Andrew Craig
Hello, and welcome to MacroWaves, the podcast of the Economic Research Department of BNP Paribas.
I'm Andrew Craig, co-head of the Investment Insight Center at BNP Paribas Asset Management, and I'm here today with William de Vijlder, chief economist of the BNP Paribas Group.
William de Wijlder
Hi, Andrew.
Andrew Craig
William, it's good to be with you. We've got a lot to talk about, particularly in a week which has seen the price of oil reach a level of around $95 per barrel, heading somewhat awkwardly towards the level of $100 a barrel.
And that obviously potentially has big ramifications for central banks, which is our subject today. The question we're going to ask is, are we at peak rates? How do central banks manage the situation from here, given the trends in inflation? Obviously we've just come from a rate hike by the European Central Bank, who on the 14th of September raised rates by 25 basis points, taking their key deposit rate to a level of 4%.
So, we've seen a very rapid rise in that key deposit rate from a level of around negative 50 basis points in July last year, to today, 4%. So, I guess the first question is, do you think they are done? Is that it?
Or should we remain on our guard for further hikes from the ECB?
William de Wijlder
Before answering your question, I would just like to come back for a minute on what you said on oil. It's an illustration of a never-ending sequence of, I would say, sources of headache. We were very hopeful at the start of the year that a decline in oil prices would contribute to disinflation.
That has indeed been the case. But of course, the most recent increase is very unhelpful, given the central bank's ambition to bring inflation back to target, but also considering that these higher oil prices have a detrimental impact on spending power of households, and thereby actually intensify the headwinds for spending in the economy, headwind based on tight monetary policy, but now also headwind related to higher oil prices.
I'm talking about households. Actually, the same applies to companies, of course. Now to your question on “are we at the peak ?” , in a binary way, I would say “yes, we are”. Admittedly, if you would ask 50 economists, a lot of them would say yes. Others would say perhaps another 25 pp, but that doesn't really make the difference.
You mentioned quite rightly the very significant cumulative tightening that we have seen in the euro area ever since the ECB started hiking rates. The same applies in the United States, where the Fed started a bit earlier. You have to think about UK as well.
So, all these rate hikes in a swift pace, and cumulatively speaking, very significant, they imply that 25 pp more or not will not make a difference. The story is there is a level of monetary restraint now, and this is going to weigh on growth going forward.
Andrew Craig
Yes, the ECB has talked about this, about now being on hold or keeping rates at a restrictive level for a long period. And it was striking last week after the ECB had announced their decision to raise rates again, which was not completely expected by financial markets and observers, that the reaction did not necessarily suggest that the market felt it would be beneficial for growth in the eurozone.
We saw the euro, the currency trade down. We saw actually the level of bond yields fall, suggesting that there may be a risk that the level of interest rates, of policy rates in the eurozone is now too restrictive.
Do you think that's a risk?
William de Wijlder
Well, my interpretation of the weakening of the euro following the announcement is that the market is now saying, well, basically, the ECB is at the peak. The Federal Reserve, we do not know yet. So, there is still a kind of an upward risk to policy rates in the US, and that would mean spread widening.
And that, I think, is something that is underpinning the dollar. Admittedly, some commentators are saying that you have a bit of a phenomenon of one bridge too far, and that the weakening of the euro would be an expression of a very gloomy outlook, a gloomier outlook with respect to growth in the euro area.
I do not buy into that view yet. I think we need to see more data, more evidence. I think the decline in bond yields is a reflection of the idea that interest rate uncertainty at the short end of the curve has also gone out of the window, if we believe that, indeed, we are at the peak.
And the element in terms of the growth outlook that still gives me a bit of comfort is the reaction of the equity market, which moved higher and which I interpret as the consequence of two things. One phenomenon being, well, if bond yields are lower, mechanistically speaking, the net present value of future cash flows moves higher, equity is up.
But the second reason is that I think the market is pricing that the uncertainty about the economic outlook following the decision has declined somewhat, so the required risk premium has also gone down. All these are, I would say, knee-jerk reactions, instantaneous reactions, so we should not extrapolate that, but it is at least my reading of what happened following the announcement.
Andrew Craig
And you've talked a little bit about the potential impact of higher oil prices, and it was striking last week that the ECB also announced they were revising upward slightly their inflation forecast for this year and for 2024. So next year, the ECB expects a level of inflation around 3.
2%. Previously, they thought it would be at 3%. This year, they're expecting 5.6% instead of the 5.4% that they forecast previously. Now, obviously, we've come a long way. Inflation in 2022 was running at 10.6%. It was at 5.3% in August. So we're going in the right direction.
But do you think the ECB can be confident that inflation will continue to fall in a manner which allows them to consider that the battle that they've been leading against inflation has now won?
William de Wijlder
The direction of the journey is clear. The question is how quick that's really, and that is also the reason why, of course, the ECB cannot afford to be unambiguous and to be clear-cut and say we are at a peak, because you never know. It could be that core inflation stops declining.
