Wapens, boter en rentetarieven

De ECB vergadert deze week onder ongunstige omstandigheden, te midden van binnenlandse malaise en aanhoudende onzekerheid over de handelsrelatie met de VS. De alom verwachte uitkomst is nog een verlaging met 25 basispunten, maar het gesprek in de Raad van Bestuur wordt moeilijker nu de 'neutrale rente' in zicht komt. Wij blijven van mening dat de risicobalans nu zo duidelijk naar beneden is gericht dat de ECB tegen het einde van het jaar de neutraliteit moet doorbreken en haar beleidsrente naar 1,5% moet brengen.

Nu de risico's van een Amerikaanse militaire terugtrekking uit Europa snel toenemen, moet de EU de defensie-uitgaven verhogen. Dit zal op zijn minst de omvang van de verwachte budgettaire verkrapping verminderen, aangezien er grenzen zijn aan hoeveel van die extra uitgaven kunnen worden gefinancierd door bezuinigingen elders of belastingverhogingen, gezien de populistische druk waar veel regeringen mee te maken hebben. In principe zou dit de ECB voorzichtiger moeten maken in het verstrekken van monetaire accommodatie, maar de verwachting van meer defensie-uitgaven legt een bodem onder hoe laag de lange rente kan gaan. Wij denken dat de centrale bank bij het kalibreren van haar beleidskoers rekening zal moeten houden met de nettoverstrakking van de algemene financiële voorwaarden, vooral omdat de lopende kwantitatieve verkrapping een andere bron van “rendementsbestendigheid” is. Maar zelfs met een “begripvolle” ECB stuiten sommige lidstaten op de grenzen van hun begrotingsruimte. Dit is voor ons nog een reden om te denken dat gezamenlijke financiering van Europa's militaire inspanningen noodzakelijk is.

Terwijl de VS een belangrijke bron van verstoring is voor Europa, zouden de binnenlandse omstandigheden daar wel eens sneller kunnen verzuren dan we dachten. Het consumentenvertrouwen verslechtert op bijna alle vlakken: Amerikanen worden nerveus over de inflatie, hun vooruitzichten op de arbeidsmarkt en de financiële markt. De begrotingsresolutie van het Huis was vorige week een doorbraak voor de Republikeinen, maar we merken op dat ze niet alle campagnebeloften van D. Trump dekt. Er doemt ook een ingewikkeld fiscaal gesprek op in Washington DC.

Under Pressure

The ECB meets this week as Europe finds itself under massive external pressure. In the short term, while the market is increasingly taking the pronouncements from the White House on tariffs with a pinch of salt, the threat of a serious hike in custom duties on European products cannot be ignored. At least, while last year the Governing Council sounded quite torn on the impact US protectionism would have on prices – the prospects of a further disorganisation of supply lines were often mentioned as adding upside risks to European inflation – a consensus has now seemingly emerged around the idea that US tariffs on imports from Europe would further slow down the Euro area economy and thus reduce rather than raise Euro area inflation.

Exports of goods to the US stood last year at 3.1% of the Euro area GDP. Assuming a unitary reaction of volumes to tariffs (to be clearer a 1% increase in tariffs cuts the volume of imports by 1%), which is not far-fetched when looking at how Chinese exports to the US reacted during the first trade war, customs duties at 25% as per Donald Trump’s very latest statements concerning the EU would mechanically reduce Euro area GDP by 0.8%, before second-round effects via investment and employment. The old “rule thumb” for the sacrifice ratio (the relationship between the decline in GDP and lower inflation, usually seen at around 1, a figure recently supported by Bundesbank Research, see link here ), would point to a reduction in inflation of about 0.8% as well.

Of course, the calculation changes for the central bank if one takes on board retaliation from the EU on American products imported into Europe. Yet, imports of goods from the US are comparatively small (2.0% of the Euro area GDP last year). In addition, given Europe’s already shaky demand conditions, we would assume that a significant share of any EU tariff hike would be absorbed by margins. All in all, we think it would be difficult for even a 25% retaliatory tariff on all US products to bring about a significant net uptick in European inflation given the magnitude of the adverse shock on growth from the US strike. Finally, we would expect the Commission to opt for “smart” retaliatory measures, focusing on products which would inflict maximum pain to US exporters while minimising the inflationary impact for domestic consumers, rather than a blind “tit for tat” approach. For instance, we do not think the EU would levy tariffs on imports of LNG from the US. This would be counter-productive domestically, especially if Europeans want to continue weaning themselves off Russian gas, without having any effect on US producers given the current overall pressure on LNG production capacity. In any case, while no calibration of the monetary policy response is doable before details emerge on the magnitude of potential tariffs on European products, at the very least the mere threat should tilt the balance of risks to growth to the downside in the ECB’s assessment, as uncertainty is probably already having an impact on investment and hiring decisions by European businesses.

