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MACRO RESEARCH
23 June 2021

Moving Away from Ultra-Loose Policy

With the worst of the pandemic behind us and the unfolding of a strong global economic recovery, central banks have started their long march towards policy normalisation. Though the US economy is set to have recovered all of its lost output already this quarter, the Fed sees few inflation threats on the horizon and is determined to remove its support only very gradually. In our view, there are a number of red flags suggesting that higher inflation could be more persistent, raising the risk that the Fed will have to change tack at some point next year. In Europe, however, the medium-term inflation outlook looks benign and we expect the European Central Bank to maintain its current monetary stance for some time apart from a few tweaks to its asset purchases.
As governments in the US and Europe are rapidly vaccinating their populations, life is gradually edging towards some form of normality. But it also seems clear that we are not reverting to the status quo ante. The pandemic appears to have accelerated some trends that would otherwise have taken many more years to unfold, such as the digitalisation of many activities or a renewed focus by policymakers on social inequalities. In the US, the return of a big ‘tax and spend’ agenda would have been unimaginable prior to the pandemic.
Inflation dynamics differ in Europe and the US
inflation_dynamics_us_europe-web.png
Source: Macrobond, J. Safra Sarasin, 27.05.2021
One implication, as we have argued before, is that US inflation will probably not drop back to its pre-pandemic levels. It is, however, the degree of inflation stickiness and the implication for Fed policy that will matter for markets. In the euro area and Switzerland, underlying price pressures are far less evident. The ECB and the SNB will most probably not rush into removing monetary accommodation, even if the economic recovery is set to accelerate.

Keep calm and carry on

The Fed has said loud and clear that higher inflation rates are likely to be transitory. It can therefore afford to keep monetary policy loose for a long time to support a faster labour market recovery. This doesn’t mean that nothing will change over the coming months. It is undeniable that progress has already been made towards fulfilling its dual mandate. We expect that by the third quarter, “substantial further progress” – the threshold to start tapering asset purchases – will be within reach, allowing the policy-setting committee (the FOMC) to announce its plans. Actual tapering will probably only take place in the first quarter of next year, given that officials have promised investors ample lead time between ‘talking’ and ‘acting’.
Two conditions need to be met for the Fed to lift rates from the zero effective lower bound (ELB): the economy has to reach maximum employment – which is defined in a broader and more inclusive way than its previous definition of full employment – and inflation must be "on track to moderately exceed 2% for some time". The objective will be to return inflation to its 2% longer-run goal, but not to push it below that level. Inflation and its expectations will be the main metrics the Fed will use to tailor its policy stance. Importantly, a drop in the unemployment rate below its estimate of the natural rate will not trigger in itself a tighter policy, as it used to.
Fed communication and its Summary of Economic Projections indicate that the FOMC will not raise rates until at least 2024, and when it does so, the pace of tightening will be more gradual than in the past. We very much doubt that it will wait that long and expect the lift-off to take place in the first half of 2023. This is already reflected in government bond yields. In our view, the risk to markets is that the Fed could end up being too slow in acknowledging its progress, forcing a sharper pivot to its policy outlook at some point next year.
Indeed, we don’t think that all of the increase in inflation will turn out to be transitory. Some inflation stickiness would actually be welcomed by Fed officials, given years of inflation undershooting. And if this happens, the central bank would only need to do some adjustment to its forward guidance. Yet too much stickiness, and a de-anchoring of inflation expectations on the upside, would be far more disruptive to markets. There are three driving forces underlying our more hawkish view on inflation: (i) downward price rigidity; (ii) higher inflation expectations and (iii) growing wage pressures. It is the intensity at which these forces will unfold that will determine whether the outlook eventually looks like our base case – some inflation stickiness but no radical change to the Fed policy outlook – or more like our risk scenario – inflation becomes more of a concern forcing the Fed to act more aggressively. Let’s look at these three forces in turn.
The reopening-inflation surge is set to be bigger and longer-lasting than previously anticipated. Demand is extremely strong and supply constraints are broad-based, which has led to a sharp increase in input costs. Prices of items that benefited from the crisis last year –such as used cars, video and audio equipment – and which should have started to fall as the pattern of consumption normalises, have risen further. This might be indicative of a broader trend: downward price stickiness. After all, if households are flush with cash, why would any company cut its prices?
It’s hard to find American workers
american_workers.png
Source: Macrobond, J. Safra Sarasin, 27.05.2021
Second, it has never been as hard for US employers to fill positions. As a result, they are bidding up wages to attract workers. The Employment Cost Index – which is adjusted to take into account shifts in the occupational mix of workers and is therefore a purer measure of wage inflation – has already accelerated over the past two quarters to previous cyclical highs. Some of the shortages should ease as the year progresses. Extra unemployment benefits, school closures and a lack of childcare as well as health risks should become far less of a drag on labour force participation by this autumn. Still, demand should remain strong and the supply of new workers will probably be quickly absorbed, adding to upward wage pressures.
This brings us to our final point: inflation expectations. They have already risen significantly, adjusting to the new outlook. And while we think they are close to a peak, the risk is that they could climb up further. There is still a huge amount of stimulus money that needs to make its way through the system and there are few signs that supply bottlenecks will ease soon. A prolonged imbalance between supply and demand would push up prices more broadly, and probably feed into higher inflation expectations. The more inflation households and businesses expect in the future, the more they will bring forward their consumption, driving current inflation higher.
The risk of a big inflation overshoot is real
inflation_overshoot.png
Source: Macrobond, J. Safra Sarasin, 27.05.2021

The ECB will keep its very dovish tilt

Economic momentum in Europe is finally building up. The pace of vaccination has clearly accelerated, allowing for restrictions to be lifted steadily. With herd immunity now in sight, business and consumer sentiment is rising rapidly. But this is coming at a cost. A large number of companies are reporting supply bottlenecks, pushing input costs higher. A case in point is the European automobile industry, which is suffering from a global scarcity of semiconductors. With huge backlogs of orders, rising capacity constraints and very strong pent-up demand, European firms are planning to pass some of the increase in costs on to their customers. Still, after peaking at 2.4% this summer, we expect euro area inflation to drop to 1.2% in the first quarter of next year, before moving somewhat higher by year end. In short, in the case of the euro area, higher inflation should turn out to be truly transitory. Different wage and inflation-expectations dynamics, compared to the US, can explain these differences. These, in turn, probably reflect the respective stages of the economic recoveries, the amount of policy support and the nature of this support.
Euro area financing conditions are very loose
euro_financing_conditions-web.png
Source: Bloomberg, J. Safra Sarasin, 27.05.2021
Given this benign medium-term inflation outlook, the ECB will be in no rush to remove monetary accommodation. At the same time, brighter economic perspectives with fewer downside risks do not require the same looseness of financing conditions. As a result, we expect the ECB to end its Pandemic Emergency Purchase Programme by March 2022, with possibly some minor tapering of its purchases before then. Yet this will not mark the end of its asset purchases, far from it. The ‘dormant’ Public Sector Purchase Programme will play again a more dominant role after March 2022, in our view.

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