Les faucons n'hibernent pas

We’ve had quite an eventful week on the monetary policy front for this last Macrocast of the year, and this fits quite nicely in our general narrative for next year. Indeed, for us 2023 is likely to be the “mirror image” of 2022. Faster, broader, and more persistent inflation has defined 2022, but with remarkable resilience of the real economy. Conversely, we expect a significant disinflation for 2023, but with a heavy toll on activity, largely because for the first time this century, central banks on both sides of the Atlantic are not trying to accommodate the slowdown. Quite the opposite, they are ready to engineer it, as a painful but necessary condition to get inflation back under control

True, the new Fed’s forecasts are still consistent with only a very shallow recession in 2023 “at worse”, but as we expected the new median terminal rate in the dot plot suggests the FOMC is ready to go very deep into restriction, and stay there for long, to get inflation back under control. Collectively, investors are still not listening though, as forwards continue to price a good 50 bps worth of cuts in the second half of next year. Even if we agree that some tangible signs of disinflation are now appearing in the US, this creates some uncomfortably large space for disappointment in the markets next year.

Meanwhile, the ECB gave us a proper “hawkish festival”. We now expect a terminal rate at 3.25%, well into restrictive territory, with risks tilted to the upside. It is tempting to read last week’s ECB communication as an adaptation to the Fed’s own hawkishness the previous day, with a desire to avoid a depreciation in the euro exchange rate which would impair the European disinflation.  This is understandable, but it feeds into the “race to the top” setup lamented by M. Obstfeld a few months ago, which may ultimately bring about an excessive degree of aggregate monetary tightening in the global economy. Besides, with this hawkish tilt, beyond the fact it is adding to the already dauting headwinds blowing against the European economy, the ECB is taking risks with fragmentation in the Euro area. The ECB has given itself some space to recalibrate QT next June. This is wise but may not suffice.