Policy tectonic plates shifting

Key points

• Massive demand for policy action is meeting a policy vacuum now that central banks move away from fiscal dominance.
• In the Euro area, upside risks to inflation are materializing while Q1 GDP partly contradicts the positive message from the business surveys. The ECB is likely to focus more on the first point.

We expect the Federal Reserve (Fed) to hike by 50bps this week, and the European Central Bank (ECB)’s rhetoric is getting increasingly hawkish to the point that a July lift-off cannot be excluded. This is more than mere “normalization". The whole policy-mix is changing. We need to brace ourselves for “instant nostalgia” for the brief era of unlimited policy support – and fiscal dominance – which the pandemic had ushered in. The West is faced with a potential policy vacuum at a time when demand for action is massive: tolerance for income inequality has ebbed, demographic challenges push for a structural drift in public spending, and citizens want decisive intervention to fight climate change together with a minimization of the impact the energy transition will have on their income.

We see three ways to resolve the tension between unlimited demand for policy action and a depleted arsenal. First, governments could decide to “call the monetary policy bluff” and maintain an extremely accommodative fiscal stance, counting on central banks to recoil at the political and economic consequences of massive policy divergence and ultimately neglect price stability to accept fiscal dominance again. Turning the clock back on central bank independence would be an extreme form of this approach. We would ascribe a low probability to this, given the huge transition costs for fiscal authorities themselves. Second, we could see a “self-limitation” of economic policy which would give up on reacting to every twist and turn of the cycle – in short a return to the 1990s. Politics are much more hystericized though and it’s unclear if our already polarized western democracies would cope well with allowing unmitigated patches of rising unemployment and declining real income. Third, governments could be tempted to harness the financial capacity of the corporate sector to achieve their goals. This could take an aggressive form – e.g. windfall taxes or regulatory pressure – or a cooperative one – e.g. incentivizing businesses to deal with global warming and the demographic challenges. A “combo” mixing these different approaches is likely to emerge, but in any case, redefining the scope of economic policy is likely to strain our democracies.

Moving away from this “high level” discussion, we look into more details in the current ECB debate in the light of the latest, contrasting dataflow: more inflation risks are materializing, while the print for Q1 GDP dampens the positivity of the message sent by the recent businesses surveys. Given the mood at the ECB, it is however likely that more weight is going to be put on the former than on the latter.