Beyond these short-term challenges, the ECB cannot ignore longer-term issues brought about by the new geopolitical configuration. Scaling up defence spending is now obvious for all member states and will probably run counter to any significant fiscal tightening in the Euro area for the foreseeable future. While some of the defence effort might be offset by cuts in other areas (see for instance the decision by the UK to slash development aid to make space for an upward revision military spending), given the political incentives for governments to keep populists at bay, a net tightening in fiscal policy will be increasingly difficult to maintain. At first glance, this should make the ECB more cautious about cutting rates beyond “neutral”. Yet, if the market reacts to this delay in fiscal consolidation by pushing long-term rates higher, then the ECB should take the whole picture on board and incorporate the tightening in financial conditions in its reaction function. In addition, as ECB board member Piero Cipollone stated two weeks ago, “to strike the right balance, we should ensure that our rate decisions adequately compensate for the tightening induced by the reduction of our balance sheet”. Quantitative Tightening blunts the impact of the ECB rate cuts. The resilience of Bund yields at around 2.4%, despite two years in a row of mild recession in Germany, should raise concerns.

In practice for this Thursday, just like everyone else we expect a fifth consecutive 25-bps cut to 2.5% for the deposit rate. The difficulty will lie in how the Governing Council handles its soft forward guidance, since the central bank is moving closer to the upper end of the range for the “neutral rate”. Isabel Schnabel made the point that, given the measurement uncertainty, she “cannot be sure” monetary policy is still in restrictive territory and wants a discussion on where to stop. Yet, Bundesbank President Nagel was more open: he played up the recent good news on the consumer prices front and affirmed his expectation inflation will return this year to the central bank’s target. The hawks may not be unified. While we think Christine Lagarde will likely want to keep her cards close to her chest and insist on how the central bank will react to the data, rather than following any pre-ordained path, we think she will maintain a general tone consistent with further cuts ahead.

We think that the point on whether monetary policy would still be “restrictive” after this week’s cut is becoming less crucial, since the right question for the ECB should be whether a mere neutral level is already inappropriate at this point, so that proper accommodation should now be the right stance. ​ We expect the central bank to revise again its GDP forecast down, with this year to take the largest hit in the ECB’s scenario (0.2pp) to only 0.9%, which would put it clearly below the consensus estimate for the Euro area’s potential growth. In principle, and taking on board the lags of monetary policy, this should be consistent with a mildly accommodative stance. ​

The inflation side of the forecasts may however be less straightforward: energy prices (particularly for gas future contracts) rallied significantly right before the cut-off date for the forecasts. Overall, we expect a small upgrade on headline inflation for 2025/2026/2027 to 2.2% (+0.1pt) / 2% (+0.1pt) / 2.1% (unchanged) but crucially core should remain unchanged at 2.3% / 1.9% / 1.9%. But again, to return to our discussion of tariffs at the beginning of this section, what will be key is the characterisation of risks around the baseline, and with evidence accumulating of a steep deceleration in wages combined with harder-blowing headwinds on growth”, we think the ECB will increasingly focus on the downside risks. We continue to think the ECB’s policy rate will fall down to 1.5% by year end.

France’s fiscal constraints come back to the fore

In some EU member states, scaling up defence spending is more a political and legal issue than a directly economic problem. Immediately after his victory in the German elections, Friedrich Merz opened the possibility to get parliament to vote on a “top up” to the special defence fund before the new MPs take their seats on 25 March, thus circumventing the populists’ blocking minority to the reform of the debt brake. It is still unclear whether this solution will ultimately be used, but merely mentioning this possibility – which is politically controversial, albeit legal (in 1998 it is an outgoing Bundestag which allowed Germany’s participation to the bombing of Serbia) - is a symptom of the depth and speed of the strategic re-thinking currently underway in Europe. France however has no fiscal space left to accommodate a further rise in its already significant defence effort. The announcement by S&P last week that they put France’s rating (which they had taken down to AA- in May 2024) on a negative outlook has put the French fiscal constraints back in focus.

