The writer is the group’s chief economist at Société Générale
The lively discussion about the volatile and new landscape of inflation is felt in the markets. It is not only a matter of how different drivers may affect the rise in prices but also the implications this has on interest rates.
Even in May, we saw significant changes in markets as investors sought to price central banks’ reasonable responses to inflation rises.
The transatlantic gap in 10-year bond yields in the U.S. and Germany rose to 2.0 percentage points in early May, but has since narrowed at 0.30 percentage points. Reducing the gap in real yields after taking inflation into account was even more impressive, falling by almost 0.70 points in May.
Long-term bond yields can be seen as a reflection of reasonable real policy rates, expected inflation and a premium for the duration of holding an investment. The change in the relative pricing of monetary policy expectations largely explains the recent real margin narrowing.
Bond markets have become more confident that the US Federal Reserve will remain clear of 0.75 percentage point interest rate hikes and continue at 0.50 basis points for now. At the same time, the European Central Bank has signaled an earlier rise in interest rate hikes More normal for the eurozone, which in turn also caused the euro to recover from some of its previous lows against the dollar.
It’s all a very different world from what we saw during the decade leading up to the epidemic, a period shaped by the dominance of structural demand weakness, which leaves central banks struggling to raise inflation to target. The term secular stalemate took the stage.
In the list of arguments that inflation will be structurally higher from now on, many fall into the category of negative shocks on the supply side, whether it be a more regional supply chain, greater protectionism, skills shortages or climate change frictions.
It can be argued that many of these supply shocks may well outweigh demand, raising the likelihood that central banks will face the difficult choice of raising interest rates despite weaker economic growth.
As a result, on both sides of the Atlantic, the debate over whether secular stagnation or stagnation will emerge from recent volatility is now at the heart of central bank policy. But we are expected to see a narrowing of the expected bond yield gap between the US and the eurozone.
Fears of stagnation have so far been more apparent in the Fed than in the ECB, but that may be about to change. Aside from supply-side shocks, current inflation stems from the rapid onset of post-epidemic economies, fueled by halted austerity and expansionary fiscal policy. This is especially true in the US, where fiscal incentives have increased household aggregate income far beyond epidemic-related losses.
However, fiscal policy on both sides of the Atlantic is about to trade in places, with significant tightening in the US while the eurozone remains more comfortable. Although this may contradict the ECB’s efforts to control inflation, the policy of the central bank that relies on fiscal incentives with its policy stance may be very challenging.
Another area of differences in the forces shaping growth and inflation between the US and Europe is the way they deal with the climate transition, with the EU expressing a greater determination to move faster than Washington.
As welcome as the acceleration of these efforts, the race to raise green investment may struggle given the EU’s incomplete bank union, the capital market union still emerging and the lack of a large-scale permanent fiscal tool. The risk now is not only higher energy prices in the EU as a result of climate change efforts but also various shortages of materials or work skills.
This means that the ECB will have to respond more aggressively to keep inflation under control, in turn narrowing the expected interest rate differential between the US and the eurozone.
Finally, regarding wage dynamics, the momentum of wage increases in the US shows the first signs of softening. Will shrink even further and with this potential also for a little more appreciation of the euro.
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