Best Laid Plans Go Awry

While they both converted to “restriction removal”, it seemed until last week that the Fed and the ECB had laid out different plans, the Fed opting for a decisive, pre-emptive path, while the ECB was choosing a more prudent, data dependent and meeting-by-meeting approach. Yet, the employment report released last week provided more evidence that the softening of the US economy is proceeding at a glacial pace, while Christine Lagarde’s latest testimony at the European parliament expresses a readiness to engage in back-to-back cuts, the Governing Council – even its hawkish wing – getting more concerned about the deterioration of the real economy. 

We think the payroll report for September “killed” the probability of a 50bp cut in November in the US. Still, given the FOMC’s willingness to act pre-emptively, even in the absence of glaring signs of an economic downturn, the most plausible scenario in our view is that the Fed continues to lower its policy rate by 25bp increments, while leaving the terminal rate above its long-term level, as long as inflation continues to behave. Yet, we also continue to think it remains very difficult to predict with any accuracy the Fed’s trajectory in 2025 before the US elections, given the binary nature of the policy proposals in terms of inflation risks. On the other side of the Atlantic, we think the most plausible trajectory for the ECB is to cut by 25bp increments at every Council meeting until June 2025 and the neutral rate, close to 2%, is hit. For the ECB to dip in properly accommodative territory, a “clear” recession would need to materialise. There is still a chance this can be avoided. 

We also take a hard look at Switzerland. Indeed, while the ECB would still retain some decent room for manoeuvre to avoid having to resort again to unconventional monetary policy instruments even in case of full-blown recession, the SNB may not have that luxury. Another “balance sheet ballooning”, triggered by massive FX intervention, could be necessary there once the meagre room left for rate cuts is exhausted.