L'effet Draghi perdure

Key Points

• The political status quo in Italy is good news, even if the majority may become more difficult to steer towards swift implementation of the structural reforms which are part of the NGEU framework. Costa’s electoral victory in Portugal will also help in the conversation with Berlin on the next steps of the EU’s economic integration.
• The Fed “means business” on curbing excess demand quickly, while the ECB this Thursday is likely to re-affirm it is in observation mode. The January inflation print for the Euro area will colour Lagarde’s press conference.

Political stability is going to be a precious asset as the world economy normalizes and economic policy needs to break from “all-out” accommodation. The status quo which has prevailed in Italy, with Mattarella remaining President of the Republic and Mario Draghi Prime Minister is the best possible outcome as the ECB’s support to the bond market is about to fade. Italy’s economic performance in 2021 has been encouraging with the Next Generation EU framework acting as a catalyst for much-needed structural reforms and catch-up on investment. The country will need to stay the course though, and the internal conflicts in the baroque parliamentary majority supporting Draghi may make the next steps more difficult. The intrinsic shortcomings of the Italian institutional setup are still there. Yet, in the meantime the alliance between Paris and Rome to reform the Stability and Growth Pact – and possibly to turn the NGEU into a permanent feature – is holding up. Moreover, the clear victory of incumbent Portuguese Prime Minister Costa in a snap general election now equips him with an absolute majority which should allow him to pursue an economic policy which can keep the populists at bay while keeping the market on board.  Avoiding crisis and delivering good macro results is what is needed – although it may not be sufficient – to convince Berlin that peripheral countries can be trusted to do their part of the job if the EU moves even further into a system of mutualized liabilities.

“Peace and quiet” on the political front – for now - is one concern less for European investors as they deal with contagion from the US. Last week’s press conference by Jay Powell has confirmed that the Fed “means business” and is not ready to soothe the market. Curbing excess demand quickly is the central bank’s new motto, and Raphael Bostic’s point on the possibility to start the lift-off with a 50-bps hike was “interesting”. Still, while the direction of travel for the Fed in the first half of 2022 is becoming even clearer, we note that the market’s expectation for the total number of hikes in the whole tightening phase has not changed much. The “Fed overkill” thesis is still prevalent.

The ECB’s Governing Council meets this week. They have given themselves quite some time to remain in observation mode and we expect Lagarde to “lower the temperature” after the series of statements from hawks. The January inflation print – to be released the day before - is likely to colour the press conference.