L'exploration d'un miracle

In our first post-Christmas Macrocast we wrote that the distribution of risks was not symmetric across the Atlantic in part because the most plausible policy mistake is not necessarily the same in the US and the Euro area. The belief in the capacity of a “soft landing” to bring inflation under control may convince the Fed to cut rates too soon, allowing a resilient economy to ultimately keep the pace of consumer prices above target. Conversely, a backward-looking approach to monetary policy by the ECB may make them cut too late, precipitating a deep recession which would force inflation below target. Yet, two developments last week might have reduced these two risks symmetrically: the combination of strong GDP growth in the US with on-target core PCE adds credibility to the “painless disinflation” hypothesis, while Christine Lagarde’s unexpected reluctance to push back market expectations last Thursday may reflect a greater readiness to alter the course of monetary policy rapidly in the face of deteriorated conditions in the real economy.

Unsurprisingly, these pieces of news have fuelled further the market’s already aggressive expectations for swift rate cuts across the Atlantic. Still, we maintain our cautious approach – our baseline is still that cuts start in June for both central banks. In the US, although we agree a case for bringing the cuts forward is getting easier to make, the very resilience of the economy should incentivise the Fed to take its time to shift to a more accommodative stance – what is the urgency? – while still keeping alive the possibility that, although the recent data flow on consumer prices has been reassuring, a line of resistance above 2% may still emerge. For an early cut by the ECB, we think that the dataflow would have to be “perfect” in the coming months.: inflation would have to recede flawlessly, more “bad data” would have to come on the real economy and the real-time indicators on wages would have to point to a proper slowdown. This is not impossible - an April cut is now part of our “plausibility range” for the ECB – but data rarely comes without ambiguity.