Carmignac: What a difference a week makes

March 14, 2023

Central bankers have seized the challenge of changing inflationary dynamics. But acting late to contain upward price pressures and the impact they have on inflation expectations has led to an unprecedented and aggressive tightening cycle.

After a year or so of a tougher stance on monetary policy, the effects of higher interest rates are starting to be felt, but not where investors expected. Credit remains robust (although recent events will no doubt slow it down) and households are still consuming, helped by a strong labor market. And inflation remains uncomfortably high.

Central Bankers are in an increasingly tough spot. They are not done with tightening and yet cracks are successively appearing in the system after a decade of ultra-accommodative pro-cyclical policies. Indeed they have to pursue their efforts to slow the economy by reducing liquidity and, at the same time, restore liquidity to the banking system to ensure the integrity of deposits, undermined by the marked depreciation of “risk-free” assets over the past three years. It is quite the conundrum.

European Central Bank (ECB)

The ECB recently expressed its intention to fight forcefully against the very resilient inflation backdrop, hinting towards the continuation of a forced tightening pace. Will the failure of a US bank allow compliance with this resolution? The 50 basis point hike recently pre-announced is no longer unanimously expected among observers. Many have cut back on their expectations of where deposit rates will peak in this tightening cycle by nearly 100 basis points.

From an economic perspective, the main risk for the ECB is some form of a de facto informal indexation of wages to the rise in prices. And consequently, the risk of seeing a de-anchoring of inflation expectations as negotiated wages have grown from 3.5% on year-on-year basis a year ago to close to 5% year on year today. This is a point of particular attention as adjustments in the European labor market are much slower than elsewhere in the world and even more so, as core inflation has surprised on the upside and is not expected to roll over in the region until the end of the summer, at best.

Thus, the Frankfurt institution has come to the realization that aiming at 2025 to bring inflation back to the 2% mark is too far in the future. And a narrowing of the shooting window (by one year or so) calls for the maintenance of its 50 basis points hiking cycle (within the broader hiking cycle), at the accepted risk of overtightening, for now.

Federal Reserve (Fed)

Through its soft-landing narrative and its maintenance of an overly easy monetary policy, the Fed has cornered itself into a financial dominance end game. The US central bank is both withdrawing liquidity (via the tightening of its monetary policy) and providing liquidity to the system (as it comes to the rescue of troubled banks) – which echoes with the Bank of England discordance last autumn as it responded to the pension fund liquidity crisis.

Yet, in a context where the Fed is poised to maintain strict financial conditions, due to both the job market and inflation being uncomfortably resilient, volatility associated with such a conundrum is not all bad news. Indeed, the recent stress of the banking sector will lead to even tighter lending conditions (companies have hoarded labor, banks will now hoard cash) and hence weigh on demand (working somewhat in the Fed’s favour).

As such, the key question is what happens to the hiking cycle beyond next week’s 25 basis points which is penciled in?

We believe the future path of monetary policy beyond the March meeting will depend on the evolution of financial conditions. Should they continue to tighten once the current stress is digested, the Fed could pause so as to assess how much damage moving target rates from 0% to 5% within 12 months has done, and whether such pain is acceptable.

Conversely, should markets rally on the “bad news (for the economy) is good news (for markets)” mantra market operators indulging on a goldilocks sweet spot would swiftly get a rude awakening from the growing realisation that central bankers’ data dependance is a double edge sword.