For the Fed, the last mile is the hardest

Anna, what was the main takeaway from January’s Federal Reserve meeting?

The most striking thing from the meeting yesterday was that Chair Powell pushed back against market expectations of an interest rate cut in March and said that the Fed needs to see more evidence and gain greater confidence that inflation is moving back to target on a sustainable basis.  

That seems like a big sign that the US economy is doing even better than hoped. 

The US economy has been very resilient and its strength has surprised everyone, including the Fed. That has been largely driven by the huge fiscal stimulus that we saw during Covid and has remained in the system longer than generally expected. Plus, companies are still benefitting from having managed to refinance their debt at very low interest rates before the hiking cycle began. All that has meant that the higher policy rates have not really fed through to the economy fully.

But you're not entirely convinced that this is the end of the story on inflation.

We think that there are some signs that inflation is sticky. And as the central bankers themselves say: the last mile on inflation may well be the hardest. They will need to see more evidence that those sticky parts, sticky components of inflation, are going back to target.

Does that approach pose a danger to the soft landing scenario?

At this point, we think a soft landing is the base case for 2024. But there are still risks that a cyclical recession can develop over the next few months. 

We certainly believe that the transmission mechanism for monetary policy has not been broken. It's just delayed. We are still seeing that policy transmission working through the system. We are seeing signs of slowing in the credit channel, but also some signs of slowing in the labour market.

In Europe, monetary policy transmission is happening faster. In the United States it is still moderate because of the impact of the fiscal stimulus. But we are starting to see it filter through. And you may see some issues develop in the months ahead, in places like commercial real estate for example.

Could the narrative change quickly?

Now that markets are perfectly priced for that soft landing scenario, we are exposed to the risk that it does not happen. That narrative could shift quickly to something different, yes. If we start getting worse data then you might get a recession narrative being priced into the market. 

Does the European Central Bank (ECB) need to cut now?

Growth is much slower and Europe may already be in recession. Inflation is declining, with some stickiness. We think the ECB should start cutting rates as soon as March, given that backdrop. 

What is the essence of the problem in Europe around growth?

Well, first of all, the transmission of monetary policy in Europe has been faster because of the structure of the banking system and the structure of the economy. But the bloc has also been paying the price of the transition towards a more secure energy system in response to the Russia-Ukraine war.

There are positives here. The environmental transition towards a more secure energy system comes with costs: we all have to pay more. But by accelerating that transition, Europe is getting ahead of the US and the UK in structural terms. A disorderly transition down the line will almost certainly cost much more.