Then it has a problem. It could be that the increase in oil prices has second-round effects. It would also create a problem. Although I do think that given the softness in the growth environment, we basically have a stagnation now, given the weakening in the sentiment indicators, I would expect that the second-round effects that would follow from the most recent increase in oil prices would be far more limited than what we have observed previously, that is, last year.
But the question is really about how quickly will it decline?, it being inflation. And on that, well, we don't know. Now, why do we not know it? First of all, the level of the inflation that we have experienced is completely atypical. As you know, we have to go back several decades to have something similar.
Second reason is that we have had inflation following from multiple shocks. That also makes it very difficult to gauge how it will evolve. The supply shock, the demand shock, the supply chain disruption, the war in Ukraine. And then also, the reaction of the economy to monetary tightening tends to take some time.
And what is making this environment difficult to assess is how far will wages go, because we still have a very tight labor market and wage growth is still pretty good from an employee perspective, but from an inflation perspective, a bit on the high side, even if you take productivity gains into account.
And then the other question mark is what's going to happen to pricing power of companies. Now, textbook economics will tell us that when the economy softens, the pricing power goes down. And this is also what you observe. ECB contacts with companies, for instance, show that the area where you still have clear pricing power is anything that is tourism, leisure, recreation related.
If it's more related to day-to-day spending by households, then pricing power has already declined.
Andrew Craig
If we cast our eyes a little bit further afield, you've talked about the US Federal Reserve. Obviously, the US Federal Reserve began hiking rates before the ECB in 2022 and is also close to or perhaps at the peak in policy rates for the US. I mean, the situation in the US economy is different.
The US economy is surprised by its resilience and by the strength of the US consumer. What's your view on the US and the US Federal Reserve? Do you think that they are now at their peak rates?
William de Wijlder
Yes, and if not, they are basically there. So just perhaps one final move and that will be it. One reason why central banks will become increasingly reluctant, would become increasingly reluctant to tighten further is that they will be afraid if policy rates have reached an elevated level, elevated if you take into account long term inflation expectations.
They will be concerned that at some point you end up having a nonlinear reaction. So what I mean by that is that all of a sudden the impression of resilience drops, disappears. So nonlinear would become, then there's a question, what could drive this nonlinear reaction?
And I see two candidates. One candidate is that companies end up realizing that their sales expectations, which have underpinned their communication in terms of hiring plans, their investment decisions, their marketing efforts, what have you, they come to realize that these sales expectations are a bit on the too optimistic side and they start revising them downwards.
What that means is that to protect the P&L, they will start cutting costs or they will refrain hiring, etc. And then it just has knock on effects. And that is going nonlinear because it creates an exponential reaction. And another reason for a nonlinear development would be that markets would end up reacting as well because they would come to realize that the hypothesis in terms of earnings per share growth or more generally cash flow developments at the company level, whether they are equities or bold issuers, would also come in below what is expected.
And that would then also trigger an adjustment. So that as a central bank, you want to avoid that. And that's why the higher the rates go, the bigger the likelihood that they would become far more cautious, would start adopting a pause. Now, once you pause, the bar to tighten again moves higher.
And the reason is very simple. By pausing, as time goes by, you will see that in the meantime, the impact of past rate hikes on the economy, the famously known long and variable lags, increasingly will manifest themselves. And that's, by the way, why the market will be very quickly price the idea if there is a pause that we are at the peak.
Andrew Craig
Yes. I mean, these lags, obviously, from the US economy, the eurozone economy, it's not certain that we've really seen the full impact of the rise in policy rates. Is there a difference for you between the sort of time lag in the US and the time lag in the eurozone?
Is there a fundamental difference, you think, in terms of the time it should take for monetary policy to actually
William de Wijlder
That's a hotly debated topic. So, it's a great question. So, what have we observed this far? One, the reaction in the US housing market has been very swift. I mean, in terms of the contribution of residential construction to GDP, I mean, it has been very significant, meaning a negative contribution several quarters in a row, to the extent that the excess supply of housing has essentially disappeared, which has become a supportive factor despite the fact that the interest rates are still elevated.
With respect to the eurozone, Christine Lagarde has insisted strongly on the fact that the governing council has the impression that the monetary transmission has been very swift in terms of bank lending, that is the attitude of banks when granting credit, but also on the demand side, the loan demand.
And we've seen that fairly clearly, of course, with respect to housing, but we've also seen that with respect to corporate credit demand for investment purposes. There is a view that the transmission could be quicker in the euro area compared to the US because the euro area is more bank-based financed, whereas in the US, capital markets play a bigger role.
And in capital markets, what we have seen is that when you look at the cost of corporate borrowing, admittedly, the treasury yield has moved higher, but the spread that companies have to pay over and above that yield has not widened, actually. So, this is something that shields them to some degree from the full impact of monetary transmission.
I think at the end of the day, it's a very complex debate. What is clear, though, is that via the bank lending channel, it is working, and the historical evidence shows that when you have these tightening of lending conditions and a drop in demand for new loans, that it is reflected in essentially, at best, a stagnation in volume terms of corporate investments and investments by households, that is residential construction activity.
