Bad Peripheral Vision

Key Points

• The reaction of Italian yields suggests the old constraints on the ECB’s monetary policy are still there.
• The ECB seems to have stopped believing in the Phillips curve: it would take a lot of macro deterioration to change the monetary policy trajectory.
• The Fed will likely hike by 50 bps this week. Check by how much the unemployment rate moves in their “dot plot”.

The ECB’s announcement of a 25-bps hike in July and a likely 50 bps one in September has merely solidified the market’s expectation of seeing the policy rate at the lower end of the “neutral range” by end-2022. The most important immediate development was the reaction of the Italian bond market to the absence of granularity on the ECB’s anti-fragmentation weapon. The new level of the Italian 10-year is higher than any reasonable estimate of trend nominal GDP growth there.  Avoiding debt “snow-balling” would entail steady fiscal retrenchment which could be made difficult by shaky political conditions from next year. Even if pressure does not extend to the periphery beyond Italy for now, it seems the “old constraints” affecting the ECB’s normal conduct of monetary policy are still with us. If no progress is made on the anti-fragmentation weapon or on further debt mutualization in the EU, disruptions on the bond market could affect confidence across the whole of the Euro area, ultimately forcing the ECB to stop before reaching its desired level for the policy rate. At this stage however it seems the central bank is ready to tolerate quite a lot of deterioration in the real economy to achieve its price stability mandate. In the adverse scenario embedded in the ECB’s latest forecasts, a significant recession in 2023 leaving the unemployment rate 2 percentage higher than in the baseline in 2024 would leave inflation only marginally below 2%. The ECB has stopped believing in the Phillips curve. That’s another shift away from the Draghi era.

The Fed is likely to hike by 50 basis points this week. Higher-than-expected inflation in May again is fuelling risks of a 75-bps move, but we don’t think the Fed will want to add to the current turmoil: there is enough market-led tightening in financial conditions as things stand. Focus is likely to be on the Fed’s forecasts. Whether the “median FOMC member puts the Fed Funds in restrictive territory by end 2022 (the latest market pricing) or by end 2023 will matter, but we will also take a hard look at the forecast for the unemployment rate. This could give us a sense of how much “macro sacrifice” the Fed is ready to trigger to get inflation back under control.