William De Vijlder

Group Chief Economist BNP Paribas

The struggle to find good news about the economy

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Cyclical outlook dominated by a shock to expectations

The latest cyclical surveys show the impact of the war in Ukraine. Confidence of households and companies has dropped, although, concerning the latter, significant differences exist between countries and sectors. In Germany, the IFO business climate has plummeted whereas in France, the decline is more limited. Services tend to be doing better than manufacturing. Importantly, employment expectations of companies remain at an elevated level. It is a key factor to monitor in view of what it signals about companies’ confidence in the medium outlook as well as for its influence on households’ sentiment about their future personal situation. This last point is particularly important given the plunge in household confidence, which is largely related to concern about the general economic outlook. Undoubtedly, the jump in energy prices and rising inflation play an important role in this respect.

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Federal Reserve

Federal Reserve: when will it stop hiking?

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.

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European Central Bank

ECB: enhanced policy optionality

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.  

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Are markets pricing in an increase in stagflation risk?

The war in Ukraine has caused a jump in commodity prices that will trigger a further increase in inflation and will weigh on GDP growth.  Unsurprisingly, the narrative that stagflation is in for a comeback is gaining ground, as shown by the increasing number of media references to this topic. Stagflation is a multi-year phenomenon of high inflation and a high rate of unemployment. Although inflation is high, the other conditions are clearly not met today. Monitoring financial markets developments is useful in gauging whether stagflation risk is on the rise. This can be done by comparing the developments in breakeven inflation and the high yield corporate bond spread. In the US, both have increased recently but it seems premature to interpret this as a sign that markets have already started to price an increase in stagflation risk. After all, these developments are of a very recent nature and the high yield spread is still low.

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Uncertainty

Radical geopolitical uncertainty

The war in Ukraine influences the euro area economy through different channels: increased uncertainty, financial market volatility, reduced exports, higher prices for oil, gas and certain other commodities. Although the economic channels of transmission are clear, the size of the impact is not. Counterfactual analysis of last year’s jump in oil and gas prices provides a reference point but the geopolitical nature of the economic shock reduces the reliability of model-based estimates. Moreover, the other transmission channels should also have an impact on growth. Finally, there is a genuine concern that, the longer the crisis lasts, the bigger the economic consequences because eventually, months of elevated uncertainty would end up weighing heavily on household and business confidence.

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Companies’ pricing power and the inflation outlook

The question of the persistence of high inflation matters because it will determine the extent of monetary tightening necessary to bring inflation under control. Key factors are growth of unit labour costs, the price elasticity of demand and its mirror image, the pricing power of companies.

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Eurozone sovereign spreads: haunted by the stylised facts

Investor behaviour is strongly influenced by stylised facts, i.e. the historical relationship between economic variables and financial markets. When Bund yields increase, the spread of certain sovereign issuers tends to widen. This positive correlation will be perpetuated when enough investors believe that the historical relationship continues to hold. This was again illustrated in recent weeks by the significant widening of certain sovereign spreads in reaction to the rise in Bund yields. It creates a challenge for governments, due to higher borrowing costs, but also for the ECB, because of its influence on monetary transmission. This explains the ECB’s insistence on the flexibility offered by the PEPP reinvestments.

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ECB

ECB: rules and a lot of discretion

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.

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William De Vijlder

Inflation: a cycle in three phases

Over the past two years, the world economy has suddenly moved from too little to too much inflation. Three phases can be distinguished. The first phase concerns the inflation impulse, which was driven by four factors: an increase in demand, a reallocation of demand, supply bottlenecks and a shift in the sector preferences of the labour force. These factors caused important changes in relative prices as well as a jump in inflation. In phase two, second-round effects enter into force. Wage growth increases and elevated inflation becomes broad-based. Key conditioning factors are negotiation power of the labour force and pricing power of companies. Both depend on the growth environment. In phase three, ‘natural’ forces such as slower growth can weigh on inflation but the prominent role is taken by central banks. They prefer to tread carefully, seeking to avoid premature or excessive tightening. Their task is complicated because at the current juncture inflation is to a considerable degree caused by a shock in energy prices. More than anything, they hold the key for the future development of inflation.

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US Federal Reserve

US monetary policy outlook: more questions than answers

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.

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10-year Bund yield back at zero percent. What are the drivers?

For the first time since May 2019, 10-year Bund yields have moved back in positive territory. Three factors explain this development. Firstly, the traditional international spillover effect of developments in the US Treasury market where following a more hawkish tone from the Federal Reserve, yields have been on a rising trend since early December 2021. Secondly, markets are pricing the end of PEPP and the tapering of net asset purchases by the ECB.  Finally, there is the prospect that, at some point, the ECB will raise its policy rate. Bond markets in the US and Germany have become highly correlated since 2021. This is an important factor given the imminent start of a rate hike cycle in the US and its possible influence on Treasury yields and, by extension, yields in the euro area.

