energy prices. Reacting to this type of inflation by tightening monetary policy would create the risk of reducing demand even more. To avoid such an outcome, it makes sense for the central bank to wait for more information to arrive, thereby adopting a risk management approach of monetary policy. When policy leeway is limited, central banks, confronted with a high degree of uncertainty, will opt for a patient stance considering the potential cost of a policy mistake. The higher their credibility, the more they can be patient.

Markets have been pricing in an early lift-off of the ECB’s deposit rate. The ECB argues that, considering its inflation outlook, this is not warranted. This difference in view could reflect a loss of central bank credibility. More likely is that market participants and the ECB disagree on the inflation outlook. Another explanation is that investors focus on the distribution of possible inflation outcomes and are concerned about the risks of inflation surprising to the upside.

Monetary desynchronisation between the US and the Eurozone seems unavoidable due to a very different performance in terms of inflation. Whether this will complicate the ECB’s task of reaching its inflation target depends, in the short run, on the impact on financial conditions in the euro area. This influence will probably be small. In the medium run, when the US tightening cycle is well underway, US domestic demand growth will be slowing down, which will weigh on imports and hence Eurozone exports to the US. This would complicate matters for the ECB if by then, inflation has not yet reached its target.

Although they have eased recently, high Eurozone manufacturing price pressures are fuelling analysts’ concerns that inflation could stay high for longer. There is an impression that the ECB is increasingly sympathetic for this view. This is important in the run-up to the December meeting of the Governing Council. Whether supply bottlenecks and rising input prices will have a longer-lasting effect on inflation depends on the transmission to the rest of the economy. One would expect it to be higher under a combination of strong demand, low inventory levels and long supplier delivery times. This corresponds to the current situation in the sectors producing durable consumer goods, intermediate goods and investment goods. Perhaps, inflation could surprise to the upside after all in the near term.

The new macroeconomic projections of the ECB staff provide sobering reading for savers hoping that, one day, the policy rate will be raised. It is clear that at the current juncture, certain conditions of the recently updated forward guidance on interest rates states are not met. Based on the latest ECB projections, it seems this would still be the case in 2023, even under the hypothesis of a mild scenario. The slow increase of underlying inflation would probably be considered as unsatisfactory. Savers can only hope that the interaction between growth and inflation will evolve or that the ECB projections turn out to be too cautious.

The sharp increase in public sector debt due to the pandemic was an inevitable consequence of the automatic fiscal stabilizers, on account of their role. This was suitable and even essential, given the key role of government measures to support economic agents and boost demand. Yet, this increase raises the issue of the future orientation of fiscal policy.