Augmenting the Bernanke Doctrine

Key Points

• The “Bernanke doctrine” on how central banks should deal with energy price shocks should be augmented by taking the fiscal stance in consideration.
• Such augmented Bernanke doctrine would be consistent with a very cautious ECB. The central bank wants to be flexible, but the direction of travel is clear: they really want to normalize.

Ben Bernanke eloquently expressed the central banks dilemma when dealing with an exogenous price shock: “monetary policy cannot offset the recessionary or inflationary effects of increased oil prices at the same time”. It must choose. He also proposed a qualitative criterion to inform the central bank’s choice: how close the economy was to full capacity before the shock. Indeed, if overheating was an issue before oil prices rose, then risks of second round effects are higher and the economy can better afford the impact of the monetary tightening. Yet, a key factor Bernanke neglected was the fiscal stance. If a lot of the GDP loss triggered by the exogenous shock is likely to be mitigated by government spending, then the central bank can focus on fighting inflation. In the Euro area, this is made more complex by the fact that the quantum of fiscal support is partly dependent on the monetary stance. Given the structural “fragmentation risk”, terminating QE can reduce the government’s capacity to increase spending.

Looking at all the elements of this “augmented Bernanke doctrine”, the ECB should proceed with extreme caution. There were no blatant signs of overheating before the start of the Ukraine war. Fiscal policy is pledging to help, but the European summit in Versailles has not produced tangible results on extending debt mutualization. Yet, although the ECB wants to be flexible and was more dovish than what could have been expected after the February meeting of the Governing Council, last week Christine Lagarde announced a faster pace of QE tapering than what was heralded in the forward guidance of December 2021. As we wrote last week the direction of travel is clear: the ECB really wants to normalize.

We continue to expect a first rate hike by the ECB in December 2022. It is predicated on the peak of the economic fallout of the Ukraine war being reached in Q2/Q3. This itself is based on the idea that the two parties cannot sustain high-intensity warfare for more than a few months. It is a very uncertain baseline of course and we explore some possible bifurcations. Note also that we cannot fully ignore the latest pandemic developments. The lockdown in Shenzhen should act as a reminder that beyond the disruption triggered by the war in Ukraine on the European macro outlook, a China-centered new shock to supply lines cannot be discarded.