Andrew Craig
I guess in this environment, one of the important questions is, are we in a fundamentally different interest rate environment? That's to say, has post-pandemic, there have been changes, fundamental changes in the economy, which mean that the neutral level of interest rates is now higher than it was previously.
That seems to me to be one of the big questions. Central Bank research, particularly in the US, suggests that the neutral interest rate is no higher than it was prior to the pandemic. What do you think? Do you now think we're in a different world in terms of the interest rate regime that we should anticipate going forward?
Or could we return to the sort of low levels that we saw in the years before the pandemic? Is there any sort of fundamental reason if inflation falls, why we wouldn't return to those sort of levels?
William de Wijlder
Well, on the neutral rate of interest, which corresponds to a real short-term rate of interest in a situation where the economy is in an equilibrium, that is you have full employment and you have no, and you have stable inflation in line with target. This is a beautiful theoretical concept.
But beyond that, I always look at it with a high degree of skepticism. However, there are other things that have changed since the pandemic. And one element is that we have seen a deterioration of public finances in combination with a policy of central banks that is aiming to scale back the size of the balance sheet.
So these factors combined means that somebody else needs to buy the bonds issued by the public sector and that should underpin bond yields. Secondly, there is a huge demand to finance the energy transition, the digital transition. The numbers are colossal.
And that means that you cannot finance it completely simply with money creation. So you must have somewhat of an impact via higher savings. And that means that in a way, households need to save more and spend a bit less. Now, to engineer an increase in the savings rate, you need higher interest rates.
So that's the second reason. The third reason is that when you look at nominal interest rates, I think we have really entered into a new era, at the minimum for quite a number of years. Gone is the era of below target inflation on a structural basis where central banks had to try everything and some other things to bring back inflation to target.
We have now moved to an environment where everybody will kind of have a sigh of relief if we get sufficiently close to target. But the likelihood that we would move below target and stay below target for a protracted period of time, I think is very small.
And why is that? Because so many structural things are happening. One element, for instance, is that because of demographics, I would expect that the pressure on the labor market will continue and will have an impact on the structural pace of wage growth because the competition for talent will not abate.
Another reason is that the reorganization of supply chains grew from an economic risk minimization perspective, that is robustness of supply chains, but also for geopolitical reasons, also means that you introduce a slight inefficiency in the system compared to what we used to have when supply chains were very long, complex, but rather reliable. And so that's another reason why you have a bit more inflation. And then it is also commonly accepted that the energy transition will also imply somewhat inflation simply because there's so much investment that needs to be done and also the cost of energy and the carbon pricing.
So when you put all these elements together, you have reasons to assume that both for real interest rates, but also for the nominal component of interest rates, inflation component, the future will be quite different from what we have seen up until early 2020.
Andrew Craig
As you say, there seem to be very powerful arguments when you think about the demographic trends, you think about the cost of the energy transition, you think about the fact that we no longer have the peace dividend, that there will now be considerably more pressure as we hear regularly on governments to spend more on defense. All of that would seem to exacerbate the pressures on government deficits and suggest that the cost of money should rise or should not fall to the levels that we saw prior to the pandemic.
William de Wijlder
And that leads to an interesting conclusion, that is that you could say, yes, we are at the peak in terms of policy rate. But the real question that we should focus on going forward is, but what about the bond yields? What about the level of the bond yields? That's far more becoming far more important than the policy rate.
Andrew Craig
Yes, real yields, which has seen as being attractive levels, are they at attractive levels? Obviously, the factors that you've mentioned, would suggest that they may have further to rise. I just like to talk quickly about China, because inflation in China has been absent.
In fact, in China has actually been in a slightly deflationary situation. Do you think that will be a factor that plays a role on inflation in G3 countries in Europe or in the US going forward?
William de Wijlder
China has indeed been very different in recent years. Think about the way they managed the COVID-19 pandemic, but also economically speaking, has been fairly different with respect to inflation developments, as you quite rightly mentioned. And it is something that can have an impact, impact globally speaking.
You could expect, for instance, that if you have very little inflation in China, or even a decline in producer prices, that it would have an impact on export prices, and that Chinese companies would try to use it to gain market share. So that would be a factor of disinflation for the rest of the world, but at the same time would also be a factor leading to more competitive pressure.
Low inflation of China could also imply that they can afford to accept an even weaker currency than they currently have. And that could then again be a factor that is lowering inflation in the rest of the world, but again, at the cost of being confronted with more competition from China.
So it is again something that we need to monitor closely, but I would say more from the competitiveness perspective than from the inflation perspective.
Andrew Craig
William, thank you very much.
That's all we have time for today. We've discussed in very comprehensively, I think, the situation at the moment, central banks and their fight against inflation. Is the job done? Next time we'll follow up on this topic and look beyond the peak and ask what comes next.
You've been listening to the Macro Waves podcast from BNP Paribas with Group Chief Economist William de Wilders. Thank you very much for joining us. Thank you, William, for your time.
William de Wijlder
Pleasure. Thank you.
Andrew Craig
And we look forward to talking to you again next time.
Thank you.
Recorded on 19 september 2023