Our colleagues Eleonore Herfurth and Hugo Le Damany have recently published a note exploring the determinants of French long-term interest rates (see link here). Their first step was to estimate an econometric model explaining 10-year OAT yields with only fundamental variables. They include monetary policy signals (both policy rates and the changes in the ECB’s balance sheet, captured by excess liquidity), inflation, an international contagion factor (US 10-year yields) and, crucially, the fiscal deficit. The model does a very good job, in retrospect, in fitting the inflexion points in French long-term interest rates, and over the most recent period, the “residual”, i.e. the prediction error of the model, remained small (see Exhibit 1). This suggests that beyond the purely political noise since June 2024, in any case the French 10-year yield would exceed 3%.

Their note tackles many other issues (e.g. non-linearities in how yields respond to fiscal news), but one aspect of their work illustrates very well the constraints currently weighing on French fiscal authorities, and how they interact with the monetary policy stance. They build two scenarios (see Exhibit 2). In the optimistic one, France gradually adjusts its deficit to 3% of GDP by 2029, while benefiting from the ECB choosing not to reduce further excess liquidity after 2026 (leaving it at 20% of GDP). The model suggests the 10-year OAT yield would settle at around 2.2%. In a pessimistic one, they maintained the deficit in the ‘red zone’, only allowing a very gradual convergence from the current level to 5% of GDP by 2029, while the ECB would pursue its quantitative tightening policy, bringing excess liquidity down to around 10% of Eurozone GDP (a level comparable to 2017-2018). Then the model suggests the OAT 10-year yield would remain at its current level of around 3.2%. Such level is important because it is very close to trend nominal GDP growth in France. This means that, under the pessimistic scenario, the country would be forced into hard action on its primary balance since it would be facing “snowballing” debt dynamics (a point made by S&P to justify their moving France into “negative outlook”).

This suggests that France could hardly push its defence effort much higher without either finding savings elsewhere or raising further a tax burden which is already very high. France is not the only member state in this situation. The European Commission’s proposal to remove defence spending from the fiscal surveillance metrics would help only marginally for them, since it is market dynamics, rather than the European institutional setup, which would act as a brake. This is one of the reasons why we think that joint issuance to fund military spending should be the way forward.

Is the tide rapidly turning in the US?

Our baseline scenario for the US economy is that, thanks to the acquired speed from 2024 and a “sugar rush” from deregulation and tax cuts projects, GDP would still exceed potential on an annual average basis in 2025, before falling below potential in 2026 as the toxic aspects of Donald Trump would start materialising from the second half of 2025 onward. This scenario could however “accelerate”: the White House’s hyper-activity may bring the toxicity forward. This is at least what consumer sentiment suggests.

We have already discussed in Macrocast the deterioration in consumer confidence reflected in the University of Michigan survey, highlighting the fact that even among Republican-leaning respondents, mood was souring from the end-2024 levels and never improved as much as it had at the beginning of Donald Trump’s first term. The Conference Board survey for February released last week does not provide a political breakdown, but the deterioration in sentiment across the board was plain to see. When focusing on expected conditions, the post-election surge has been completely offset, returning to one standard deviation below the long-term average (see Exhibit 3). In the Michigan survey, the upward shift in inflation expectations had been striking, moving back close to the historical peak. The movement was in the same direction for the Conference Board but still within ranges seen in the recent past (see Exhibit 4).

Beyond inflation resilience, US consumers seem to be increasingly worried about the labour market, with the balance between those expecting more, rather than less jobs ahead turning negative in February (0.7 standard deviation below the long-term average) for the first time since June of last year (see Exhibit 5). The divorce between labour market expectations and objective conditions on the ground is striking. Employment Reports suggest job creation remains robust and has even re-accelerated lately to reach 1.8% in annualised terms. Job openings are normalising, which may weigh on households’ perceptions, but they are still in line with their long-term average, and as we discussed two weeks ago, the employment rates in the belly of the US workforce are historically high. This disconnect is consistent with the signals from the Citigroup’s surprise index – which tracks gaps between the market’s expected value for key macro indicators and their actual releases. It has deteriorated much more on “soft” indicators (i.e. surveys) than on “hard” ones.

The risk however, as usual, is that this “generic grumpiness” becomes self-fulfilling if consumers start reining in their spending. This is not certain. After all, their job expectations were already slightly depressed in the first 10 months of 2024, and households still maintained a strong consumption effort. There is however a new development: households are no longer counting on a decline in interest rates and are getting more cautious on the prospects for the equity market (see Exhibit 6). Given the sensitivity of US consumption to wealth effects, such revision in expectations cannot be taken lightly.

It is difficult to evaluate the precise contribution of the White House’s various announcements to the general deterioration in consumer confidence, but we think an indication lies in the distribution across income levels: mood has soured much more swiftly for those making more than USD125K a year than for those closer to the bottom of the income ladder (see Exhibit 7). The highest earners are probably among those who are the most attuned to the policy news flow. Interestingly, the prospect of the prolongation of the TCJA tax cuts under Donald Trump’s does not seem to lift their spirits. The constant bombardment of news pertaining to tariffs may weigh on mood. This may help explain the deterioration in Donald Trump’s approval ratings (see Exhibit 8).

