What will it take?

Upon postponing the beginning of the Fed’s change of stance, Jay Powell still maintained an easing bias. To some extent this may merely be about avoiding an overreaction – if for instance the resumption of hikes became the “talk of town” on the market - but he also made it plain that in his “personal forecast”, more progress should be seen on the inflation front this year. At this stage, given stubborn price dynamics since the beginning of the year, the key issue is to determine what it would take to finally re-start the disinflation process. To explore this, we use a simple “augmented Phillips curve” in which observed inflation is the lagged product of consumers’ expected inflation and the under-employment rate. If households were to keep their current price expectations unchanged the under-employment rate would need to rise by 3 percentage points to bring inflation back to target. This would be in line with the deterioration seen during the very shallow recession of 2001. This calculation however probably overstates the magnitude of the required softening of the economy. Indeed, consumers’ price expectations would probably decline as the labour market deteriorates. Moreover, there are still some idiosyncratic factors pushing inflation up – e.g., car insurance and rents – which should fade this year irrespective of the state of the real economy.

Even if prudence is of the essence, the very latest US dataflow supports the assumption that the softer-than-expected print for Q1 GDP was not a mere mean reversion episode. We affirm our baseline scenario that the Fed will still be able to cut twice this year, starting in September. The “not so hawkish” performance by Powell and weaker than expected US data flow are good news for the ECB. The Governing Council should be encouraged to cut in June by the further deceleration in core consumer prices in April, but looking ahead, a higher probability of a change of stance by the Fed with a lag of only a few months would clear the way for more cuts in the Euro area in the second half of this year without too much concern about an exchange rate backlash.