Central banks: seeking to extend the cycle

Tuesday 09 July 2019

Cross Asset

Read the Complete July/August Cross Asset Investment Strategy

Didier Borowski

Head of Macroeconomic Research

Monica Defend

Head of Strategy, Deputy head of Research

Philippe Ithurbide

Global Head of Research

The ECB and the Fed delivered the same message: they are ready to act "if necessary." Their tones contrast with the current economic conditions. Domestic demand on both sides of the Atlantic remains resilient, particularly household consumption, which still benefits from good labour market performances. True, the manufacturing sector and global trade are both at half-mast and business investment is expected to slow in the US. And we have been observing for a few years that the correlation between industry and services tends to diminish.

That said, more pressure on the manufacturing sector implies higher risk that weakness will spread to the economy as a whole. This is CB’s fear today, in addition to inflation, which is too low at this stage of the cycle.

The ECB has revised its economic forecasts, but at the margin. The stronger-than-expected growth in Q1 gave the bank the opportunity to raise its figures for the Eurozone in 2019 (from 1.1% to 1.2%); on the other hand, it revised its forecast for 2020 down (from 1.6% to 1.4%). The ECB is concerned about the weakening of inflation expectations. Companies do not have enough pricing power to pass on wage increases in selling prices. The combination of subdued growth, falling inflation expectations and increased downside risks explains the ECB's tone. Opening the door to a rate cut is intended to prevent the euro from appreciating "by default" (if the Fed were to lower its key rates sooner than expected). Opening the door to a new securities purchase program is intended to maintain very accommodative credit conditions. Finally, the generous terms of the TLTRO-IIIs are intended to guarantee the banks cheap funding for an extended period of time.

On the Fed side, the bias has clearly become accommodative with the disappearance of the term "patience" in the bank’s statement of 19 June. The economic outlook ‒ even if business investment is expected to slow further ‒ does not fully justify the rate cuts that are priced in by markets. And, Chairman Powell was very careful not to feed such expectations. But a possible increase in protectionist tensions between the US and China is being taken very seriously by both the Fed and the ECB. The Eurozone is about twice as sensitive to world trade as the US. A fall in global demand can therefore be accompanied by unwelcome disinflationary pressures if the euro appreciates at the same time. The ECB is now expected to clarify its intentions and forward guidance at its next Monetary Policy Committee meeting (25 July). The next FOMC (31 July) could also be an opportunity to give some more clues regarding Fed’s policy. Finally, while trade-related risks are explicitly mentioned by the ECB and the Fed, both CBs fail to highlight what growth owes to the increase in public and private debt.

To ensure the solvency of indebted agents, there is nothing like keeping interest rates artificially low (i.e. well below nominal GDP growth) ‒ in addition to the fact that by containing the debt burden, monetary policy opens up opportunities for a complementary fiscal stabilization, if needed.

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Date of First Use: July 9, 2019.

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