How Far to Diverge

• The Fed has probably hit peak policy rate, we expect two more 25 bps hikes from the ECB
• Euro area core inflation may be stickier than in the US, but some “policy patience” may be warranted there

Last week’s communication from the Fed and the ECB points to a divergence in the months ahead. We think the “soft hiking bias” the Fed retains is largely driven by a so far unsuccessful attempt to stop the market from pricing future rate cuts even more aggressively. The mention of an “additional firming” of monetary policy in the US no longer is the “statement of intent” it was last time, and there was enough in Jay Powell’s comments to hint at a pause. On the other side of the Atlantic, Christine Lagarde’s mention in the press conference that the ECB has “more ground to cover” told us that they are not “done”. Our baseline is that the Fed has indeed reached the peak of its monetary tightening in this cycle, while we expect from the ECB two more 25-bps hikes to a terminal rate of 3.75%, with a significant risk it goes to 4%. In our own forecasts core inflation in the Euro area will not decelerate markedly before the end of the summer, and this is clearly crucial in the ECB’s current reaction function.

Yet, from a “normative” point of view – what we think the ECB should do, rather than predicting what it will do – we are worried. The ECB is taking the deterioration in credit origination seriously – this was key in their decision to opt for 25 bps rather than 50 last week – but seems yet unconvinced this will have a serious enough impact on the real economy to take core inflation durably down. The saving buffers accumulated by the private sector since the pandemic may delay the transmission of tougher credit conditions to spending decisions, but this protection cannot be eternal. The US remains the epicentre of a “banking turmoil” which keeps on re-appearing, but the decline in credit demand from the private sector in the Euro area is a concerning signal. The shape of the yield curve in the Euro area has become very similar to the US one. The bond market may be signalling that if the US gets into recession, it will be difficult for the Euro area to avoid one. This brings a clear limit to the scope of policy divergence beyond the next few months. Sticky inflation in the Euro area may reflect a slower reaction to macro conditions than in the US, not necessarily a difference in the ultimate sensitivity to the cycle.