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Federal reserve

US: bye bye QE, here comes QT

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.

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Global: supply side disruption, some hopeful signs

The current business cycle is atypical and this influences the analytical approach, with a focus on the supply side and whether it will be able to meet the level of demand in the economy, rather than on the demand side. Supply side disruption has been a key issue but recent PMI data suggest that we may have seen the worst. In the euro area and the US, the percentage of companies that are confronted with rising input prices and are contemplating to increase their output prices has started to decline and delivery lags are shortening. The Federal Reserve of New York’s global supply chain pressures index seems to have peaked. However, anecdotal evidence suggests visibility remains very low. Given the importance of supply disruption for the growth and inflation outlook, it implies that forecast uncertainty will remain very high. 

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Illustration ECOTVWeek Jan 2021

Euros in our pockets: looking back, looking ahead

20 years ago, on 1 January 2002, the biggest cash changeover in history took place when 12 EU countries introduced euro banknotes and coins. Today, the euro is the currency of 19 EU countries and more than 340 million people. It benefits from a high degree of popular support. Since its launch, the euro has gone through different phases: a first decade with good growth but increasing imbalances; the sovereign debt crisis; the years of disinflation and finally the Covid-19 pandemic. Looking ahead, important challenges remain: the project of launching a digital euro, finalising banking union and making significant progress towards a capital markets union. In addition there is the need to reform economic governance, which is big challenge. In the nineties, huge adjustment efforts were undertaken under external pressure, the argument being that they were necessary to be able to join the euro. Now, the euro area countries find it hard to agree on what pressure is needed to steer national policies in a direction that would benefit all.

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2022

2022: assessing upside and downside risks

Judging by the latest forecasts, the outlook for growth in 2022 is positive and, at some point during the year, inflation should start to decline. Uncertainty remains elevated however so there is a risk that key economic variables evolve differently than anticipated. The biggest ‘known unknown’ concerns the future development of the pandemic. Real GDP growth could surprise to the upside should inflation decline faster than expected. A tightening of financial conditions, more supply disruptions and inflation staying high for longer are the key sources of downside risk to growth.  

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Fiscal policy

Fiscal policy to continue to support euro area growth next year.

In most European countries, the structural primary deficit should shrink next year. This reduction represents a negative fiscal impulse, raising concern that it would act as a headwind to growth. However, the level of the primary deficit is such that it still corresponds to an accommodative fiscal stance. Taking into account national fiscal policies as well as expenditures financed by the Recovery and Resilience Facility and other EU grants, fiscal policy in the euro area should have a significant positive impact on GDP growth next year, thereby accompanying and strengthening the ongoing recovery. In addition, it should enhance the effectiveness of the ECB’s accommodative policy.

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Bank

Central banks: Same objective, different data, different policies

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.

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Year 2022

2022: towards the big normalisation

After last year’s sudden, deep and a-typical recession, caused by the Covid-19 pandemic, this year has also been a-typical in several respects. Supply bottlenecks and supply disruption have been dominant themes throughout the year, acting as a headwind to growth, both directly but also indirectly, by causing a pick-up in inflation to levels not seen in decades. Under the assumption that the pandemic is gradually becoming less of an issue thanks to the vaccination levels, 2022 should see a normalisation in terms of growth, inflation and monetary policy.

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EcoTVWeek - December 2021

Beyond interest rates: the role of fiscal, financial and monetary conditions

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.

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Ciel menaçant

Three headwinds to growth

In his testimony to a commission of the US Senate, Jerome Powell has acknowledged that inflation is less transitory than considered hitherto, adding that, as a consequence, a faster tapering seems warranted. Despite this hawkish tone, the reaction of US Treasuries was muted. This may, amongst other things, reflect concern about how the pandemic might evolve. The new Omicron variant undeniably represents an uncertainty shock for households and companies. It comes on top of a negative supply shock that is already a clear headwind to demand. It clearly makes the task of central banks more complicated than ever when deciding how much of a monetary headwind they can create.

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The bond and stock markets appear to be immune to inflationary risk – but are they?

Several factors might explain current market behaviour in the face of higher inflation. Firstly, the high inflation is considered transitory. This is the belief of the central banks and it is shared by professional forecasters, who are collectively predicting that inflation will fall next year. The findings of the European Central Bank’s survey of monetary analysts and the US Federal Reserve’s survey of market operators are both along the same lines.

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About William De Vijlder

Group Chief
Economist
BNP Paribas
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