Whatever it takes, in reverse

The Fed’s put and the ECB’s ‘Whatever it takes’ are virtually working in reverse: it is no longer about preventing a recession/deflation or preserving the EA stability, but re-anchoring inflation expectations and restoring credibility, notwithstanding the recession risk. To a large extent, central banks face a supply shock, and there is little they can do against that.

Still, they are ready to act in a way that will undermine demand and restore a supply-demand equilibrium at a lower level of inflation. China’s zero-Covid policy has added to global supply chain disruptions this year; restrictions there are now being eased and this should offer some relief. Commodity prices are also seemingly cooling off as demand ebbs. Assuming market prices stabilise, the base effect will start to improve this autumn, and much more so in 23Q1. But central banks must still lean against the much feared second-round effects. Employment costs have surged in the US (left chart) as the labour market has tightened. Even in the euro area, where data lags significantly, negotiated wages are flirting with 3% yoy, and clearly on the way up.

The latest announcements, e.g. in France where public sector employees get a 3.5% hike on July 1st while pensions and social benefits are set to be raised by some 4%, will be noticed at the ECB. The two right-hand charts below show the market expectations about inflation: still very high in the next 12 months (about 6% in the EA and 5% in the US), above target in the 12 months that will follow (1y1y at respectively 2.5% and 2.9%) and returning closer to target in the following year. This looks possible but such a relatively quick normalisation would most likely require forceful policy tightening and a sharp eco-nomic slowdown. The Fed’s projections show core PCE inflation down to 2.7% al-ready in 2023, with unemployment rising to just 3.9%. This looks rather optimistic: we fear that it will take more economic pain for inflation to recede so quickly.

Recession risks rising 

Risks to our growth forecasts are skewed to the downside. Our growth fore-casts have been clearly below consensus since the invasion of Ukraine but may still be too high. We see US growth at 2.2% this year and 0.9% next, almost 1 point p.a. below consensus. The US is less exposed than Europe to the war, but the triple shock of higher yields, commodity prices and US dollar is however recessionary. Q1’s neg-ative number was mostly an inventory and net trade issue, but the latest revisions also warn about a dispirited consumer. The coincident surge in gasoline prices and mortgage yields has contributed to a collapse in confidence. We also see clear signs of a slowdown in the manufacturing sector: the order-inventory component of the ISM suggest that the headline will quickly fall below 50. Employment has been rock-solid but leading indicators such as the momentum in NFIB hiring plans indicate a sharp turn in the coming months and quarters.

The euro area economy is coming to a halt. We have had to slightly raise our 2022 growth forecast to 2.6% – following an Ireland-driven anomalous gain in Q1 – but we see a flattish profile for the rest of the year (Q2-Q4); it would not take much – e.g. Russia cutting off its gas supply – for a couple of consecutive negative readings (technical recession). Our 1.6% forecast for 2023 is 0.6pp below consensus but could well still be too high. The ECB has a very rosy 2.1%, which also reflects generous carry-over given the rosy predictions for 22H2 (+0.4-0.5% qoq in the last two quarters of the year).

This has been the frustrating part with the ECB’s wishful thinking ap-proach to policy and communication. How would the economy run above potential in H2 following such a large shock on confidence and financial conditions? Puzzling. For investors, it all smells of recession already, if we follow the cycle clock measured via the Sentix survey (right-hand chart below).