William De Vijlder

Group Chief Economist BNP Paribas

Central banks, markets and the economy: three times wrongfooted

Read more

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.

Read more
 
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.  

Read more
 

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.

Read more
 
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.

Read more
 
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.

Read more
 
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.

Read more
 
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?

Read more
 
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.

Read more
 
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.

Read more
 

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.

Read more
 

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.

Read more
 

The worrisome cost of worrying about recession

The global economy has been hit by multiple shocks this year: new Covid-19 cases in China, the war in Ukraine, rising interest rates. Financial market behaviour and the US Survey of Professional Forecasters point to mounting concerns about the risk of a recession. These worries come with a cost to the economy and may cause growth to slow down further. Some degree of concern is welcome because it enhances the effectiveness of a restrictive monetary policy. There is a tipping point however, beyond which slowdown fears become self-fulfilling. Addressing these would be difficult if by then inflation has not yet converged sufficiently to target.

Read more
 
Récession

The recession narrative

Since the start of the year, media increasingly use the word recession and, over the same period, there was a significant increase in Treasury yields. The common driver behind these developments is, to a large degree probably, the more hawkish tone from the Federal Reserve. Unease about recession risk shows up in the latest quarterly Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia. Recession probabilities across the projection horizon have moved higher and they are now well above what we have seen in the past at this stage of the tightening cycle. Exceptionally high inflation requires aggressive rate hikes to bring it back under control. This implies a difficult balancing act for the Federal Reserve and explains the heightened concerns about recession risk.

Read more
 

Inflation: shifting focus, shifting concerns

Historically, there is a close relationship in the US and the euro area between, on the one hand, a measure of price pressures based on survey data on manufacturing delivery times and input prices, and, on the other hand, core inflation. The recent flash purchasing managers’ indices show that price pressures may be peaking, thereby providing hope that inflation will follow in the not-too-distant future. This will focus the attention to the speed of decline in inflation. A very slow process would be highly discomforting, raising fears that ever-higher interest rates would end up causing a recession. Everybody wants slower growth to bring inflation under control, but nobody wants the growth engine to stall.

Read more
 
Incertitude

Europe: the reaction of uncertainty to Covid-19 and the war in Ukraine

Uncertainty matters greatly for households and businesses when taking decisions. It can have many causes: economic, economic policy, political or even geopolitical. Survey data of the European Commission show that the Covid-19 pandemic has caused a huge jump in uncertainty, followed by a gradual decline. The war in Ukraine has triggered another, albeit more limited, increase. It will be important to monitor the development of uncertainty in the coming months at the level of consumers, businesses and individual countries. In the absence of a decline, one should expect that the negative impact shows up in spending and activity data.

Read more
 
Inflation

Multiple dilemmas on the horizon

In most developed countries inflation is exceptionally high. It is widespread – it affects the vast majority of the components of the consumer price index – and, what’s more, it is persistent, as statistical analysis shows. It should therefore take time to return to a level in line with central banks’ objectives.

Read more
 
Inflation

Inflation and the sustainability of public sector debt

At first glance, higher inflation seems like good news for governments. After all, inflation erodes the real value of debt and lowers the public debt/GDP ratio through a higher nominal GDP. However, the impact of inflation on public finances depends on whether higher inflation was anticipated by financial markets and on its expected persistence. Both factors would influence the borrowing cost and hence the dynamics of the debt ratio through the difference between this cost and nominal GDP growth. Public finances should benefit from having a central bank that is credible in its ability to keep inflation expectations well anchored and is not afraid of tightening policy when inflation has moved well above target. In the euro area, higher Bund yields cause higher sovereign spreads, reflecting a higher risk premium, which in the longer run will worsen the dynamics of the debt ratio. It implies that fiscal policy also has a role to play by keeping the debt ratio under control.

Read more
 
Central banks

Central banks: the need and courage to act

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.     

Read more
 
Dollar vs euro

ECB: the weaker euro, a blessing or a headache?

At first glance, the significant depreciation of the euro looks like a blessing for the ECB. Via its mechanical effect on import prices, it should remove any remaining doubt about the necessity of hiking the deposit rate. However, upon closer inspection, there is concern that the weaker euro, through its effect on inflation and hence households’ purchasing power, will weigh on growth. This would warrant a cautious approach in terms of policy tightening. On balance, a deposit rate hike in the second half of the year looks like a certainty, but the real question is about the scale and timing of subsequent rate increases. This will depend on how the inflation outlook develops.  

Read more
 
Inflation

Global: inflation persistence and why it matters

Elevated inflation has become widespread. It raises the risk of further price increases because companies may be more inclined to raise prices when most others are doing the same. This would make high  inflation more persistent, implying that it would take more time for inflation to converge back to target.  Persistently high inflation could weaken the credibility of the central bank and cause an un-anchoring of long-term inflation expectations. To pre-empt such a development, monetary authorities could decide to tighten policy aggressively. Research by the Federal Reserve shows that US inflation has become more persistent. This helps to understand the increasingly hawkish rhetoric of Federal Reserve officials and their insistence on the need to frontload monetary tightening. The ECB is also monitoring inflation persistence closely. This could mean that, depending on the data, the first rate hike could come sooner after all, even as early as July.

Read more
 
US yield curve

US: should we worry about the flattening of the yield curve? Not yet.

 The US yield curve has flattened, giving rise to comments that, given the historical experience, risk of a recession is increasing. Yet, when drawing conclusions, caution is warranted. Market-based inflation expectations, which are very high, should decline after a number of rate hikes. This could pull down long-term nominal bond yields, leading to a further flattening or even an inversion of the curve. However, a decline in inflation is growth-supportive. Another reason for caution is that due to past central bank asset purchases, the slope of the yield curve is less steep. Past QE may thus reduce its quality as a leading indicator of economic growth. For these reasons, an alternative indicator has been developed. The near-term forward spread compares market-based expectations for short-term interest in 18 months’ time with current short-term rates. Its record as leading indicator is better and, what’s more, the current spread is very large. This implies that we should not yet be concerned about the flattening of the yield curve.

Read more
 

About William De Vijlder

Group Chief
Economist
BNP Paribas
Read more
Menu