The Endgame for Central Banks Inflation Fight

There is little doubt about central banks’ monetary policy in the short term. Both the U.S. Federal Reserve (Fed) and the European Central Bank (ECB) will hike by 25 basis points next week. But uncertainty is high beyond that. Despite growing evidence that monetary policy transmission works better and faster in the euro area, the level of inflation continues to differ from country to country with prevalently higher rates in Central and Eastern Europe. In turn, market expectations were leading to the longest streak of strengthening of EUR/USD since 2004, while the region remains strongly dependent on the cross when it comes to overseas trade.

In the United States, the money market now prices a pause until March 2024, when the Fed is expected to start its easing cycle as a move to counter slowing growth. This can make sense based on the latest statistics available. The growth momentum in the United States is slowing down. A recession is all but unavoidable, however. A soft landing of the US economy is now the main baseline. Add to that the disinflation process has accelerated in recent months. Both the June headline and the core CPI came in softer than expected. The headline CPI inflation increased to + 0.18 % month-over-month in June. Notably, core CPI slowed sharply to +0.16 % month-over-month. It was the slowest month-on-month change since February 2021. Separately, the Atlanta Fed’s core sticky CPI, a weighted basket of items that change price relatively slowly, fell to +2.8 % on a one-month annualized basis. This is another very positive signal.

Nonetheless, it’s too early to call victory. There are a lot of sources of concern on the inflation front: oil prices are up, Russia/Ukraine grain deal teetering, labor strikes may generate wage contracts significantly higher than 3.5 % and annual comparisons will get worse. The path to 2 % will likely be bumpy and it will require softer labor markets.

It is far from certain that the Fed really wants to reach the 2 % target if this implies taking the decision to push the economy into a recession. This is not necessary: a 3 % implicit target or a 2 % official target does not have major macroeconomic implications. It would be ill-timed as well since the 2024 presidential election is approaching. In our view, the central bank can go along with a long-term average inflation close to 3 % without the market worrying much about it. In that sense, a long monetary policy pause after the July hike is the most sensible scenario.

This is always more complicated in the eurozone

Markets dislike monetary policy divergence. Without surprise, the debate about pausing is also rising in the eurozone. Earlier this week, ECB Governing Council member Klaas Knot (who stands as a hawk) declared in a widely commented interview to Bloomberg that monetary tightening beyond next week’s meeting is “at most a possibility, but by no means a certainty”. Some hawks are pulling back but not all of them. There is strong disagreement between council members on what should be done after the summer reset. In the ECB minutes published last week, several other members raised the prospect of more interest rate hikes, with at least one more hike in September.

The outlook is more puzzling in the eurozone. The Union is experiencing a technical recession, mostly reflecting the downward revision of Irish figures. This is more an epiphenomenon than anything else. On the inflation front, the situation is much bumpier in the eurozone than in the United States. There are reasons for optimism: weak CPI headline, encouraging details, and super core was down to 0 % month-over-month in the latest release for June.

There is growing evidence that monetary policy transmission works better and faster in the euro area. But, at the same time, the level of inflation strongly differs from country to country, which makes the task of the ECB harder. In France and the periphery, growth is stronger, and inflation is lower than in core countries. The unusual suspects are the services sector (in some countries, it is more resilient than in others) and the labor markets (in some countries, the market is tighter than in others). Hopefully, the United States exporting disinflation via the dollar slide will be of some help in the coming months if the drop in the dollar continues, as expected by the forecasters.

Euro surge: Too good to be true

FX-wise, the EUR/USD was headed for its 10th day of strengthening, potentially the longest streak since 2004. The trade-weighted euro, which is more representative of euro weakness/strength, is standing at a new all-time high. The recent surge in the euro is mostly explained by expectations the ECB will continue hiking while the Fed will pause. That’s far from certain. We think that further gains will likely be more constrained given still weak eurozone growth (the growth momentum is much stronger in the United States than in the eurozone with US GDP increasing by 82 % since 2008 and eurozone GDP barely increasing by 6% over the same period) and the potential for the ECB to refrain from hiking in September. In other words, expectations that the EUR/USD will test the 1.15 threshold this summer are certainly exaggerated. In our view, the EUR/USD will stabilize between 1.05 and 1.12 for most of H2.

“Romania, as well as the region, remain strongly dependent on the EUR/USD cross for international trade overseas. The long-term uncertainty around the interest rate hikes or pauses to be determined by the Central Banks and their impact on inflation will remain a main driver for EUR/USD in the upcoming months,” said Alin Latu, Country Manager iBanFirst Romania.

central banksendgameEuropean Central BankEurozoneiBanFirst RomaniainflationUS Federal Reserve
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