And now to the ECB (again)

As we expected the rise in US long-term interest rates continued last week. A new development is that real rates are rising as well. It is no longer only a question of inflation expectations. The situation is still manageable for the Fed though. Real yields are still very negative, maintaining very favourable financial conditions while the US economy is about to receive another substantial fiscal stimulus. The market has brought forward its timing for the first Fed hike by a few months, but it is still not expected before 2023, thus consistent with a very long phase of accommodative monetary policy, considering the fact that with the Biden plan, the US economy may well close its output gap by the end of 2021. At some point the Fed will have to change its mode of intervention on the bond market – possibly with an “operation twist” – if the tightening in market conditions continues, but the “pain threshold” probably has not been met yet.

The rise in real yields in the Euro area is more problematic in our view, as it is at odds with the more compromised macroeconomic situation of the region, and with the ECB’s explicit willingness to focus precisely on real interest rates when defining the favourable financing conditions which it has committed to defend. This calls for action, and a decisive acceleration in PEPP purchases could do the trick.

Still, some economic overheating in the US triggering a faster-than-expected rise in market interest rates there could play in the hands of the ECB, as it could lead to a depreciation in the euro exchange rate contributing to bring Euro area inflation in line with the central bank’s target. We offer in this note some illustrative quantifications. In case of a “fast tapering” in the US bringing 10-year treasury yields to 3% in 2022, the euro could weaken by 10% against the dollar, in turn lifting inflation to 1.9% in 2023 (against 1.4% in the ECB’s baseline). The relationship between exchange rate movements and inflation has been far from perfect though. Since the advent of the single currency in 1999, 3 out of 6 phases of euro depreciation ended up with a deceleration of inflation. Higher imported prices can permeate consumer prices only if domestic cyclical conditions are strong enough. If the European output gap is still far from closed by the time the depreciation occurs, then it is illusory to count on the exchange rate movement to lift inflation. This is another reason why the ECB would need to accelerate PEPP spending, beyond protecting a wide-enough spread with the US. Easy financial conditions in the Euro area are a condition for a quick absorption of capacity underutilization.