Andrew Craig
Hello, and welcome to MacroWaves, the podcast of the Economic Research Department of BNP Paribas. My name is Andrew Craig. I'm co-head of the Investment Insight Center at BNP Paribas Asset Management. And I'm here today with William de Vijlder, Group Chief Economist for BNP Paribas. Hi, William.
William de Vijlder
Hello, Andrew.
Andrew Craig
Listen, our topic today is looking beyond the peak. We talked last time about the battle that central banks have fought against inflation, about whether or not they have won that battle. And today we're going to look beyond the peak. We agreed, I think, last time that if policy rates are not at the peak, they're very close to the peak, such that it barely makes a difference whether they should rise a little bit more or not. The question now is perhaps how long will central banks hold rates at these levels? How long will they plateau at these current levels? And what comes after that? So what's your view on the duration? The ECB talked recently about holding rates for a long duration at current levels. What do you think?
William de Vijlder
Let's first elaborate a little bit on why is there reference to duration plateau? It is that because central banks consider that monetary restraint is driven not only by the level of interest rates, but also by how long you keep policy rates at an elevated level. So that's why they insist on for a long duration. But of course, they do not know how long.
And this is going to be the focus of the analysis by investors, companies, market commentators. How long will they stay there? So what it really means is that the attention has now completely shifted from “are we close to the peak ?” to “when is going to be the first rate cut ?”. Because the first rate cut is of course very important for financial market developments. It has a bearing on how companies will decide to issue debt, whether they want to go for short maturities or longer maturities and so on. What commentators need to do or analysts need to do is to understand what is the reaction function of the central bank. Now what is a reaction function? That is that you have data and these data that are published on a regular basis, they help you to infer, to anticipate how inflation will evolve going forward. That is what central banks do. This is also what any economist or even any business person does when he is really concerned about inflation dynamics. And then the question is, when do you start reacting to this data? Considering that of course central banks need to keep in mind that there is an underlying trend of desinflation. So they should not wait until on a year over year basis the pace of price increases has dropped to 2%. They have to ease well ahead of that moment because if they would wait too long, the pain inflicted to the economy would be such that it would have a very detrimental impact on activity, the labour market and so on. So that is going to be the difficulty.
The problem being that central banks are actually quite opaque about how they will react. The ECB for instance has said, and I'm quoting its president Christine Lagarde, that we look at the data and what they will tell us about the inflation outlook. We look at the underlying dynamics of inflation, which is really looking in the rear view mirror, and we look at monetary transmission. On monetary transmission it has gone surprisingly fast in terms of the bank lending and etc. But we still need to see the impact on what happens to activity and demand. But that's about it. But we have no idea on how these shifting views will end up influencing the timing of the first rate cut.
Andrew Craig
When we talk about the reaction function of central banks, in the US it's been clear that one of the factors keeping inflationary pressures at uncomfortably high levels for the US Federal Reserve has been the strength of the job market. And clearly one of the Fed's objectives is to weaken conditions in the US labour market. And we're seeing signs that they're achieving that. But if we look back over time, there are very few examples of situations where the unemployment rate in the US has risen with a soft landing. Typically a rise in the US unemployment rate leads to recession. Do you think that the US economy will achieve a soft landing? How do you evaluate the probability of a soft landing in the US and the Fed managing to weaken conditions in the US labour market without breaking, if you like, the economic dynamic?
William de Vijlder
There are several parts to the answer. The first one, and this is just straightforward. The ambition of the Federal Reserve is to achieve a soft landing. Okay, so that's not the answer to your question. Then you have the historical record, as you mentioned quite rightly. Achieving a soft landing is pretty unique. It does not happen very often, not at all. Then you have to look at, yes, but in the current environment, is there something different? Is there something that could actually increase the likelihood of a soft landing? And really it's the same factors of resilience, or certain of the resilience factors that will continue to play a role going forward. And a key factor is the necessity of companies, but also households, to invest to reduce their carbon footprint, to change their capital stock from high carbon footprint to low carbon footprint, to achieve the digital transition, etc. And that's of course where the Inflation Reduction Act and the CHIPS Act have been instrumental in supporting investment. These are developments that you would expect will continue. I would also argue that in our base scenario, we have a short and shallow US recession. I always call it a look-through recession. Now what is a look-through recession? It is something that as a businessman, you can basically ignore it because it's short-lived and not very deep. So you're not going to change your corporate strategy for that.
