Volcker-Skelter

Key points

• The ongoing debates at the Federal Reserve (Fed) get us to explore the “Volcker tightening” of 1980.
• Messages from the European Central Bank (ECB) continue to get more hawkish.
• The United Kingdom (UK) to spend more on mitigating the income shock from energy prices. This will push the Bank of England (BoE) to hike more.
• Going after the “big corporate beasts” will not necessarily work against inflation.

The Fed is now talking about the possibility to bring its policy stance in restrictive territory – and not just neutral – to tackle inflation. This is not a unanimous approach, as evidenced by Raphael Bostic’s call for a pause in September but these discussions about a painful tightening in monetary policy against a background of stubbornly high energy prices bring us back to Paul Volcker’s 1980 “inflation killing journey”. One of the features of US inflation in the early 1980s is that its correction was essentially driven by its core components, with limited help from lower energy prices. The early 1980s show “it can be done”, but the macro price to pay was huge (it took a doubling of the unemployment rate). Of course, we are not in 1980 and it may be possible to put the inflation genie back into its bottle at a much lower cost to the real economy: inflation expectations are better anchored today than at the end of the 1970s, and the labour market is now much less rigid. Yet, we suspect that “killing inflation” will take more than a “few ticks on the unemployment rate”, to quote Powell.

While the debate seems to open at the Fed, at the ECB the “hawkish drift” continues, with the possibility to start the lift-off in July with a 50 basis points hike now on the table. We continue to expect 25 basis points in July (with another one to zero in September). We note that some “de-pricing” of the Fed hikes has lifted the euro a bit, and the exchange rate seems to be a key variable for the Governing Council at this stage.

The UK announced a significant upgrade in its support package for consumers partly funded by an exceptional levy on the profits of energy companies. This fits well with our expectation that governments, irrespective of their political leaning, are still responding to “infinite social demand” despite the deterioration in their policy space. We think the Bank of England will consider that with higher fiscal support, it can afford to tighten further and help anchor inflation expectations without being too nervous about the state of the economy.

Finally, we look into Larry Summers’ critic of the current focus on anti-trust policies as a tool against inflation. We think he has a point. Yes, large companies can capture rents, maintain inordinate profits, and impair the adjustment of relative prices, but they can also benefit aggregate productivity. We note that the 1980s disinflation coincided with a rise in firms’ profit margins.