Suspects inhabituels

• Strong domestically-driven inflation in the old “D-mark zone” - in contrast with the developments in the periphery – is a new form of divide in the Euro area with significant policy implications.
• Last week’s dataflow was kind to the Fed: the “pause scenario” gained in likelihood.

ECB Governing Council members from the old “D-mark zone” continue to be quite vocal about the need to continue tightening monetary conditions in the Euro area. Conditions in their countries may explain some of this: services inflation – which is normally the most “idiosyncratic”, domestically-driven component – is significantly above the average in Austria, Belgium, and the Netherlands, in clear contrast with the relative moderation seen in Southern Europe. This does not seem to reflect a specific situation of excess demand in the “North”. Relative to their historical standards, labour market tightness is at least as prevalent in Italy and Spain. It may be the extreme “speed limit” on prices which was imposed on peripheral countries a decade ago to deal with the sovereign crisis which may have formed a “habitus” which is coming handy now, even if we should avoid seeing this as an eternal feature. Whatever the reasons, persistent inflation in the “North” may tilt the ECB into hiking on after this summer. This could create some political frictions.

Last week’s dataflow has been kind to the Fed, supporting a pause. Core inflation as a whole only decelerated by 10bps in April, but the crucial “services excluding rents” component continues to decline markedly. The Senior Loan Officer survey pointed to only a minor additional tightening in lending standards – probably a surprise in the context of the banking turmoil – but it also signalled a significant drop in credit demand by businesses. This suggests that irrespective of the change in the banks’ appetite to lend, the Fed tightening is working its way through the economy.

We think the Bank of England has joined the Fed in hinting at a pause after one last hike last week. Governor Bailey’s mention of having “no bias” matters, and the BOE’s insistence on how policy transmission may be slower than before is consistent with some patience at the MPC. Still, given the upward revision in the Bank’s growth and inflation forecasts, we have pushed our first rate cut to February 2024 instead of the end of this year.