And that would then also be an element of resilience. Now with that resilience comes of course the reverse side of the metal. Because if you buy into the view that there's going to be resilience, then it begs the question, yeah, but okay, that means that labor market tightness may last longer. So what is going to happen to wages? And that brings us to the point that you can have a soft landing, but that just takes a lot of time. And that would have to keep rates at an elevated level, that plateau, far longer than we currently expect and then is currently priced in by the markets. So that's going to be the very tricky part. So I would say that for a number of reasons, you can have this a priori that a soft landing can happen, but it would bring new challenges, analytical challenges and kind of assessing, but does that mean that it would then end up being trickier? And I think in particular with respect to market pricing, but then this has a knock-on effect on the bordering conditions of households for building a house or buying a house or for companies when they have to make investments or when they have to refinance that.
Andrew Craig
If we think about rates at their peak, so the next move after the plateau is obviously downward. What do you think central banks would like to achieve in terms of the pace and the timing of rate cuts? Obviously, markets are now speculating on when central banks will start cutting rates and the rhythm at which they will be cutting rates.
What do you think central banks ideally would like to be achieving when they start their cycle of rate cuts in terms of the pace and the rapidity with which they undo the restrictive policy that we have now in monetary policy?
William de Vijlder
This cycle has been atypical in terms of the pace of tightening and I think it will be atypical in terms of the pace of rate cuts. Normally tightening cycle is a slow process and an easing cycle is fast paced. This time around, what we have observed is that the tightening was very fast paced and I would expect that the easing will be slow paced. The reason is that central banks will start easing when inflation is still above target so they cannot really afford to be too aggressive because otherwise they may have an issue in terms of credibility, inflation expectations might go up and so on. So that is slow paced. Now another reason which is more structural and we discussed that in the previous podcast, is that the inflation developments are such that we can expect to move, say, rather close to target but really not to drop below it. So that is another reason why central banks, I expect, would take a more cautious approach in the pace of rate cuts. You could also argue that, but is it a possibility that it would be different, that it would have to move to fast paced cuts nevertheless? If that were to happen, I would say it would be bad news for the economy. That means that there has been no soft landing, that the extent of the recession has been underestimated. With that would come a swifter disinflation but it would also force them to really proceed with fast rate cuts. So it wouldn't exactly be a great thing.
Andrew Craig
I mean at the moment we know that central banks don't have great visibility. They both, the US Federal Reserve and the European Central Bank and other central banks talk about the fact that they're very data dependent, that they have very open minds on what the next step in monetary policy will be.
Do you see this as a problem? Is this a real issue that there's a sort of poor visibility in terms of what's coming next?
William de Vijlder
Well, one can explain why we have this reduced visibility and clearly it is a problem. Why do we have this reduced visibility? Because we have had exceptionally high inflation that we haven't seen for several decades and the economic models that we use both in a judgmental way but even in a more statistical way, econometric way, they are not adapted to that. That's point number one. Point number two, when you look at the diverse nature of all the shocks that we have seen, it's very difficult to come to grips with which shocks have already shown their complete impact and others still have to do that. So that makes it all very difficult. And then on top of that comes what I've already mentioned, which is this necessity to invest because of the green transition and so on. So you put all these elements together, the visibility or the reliability, the confidence level about growth projections beyond one year is lower now than what it would have been otherwise. And that is why they go for a data dependent approach. Also because if they would be too, let's say, clear on what they expect, too adamant about it, and then would have to come back on what I've said earlier, then it would be very bad for credibility. Christine Lagarde in recent speeches has insisted on the fact that as a forecaster in a central bank, we need to be humble and that humility is going to be credibility enhancing. Now business people, households, markets also as a consequence become data dependent.
The issue it is creating is that you can have really big shifts in sentiment when the balance tips in one or another direction. And that is something that we need to be aware of. Up until now, we have been in an environment of US economy is resilient. We've also seen that in terms of market behavior. But when you're in a data dependent mode, at some point, the proverbial straw that breaks the camel's back can tip the balance in the other direction. And then you can have swift reactions.
Andrew Craig
The tipping point, as it were.
Well, that's all we have time for today. Thank you very much, William, for looking beyond the peak with me.
William de Vijlder
Pleasure.
Andrew Craig
We look forward to talking to you again next time. You've been listening to the Macro Waves podcast from the Economic Research Department of BNP Paribas with myself, Andrew Craig and William deVijlder, Group Chief Economist. Thank you, William.
William de Vijlder
Pleasure.
Andre Craig
And we look forward to talking to you again soon. Bye bye.
Bye bye.
Recorded on 19 september 2023
