Le Syndrome de Stockholm

• The February inflation data vindicates the ECB hawks. We remain however concerned with the “financial channel”: the January batch for loans confirms the credit impulse in deeply negative.
• We look at Sweden and the UK as “canaries in the coalmine” when it comes to monetary policy transmission.

In the Euro area, the inflation figures for February vindicate the Governing Council’s decision to signal its intention to deliver another 50-bps hike on 16 March.  The slowdown in economic activity is not yet having the expected moderating impact on price behaviour. We continue to think the monetary tightening has however started to work its way through the economy, even if it has not yet visibly impacted aggregate demand. The data for January has confirmed the steep decline in the credit impulse. The historical relationship with GDP with a lag of a quarter is relatively tight, even if base effects from the pandemic may have blurred the picture and ample liquidity buffers may delay the transmission to business and consumers decisions.

Cracks usually appear first in the most interest-rate sensitive sectors of the economy.  The recent developments in Sweden are interesting from this point of view. Transmission should be swift there, given the dominance of variable rate mortgages and an extremely stretched housing market before the tightening began. GDP contracted significantly in Q4 there (-0.9%) amid sharp declines in house prices. The Riksbank is in a quandary. If it stops hiking rates, it risks fuelling the depreciation of the currency and hence imported inflation. Accepting a quite deep recession – and the collateral risks to financial stability – may be the only workable avenue there. The UK could be the “next shoe to drop”. The recent dataflow is not as bad as in Sweden, but the housing market correction has started.

The ECB Governing Council is visibly tempted by additional tough moves beyond March, but we feel that the risk of a “double dip” scenario is also gaining ground. Transmission may be slower than in the UK or in Sweden because of structural features of the Euro area economy – with the dominance of conservative lending practices and fixed rate mortgages in many member states – but it does not necessarily mean that down the road the impact is smaller.