Le miracle de 1994 revisité

• Beyond the additional hikes in the US, UK, and Euro area this week, we don’t expect a change of tone from the central banks.
• We take a hard look at the likelihood to see a replication of the “recession free” tightening of 1994. We are not optimistic.

A “central bank super week” is starting. The Fed, the ECB and the Bank of England all meet. Last week the Bank of Canada chose to buck the trend – or precede it for the optimists– by announcing a pause after its 25bps hike, although disinflation in Canada is still tentative, and it’s going to be tempting for the market to read into the decision in Ottawa the harbinger for the long-awaited “dovish pivot” elsewhere. We don’t think the time has come though. True, we expect a downshift to 25 basis points by the Fed this week, but their communication remains consistent with considering to pause only in Q2 – at best. The ECB for its part could not be further away from the BoC thinking at the moment. We expect the ECB to hike by more than the Fed not only this week, but also in March, which would solidify the recent rebound in the euro exchange rate. The Bank of England is – again – in a delicate position. A still tight labour market combined with still higher-than-expected core inflation call for a 50bps hike – out central scenario – but the Marginal Propensity to Consume (MPC) is clearly concerned by the risk of “overdoing it”.

So far, the real economy has remained resilient despite the relentless rate hikes, to the point that the equity market may be counting on the replication of the “1994 miracle”, the only episode of Fed tightening since the early 1960s which did not trigger even a shallow contraction in US GDP. Beyond the fact that the size of the cumulative tightening is already larger than in 1994, we note that it now applies to a more leveraged economy than then. In addition, in 1994, the Fed responded to “imaginary inflation”: corporates did not have to deal with margin contraction and households’ purchasing power was not eroded. Finally, supply-side conditions were much more favourable then. In the first half of the 1990s, the civilian workforce was expanding much faster than today, while “animal spirits” were probably spurred by the emergence of globalization, materialised very concretely in the US by NAFTA. Current resilience is welcome, of course, but we continue to dispute its longevity, especially with central banks “not being done”.