Summers’ Blues

• Fed to “stay put” for now, ECB to hike by 25bps, but all eyes on “soft forward guidance”.
• Larry Summers has painted a bleak picture of the US long-term fiscal challenges. We use it as a starter to discuss Europe.

This week is of course going to be defined by the central banks. We expect the Fed to “stay put” for now, but the focus will be on the future trajectory. We expect the prepared statement to stick to the line laid out in May and maintain a “soft directional” bias, but we acknowledge that the US data flow will have to deteriorate further on the growth side – as in our baseline - to avoid another hike in July, while the May inflation print to be released this week could be crucial. Just like everyone else we expect the ECB to hike by 25 bps this Thursday while maintaining a tightening bias for the future, but without firm guidance. We continue to think July will be the peak of the ECB’s tightening, but we also think that the Governing Council has not reached a consensus as to what to do after the summer break. September remains in play, despite the Euro area’s fall in “technical recession.”

Now, while we have been discussing monetary policy a lot since the end of the pandemic, we think fiscal policy is going to be more in focus in the coming years. We listened carefully to Larry Summers’ speech at the Peterson Institute on 1 June. It’s not for the faint-hearted, as he painted a quite bleak picture of the structural forces shaping US public finances. His main point seems to be that Americans need to accept a significant rise in taxation across the board, implicitly towards European levels. This is of course a politically challenging proposal in the current environment, both for the right and the left since he believes that the “populist solution” (taxing the wealthiest only) would not be commensurate with the magnitude of the revenue shortfall on trend.

Europe’s starting point is more favourable (the deficit and debt ratios are lower in the Euro area as a whole than in the US, “consent to taxation” is higher, the fiscal process is less ideologically charged), but thorny issues abound on the horizon. We add to the mix the cost of the green transition, drawing on Jean Pisani-Ferry and Selma Mahfouz’s report. While the debate usually focuses on more debt and more tax, we also take a quick look at episodes of spending restraint.