After being left reeling by the unexpected money-market crisis during its first round of quantitative tightening (QT1), the US Federal Reserve (Fed) intends to manage the second (QT2) with the utmost caution. This means reducing its securities portfolio without creating a shortage in central bank money, in view of the liquidity requirements imposed on banks under the Basel 3 framework. As it is unable to estimate the optimum amount of central bank reserves needed to ensure that its monetary policy is properly implemented, the Fed aims to reduce the stock of reserves to a sufficiently "ample" level.If QT2 is ended too early, it would have to activate its liquidity draining tools in order to limit the downwards pressure on short-term market rates
The FOMC kept the target range for the Fed Funds rate at 4.25% - 4.5% at the 18-19 March meeting, as widely expected. Jerome Powell and the committee have started to price in downward risks to economic activity and upward risks to inflation. In the short term, the stability of the dot plots, the downplaying of the long-term tariff related risks and the consistent message of patience are aimed, implicitly, at providing stability in the midst of the current turmoil. In our scenario, the FOMC is expected to cut the rates quite sharply in 2026.
They say the Davos consensus is always wrong, but it usually takes longer than a couple of months to be apparent. Not so in 2025.
Our nowcasts for Q1 show moderate growth in the euro zone (+0.2% q/q) and in France (+0.1% q/q). The Atlanta Fed's GDPNow, on the other hand, suggests the risk of a significant slowdown in US growth in Q1. In other countries, our forecasts are for continued outperformance in Spain, rebounding growth in Italy and the UK, and moderate growth in Japan. In Germany, growth is likely to remain weak in Q1, with the upside risks associated with the next government taking office more likely to affect Q2. Chinese growth is exposed to downside risks.
The Main recent economic news.
The unemployment rate held steady at 6.2% in January, an all-time low. Declines are most marked in southern Europe and Ireland, while the unemployment rate is relatively stable in France and Germany. Negotiated wages rose by 4.1% y/y in Q4 2024, less than in Q3 (5.4% y/y) but still well ahead of inflation.
Equity indices, Currencies & commodities, and Bond markets.
The IFO business climate index remained stable in February compared with January, at 85.2, and remains close to the low recorded in November (84.7). It is the situation of industry that is having the greatest impact. Industrial output, including construction, contracted again, by 0.7% q/q in Q4 (the 6th fall in 7 quarters). However, January's figures show a slight rebound (+0.6% month-on-month on the 3-month moving average).
Household confidence rebounded from 89 in December to 93 in February (95 in September, 100 on long-term average). The balance of opinion on past price trends, at -5 in February, reached its lowest level since July 2021. On the other hand, the balance of opinion on fears of unemployment rose again in February (+55, compared with +29 in September), fuelling the opportunity to save.
Intentions to make major purchases in the coming year are at their highest level since July 2021. This should enable private consumption to further buoy Italian growth. For the time being, hard data remains disappointing: new vehicle registrations are slowing (-3.3% 3m/3m in February), as are retail sales volumes (-0.4% 3m/3m in January).
The composite PMI (55.1 in February compared with 54 in January) was buoyed by the services component (PMI at 56.2; +1.3 pt). Nevertheless, industrial activity is deteriorating sharply, with industrial output down by 1% y/y in January (-22.8% y/y for vehicles) and the manufacturing PMI falling below 50 for the first time in over a year in February (49.7; -1.3 pt).
Household sentiment deteriorated in February according to the Conference Board (98.3, -7.0 pts) and even more in March according to the University of Michigan (57.9, -6.8 pts), dragged down by worsening expectations. According to the University of Michigan survey, the jump in 1-year inflation expectations (+4.1%, +1.0 pp) was accompanied by a 30-year record for 5-year expectations (+3.5%, +0.3 pp).
The GfK index rose in February (+2 points to -22), but did not erase January's fall. The balance of opinion on the one-year financial outlook is back in positive territory. Retail sales rebounded by 1.6% m/m in January, after four months of decline. This upturn was confirmed by the BRC/KPMG survey, which showed retail sales (smoothed over three months) up by 2.2% y/y in February.
The upward trend in nominal wages continued in January, with contractual wages scheduled to rise by 3.2% y/y, a record since 1992. However, the real wages index fell sharply to -1.8% y/y in January (-2.1 pp), its lowest level since March 2024. At the same time, the unemployment rate was stable at 2.5%.
Manufacturing PMIs rebounded in February, returning to their average level of Q4 2024 (50.2 for the NBS index and 50.8 for the Caixin index). In services, the PMIs remain below their Q4 level but are above the expansion threshold (50 for the NBS index and 51.4 for the Caixin index). The latest activity data confirm this reassuring but rather lacklustre performance: growth in industrial production slowed in January-February after accelerating in December, but held steady at almost 6% y/y. The slowdown in growth in production in services was more marked (+5.6% y/y in January-February, vs. +6.3% in Q4).
The updated economic scenario and forecasts of the Economic research
Government bond yields in advanced economies are highly correlated, much more than the correlation of real GDP growth. Governments should be cognizant that a lack of fiscal discipline can create negative externalities, by pushing up bond yields abroad. Given the prospect of huge financing needs in the public and private sector, every issuer of debt should prepare for the possibility of structurally higher interest rates and stress test his balance sheet in order to test its resilience.
We are almost a week away from a vote that could change the face of Germany. On 18 March, the Bundestag will decide on the adoption of two structural defence and infrastructure projects. A massive budget plan that could exceed EUR 1,000 billion over the next ten years and revive German growth, which has been absent for almost 3 years.
Inflation is no longer the No. 1 economic problem that it has been for the past three years, but it remains a major challenge. While it has not reached its 2% target yet, and the last pockets are slowly deflating, new inflationary pressures are mounting. At this stage, those pressures are limited but not negligible and new inflationary risks, linked to the economic and geopolitical context, are taking shape. The Fed's task is becoming more complicated by the risk of a US stagflation, and the ECB's one happens to be slightly trickier when balancing between downside and upside risks on growth.
The two most recent shocks to emerging countries (the 2022-2023 tightening of US monetary policy, and the election of Donald Trump at the end of 2024) have not affected their financing conditions. However, supporting factors have weakened since the second half of last year. In the coming months, financing conditions could tighten as a result of rising geopolitical risk in particular. However, the adverse impact on emerging economies should be viewed in perspective, given the low transmission of the two recent external shocks to interest rates. Although exchange rates have continued to depreciate against the dollar, the vulnerability of debt to foreign exchange risk is moderate or low for households and non-financial companies
Peace talks have started. We do not know how soon or exactly where they will land. But things are moving fast. While much of the focus is, rightly, on the unexpectedly daunting geostrategic challenges, it’s not too soon to start mapping out the key economic implications for Europe.