In addition, some “hard indicators” are now starting to come out on the wrong side of consensus. Personal consumption expenditure fell 0.5% mom in real terms in January, the biggest monthly decline in 4 years. Specific factors – extreme cold conditions in particular – may explain some of that underperformance, as well as possibly some random mean reversion after a string of very strong readings, but of course this data release adds to the risks of a proper deceleration in the US economy. This reading, on top of disappointing trade data released earlier, had a strong effect on the Atlanta Fed Nowcast, which now sees GDP growth in negative territory for Q1 2025 (-1.5% qoq annualised), from 2.3% - same pace as in Q4 – a week before. In one takes out a strongly negative contribution from changes in inventories, Q4 GDP was very strong, so, there again, some payback in Q1 could be expected without necessarily pointing to an underlying weakness, but the sky over the American economy is no longer uniformly blue.

Grumpiness has seemingly extended to financial markets. We routinely use the breakdown in US treasury 10-year yield between expected inflation and the “real interest rate”, which is in principle more sensitive to growth expectations, as a way to capture the market’s assessment of the US policy stance. The recent decline in the real rate is remarkable, while 10-year inflation expectations edged slightly further up (see Exhibit 9). The ugly “stagflation” word is becoming popular again.

Still, despite the market’s inflation outlook, forwards still point to two cuts by the Federal Reserve this year, in a clearer way than just two weeks ago (see Exhibit 10). Habitual readers of Macrocast know that we think the Fed is “done” for this year. We recognise however that the signals of deterioration on the real side of the economy could precipitate one more cut, for instance at the June meeting, but for now the labour market has not showed signs of deterioration, which should be key to the FOMC given their current insistence on their dual mandate, while there is no evidence such softening in the real economy – which needs to be confirmed anyhow – is having any dampening effects on inflationary pressure. Yet, naturally, in this more uncertain environment, any “accident” on the Employment Report (there is one at the end of this week) would have a strong market effect.

The beginning, not the end, of a complex fiscal story

Between the “grumpiness” of households and a Fed on pause, the US administration needs good news. The prospects of an even more accommodative fiscal policy have improved on the margin with the passing of a budget resolution by the House last week. Given the Republicans’ razor thin majority, this was no small feat. The process remains complex though. Since the Republicans want to use the “reconciliation” approach, the exact same resolution needs to be supported by the House and the Senate, and what we had last week was only the bare bones of a proper budget, with a lot of details on how spending cuts would be apportioned still in need of clarification, opening the door to much intra-Republican bickering. More fundamentally, the House’s resolution, while significantly raising the primary deficit in the decade ahead, would still not offer enough space for the entirety of Donald Trump’s tax plans announced in the campaign.

The House’s resolution would cut tax revenues by USD 4,500bn over the coming decade, only partly offset by some USD 1,700bn of net mandatory expenditure cuts (the 2,000bn “headline” spending cuts do not consider the USD300bn in additional spending towards border security and defence). This would result in an additional primary deficit of c.0.8% of GDP annually across the decade, when using the CBO’s latest forecasts for nominal GDP. This would send the overall federal deficit to around 7% of GDP from slightly more of 6% today. Yet, as a note by the Penn Wharton Budget project made it plain last week (see link here), this would not cover much of Donald Trump’s current plans. Indeed, the mere prolongation of the TCJA dispositions which were supposed to expire from this year onward would result in an overall decline in tax revenues of USD 4,000bn. Other promises, such as exempting social security pensions from income tax (USD 1,100bn) or eliminate income tax on overtime (USD 600bn) could not be funded within the parameters set by the House. According to the Penn-Wharton’s model, it’s roughly half of the electoral promises which would need to be dropped.

From a debt sustainability point of view, this would be a better outcome – although a deficit permanently hovering around 7% of GDP would still remain daunting. Yet, investors who believed in the Republican “sugar rush” may be disappointed, as could some segments of Donald Trump’s political base. If most of the fiscal space offered by the House Republicans goes to prolonging the TCJA – the 2017 cuts - then most of the benefits of the new administration’s fiscal policy will benefit those at the upper end of the income ladder. His blue-collar supporters, who were going to be the main beneficiaries of the “new” cuts (those pertaining to social security pensions and overtime) may object. This creates the conditions for a difficult conversation as the ball now goes to the Senate.