Beware of Contagion
- The Fed is ready to go far to achieve its inflation goal. The cost to growth will be large.
- Contagion to the Euro area should make the ECB think twice before starting QT, but the hawkish rhetoric remains strong.
- Predictably, the UK’s adventurous fiscal package is met with market sanction.
The Fed’s narrative is clearer: they want to see the labour market soften, and if that takes a recession, “so be it” – even if it’s not their baseline still. The resilience of job creation calls for more tightening and the new peak in the “dot plot” is far into restrictive territory. Aggregate financial conditions are now back to pre-Great Financial Crisis levels, even after correcting for the new inflation expectations. Potential growth has diminished since 2008, which suggests that the actual level of financial pressure on the economy is already quite significant, even before the further 100 bps in Fed Funds hikes which we expect. The cost to growth should not be understated.
The spillovers to the rest of the world are getting every day more problematic. We discussed last week Maurice Obstfeld’s point on central banks engaging in a race which will end up in an excessive aggregate tightening. The European market reaction to the Fed’s announcements last week is a case in point. Investors have revised further up their expectations for the ECB trajectory, probably considering the exchange rate issue will play an even bigger role in the central bank’s reaction function in the coming months. To be fair, the latest communication from the ECB gave the market plenty of reasons to expect an even more hawkish stance. The bond market is also moving fast. As of last Friday, the Italian 10-year rate stood at 4.34%. This may act as a reminder to the new administration in Rome that its fiscal room of manoeuvre is going to be tight. In any case, we think the current state of the market – and further transatlantic contagion – should make the ECB think twice about moving fast on Quantitative Tightening, even if the “noises” from Frankfurt are not reassuring on that front.
The Bank of England was isolated in choosing not to do a “jumbo hike” last week. They may well have to deliver one very soon, That the market did not like the latest fiscal policy announcements in the UK is an understatement. We reiterate our view that it’s a very adventurous package. The recipes of 1980 don’t work well in the 2020s.