Hawks Aplenty

Key Points

• Lagarde sent the ECB on a course consistent with a rate lift-off this year. We expect it in December, but it could come as early as September.
• The memory of the “Greenspan put” probably makes the Fed ready to look through quite a lot of market pain. For the ECB, fragmentation, as always, would be the problem. As the monetary mood changes in Europe, progress on the fiscal framework must accelerate.

Christine Lagarde’s refusal last week to repeat the point she made in December about a rate hike this year being unlikely, while mentioning a “unanimous concern” about inflation in the Governing Council, is a big shift. The ECB is now ready to follow the Fed with a first hike with only a 6 to 9-month lag – we now expect the lift-off in December. Yet, the Fed “bared its teeth” only when wage data made it absolutely clear the US inflation process had turned endogenous. The ECB is changing its stance before wage acceleration appears in the Euro area. Of course, the January print for consumer prices was hard to ignore, but the ECB’s pre-emptive stance suggests a sensitivity to inflation risks at odds with the cultural change imposed by Draghi during his tenure.

Financial markets are currently bombarded by a steady flow of hawkish signals from all major central banks. On top of the Fed’s and now the ECB’s tougher rhetoric, the Bank of England, upon delivering another 25 basis points hike last week, revealed that 4 members of its Monetary Policy Committee voted for 50 basis points. A key issue is whether the market reaction could ultimately “stay the hand” of the central banks. At the Fed, the memory of the “Greenspan put” and its fateful consequences are probably vivid enough to make the FOMC look through quite a lot of pain on the markets. Asset prices developments would have to significantly affect the real economy before the Fed changes course, especially in a situation where there is enough excess demand for the central bank to take risks with the magnitude of its tightening.

The “feedback loop” works differently in the Euro area. the central bank could not completely ignore a widening in sovereign spreads which would bring back existential questions on the functioning of the Euro area. Fortunately, positive political developments in Italy and Portugal provide a buffer against too brutal a market reaction. Still, If the ECB normalizes faster, the evolution of the fiscal institutions of the EU should also go faster, and deeper. The French Presidency of the EU convened a special European Council on 10-11 March to kickstart discussion on a new model for the Stability and Growth Pact.  The proposal by Giavazzi and Weymuller (economic advisors to Draghi and Macron) we discussed here a few weeks ago is becoming an even more appealing option given the new monetary mood. Draghi’s legacy at the ECB may be in question, but his capacity to shape the debate in Europe remains high.