Fra BNP Paribas:
The Fed wants to tighten US financial and monetary conditions to slow US growth, as subnormal US rates could lead to too-low unemployment, inflation and an eventual recession.
If the US achieves the requisite tightening through higher US rates alone, the result will be lower global growth and inflation.
– If the ECB delivers the same amount of tightening in the US through aggressive ECB easing, producing a much stronger USD, the result will be higher global growth and inflation.
– From a global perspective, therefore, the best result in December is that Mr Draghi eases so much that EURUSD falls to the extent that the Fed hike is unnecessary. Go for it Mr Draghi. We are often asked by clients if the ECB easing will get in the way of the Fed tightening.
This concept views the two as substitutes, which is true in some ways. However, it is wrong to infer that the ECB doing its job impedes the Fed in the pursuit of its dual mandate. In fact, from a global perspective, we see an ECB easing that softens EURUSD as the best possible form of Fed tightening, since it will result in higher global GDP.
This is as opposed to the Fed being solely left to tighten financial and monetary conditions by raising rates, which will result in lower global growth. Let us ask, then, what is the point of the Fed tightening? The Fed will say to “normalise rates”.
So rates are below normal. What is the consequence of that? Presumably it is growth that is above potential, as is seen in the unemployment rate falling from a peak of nearly 10% to today’s 5.1%. We do see this above-potential growth as a result of rates that are below equilibrium. If the unemployment rate continues to fall quickly, we could see higher inflation and, ultimately, another recession, as the Fed will have to raise the unemployment rate again, and soft landings are hard to find.
So the point of Fed tightening is to reduce the growth rate and to prevent the unemployment rate from falling too low. As there are many ways to skin a cat, there are also many ways to slow growth. If the Fed tightens monetary conditions solely by raising its policy rate, it will slow growth. By slowing US domestic demand, it will also slow US import growth and thereby slow global growth.
Any moves by foreign central banks to prevent their currencies from depreciating would add to this. Any disruptions to financial markets though increased risk premia would add to the GDP loss. So we come up with the conclusion (hardly surprising) that Fed tightening is bad for global growth. But what if the same amount of slowdown in US growth were achieved not through higher rates, but by the ECB easing so aggressively that the fall in EURUSD completely negated the need for the Fed to hike?
Some other central banks (eg Scandinavia) would likely ease to offset their currencies from appreciating against the EUR. The Bank of England’s hike could be delayed. In other words, an ECB easing would likely result in sympathetic easing elsewhere. Growth would be transferred from the US to the Eurozone.
US imports would be lower due to lower domestic demand, but higher on account of worse competitiveness, with the reverse being the case in the Eurozone. Taking the US and Eurozone together, a reasonable approximation is that imports from the rest of the world would be unchanged.
Overall then, US interest rate tightening would lower global demand and inflation; whereas ECB easing would raise global demand and inflation. It is clear which policy is the preferable route to achieving slower US growth when global growth and inflation are both struggling. Go for it Mr Draghi!
