(BFM Bourse) – After an ECB monetary policy meeting and a few days before that of the Fed, two experts from the German asset manager DWS decipher the possible strategies that central banks might use, in an economic environment that has become well more delicate by the war in Ukraine.
The war in Ukraine, a new headache for central bankers with a view to monetary normalization? While Christine Lagarde surprised the market on Thursday by adopting a less accommodating bias than that expected by observers, DWS Europe economist Ulrike Kastens believes that this is “good news”. “Despite the economic uncertainties caused by the war in Ukraine, the ECB is ready to end its asset purchase program [l’APP, NDLR] in the 3rd quarter of 2022. In doing so, it is clearly taking a step towards the normalization of monetary policy, while keeping an exit door open”, he believes.
The European Central Bank has in fact made it clear that if financing conditions deteriorate and the inflation outlook changes such that the inflation target will not be met, it will reconsider the volume of asset purchases in terms of size and/or duration. “That way she keeps all the options open,” comments Ulrike Kastens.
“Contrary to what the Fed has expected, however, rapid and sharp interest rate hikes are not expected. The ECB President expressly stressed that interest rate hikes should also only be gradual” adds he.
Inflation soaring
According to the latest projections, the ECB forecasts an inflation rate of 5.1% for 2022 – a figure significantly raised on Thursday compared to the previous estimate (+3.2%) even if we can according to the expert “still wondering if all the price increases for energy and other raw materials have already been taken into account”. In addition, there will be “higher wage agreements in the medium term and greater public spending, also at EU level with a possible new fund for common financing of defense and energy expenditure”, he predicts. “In this context, it seems doubtful that the ECB can maintain the prospect of only a gradual increase in interest rates”, the scenario favored at this stage by the European monetary authority.
At the same time, across the Atlantic, the next Fed meeting (next Tuesday and Wednesday) “will most likely mark a historic turning point for US monetary policy,” says Christian Scherrmann, US economist at DWS. The Fed is indeed expected to raise its fed funds range by 25 basis points (or 0.25 percentage points), the first hike since it cut rates to zero aggressively in response to the Covid-19 pandemic. 19 looming. “This will most likely only be the start of a rate hike cycle, as it looks like fighting inflation has become the Fed’s primary focus,” the expert said.
A game-changing war
The environment in which the Fed will tackle inflation has, however, “suddenly become much more difficult for central bankers”, he notes. “Geopolitical risks stemming from the conflict between Ukraine and Russia have made the economic outlook much more uncertain, have deteriorated financial conditions and might prolong some price pressures that might otherwise have abated” lists Christian Scherrmann .
Another difficulty identified by the economist: not all the elements of currently high inflation can be controlled by monetary policy. “Price pressures caused by disruptions in the global supply chain, for example, will not go away because policy rates are raised,” he explains. For the time being, the primary objective of central banks must therefore, according to him, be “to control inflation expectations, which presupposes that central bankers maintain the confidence of the population in their ability to implement the policies necessary to stabilize prices. “Given the great uncertainty, the very high level of inflation and the strong expectations of future inflation, the March meeting of the Fed will therefore be an important test of credibility” he judges.
Play on the size of the balance sheet
Ahead of the ECB, the Fed also wants to start reducing its balance sheet and “will most likely start doing so in July of this year” anticipates Christian Scherrmann, who recalls that the active purchase of Treasury bills and to mortgages is seen as a means of providing liquidity to the financial system in times of stress, thereby easing financial conditions. “The balance sheet reduction is therefore a sign of confidence on the part of central banks, who believe that the worst is over,” he said. But given that the current geopolitical uncertainty weighs heavily on financial conditions, “any reduction by the Fed might be more moderate than initially expected.”
Overall, then, “it looks like it won’t be easy for the Fed to engineer a ‘soft landing’ – in which raising policy rates helps moderate demand to reduce inflation without hurting global economic dynamics. “But right now, we don’t think the economy is on the way to recession with the rate hike,” he said. Before explaining: “The labor market is recovering from the pandemic, demand for workers remains at record highs and economic momentum appears to be robust. The reality we are most likely facing, however, is that inflation and higher rates imply less growth. We expect this scenario to be reflected in the Fed’s updated summary of economic projections.”
And in terms of credibility, “long-term projections on the appropriate policy trajectory will be crucial at the March meeting,” he concludes. Interest rates that are too low might indeed suggest to the markets that the Fed is not taking its role of fighting inflation seriously enough, while high rates might weigh heavily on financial conditions.
Quentin Soubranne – ©2022 BFM Bourse
