In Jackson Hole, Chair Powell announced the start of a new cycle of rate cuts, putting an end to the inflation episode since 2021. It is, therefore, time to draw some lessons for economics, economists and monetary policy. 1/ First, inflation has no mono-cause explanation or model and not all episodes are equal. Particularly, models that mostly rely on the role of domestic economic slack and weak labour market are not suitable. Only open economy models are meaningful. 2/

Macron dramatic: Europe is mortal and may die. He said it in his recent speech and repeated it in an interview with The Economist. The warning was matched by his lofty rhetoric in identifying the challenges and their solutions (military, industrial, environmental, political) 1/ His vision is very ambitious. He demands a European Defence with nuclear weapons, European industrial champions duly supported and protected, a true Green Deal, Energy safety, a Union Council of Homeland Security, a dual mandate for the ECB, the doubling of the EU budget… 2/

The ECB announced that it will take a decision in March on the very important issue regarding the future operational framework to use a policy rate to influence the interbank overnight rate. The decision is also linked to the issue of the future size of the balance sheet. 1/11 I fear a mistake may be made if the decision departs from a “floor system” that has been quite approximately followed by the ECB since 2088 and then in a full-fledged way since 2015. Instead of the volatility of the Eonia until 2008, the floor system worked perfectly (slide) 2/

Disinflation momentum in the Euro Area has broadened. That will be reflected in the future wage/price decisions, contributing to a future decrease in core inflation that, wrongly, has been taken as the proxy target of monetary policy 1/ The DB index of the ECB’s Governing Council indicates an increase in divergence of views about the future, according to public statements of its members 2/

A missed debate in the ECB’s Sintra Forum was about the desirable size of the CB’s balance sheet. The paper dealing with the issue missed the point by using as the sole criterium the maximising of the reserves supply net convenience value 1/ecb.europa.eu/pub/conference… The convenience value is the price premium that very liquid and safe assets (e.g. AAA sovereign bonds) can get in the market. The paper took the view that the balance-sheet size doesn’t matter to MP when the policy rates are above the effective lower bound. This view is wrong 2/

The Sintra ECB Forum started this year with an excellent paper, presented by Silvana Tenreyro, on “Monetary policy in the face of supply shocks:the role of inflation expectations”. Theory and mainstream models give an exaggerated role to expectations in the inflation process 1/ Woodford (2003) wrote that monetary policy is mostly about managing expectations and that hardly anything else matters. The models made expectations endogenous with rational expectations but the mechanisms that would operate in reality were never really well explained 2/

As predicted, euro area inflation in March tumbled to 6.9% from 8.5% in February (see the Eurostat table). I expect a similar decrease for April. This means that inflation is on its way down to the level implicit in the ECB projections, close to 3% by December this year 1/ These results come from the drop in international prices and the delayed effect of monetary policy. Interest rate changes take time to produce their effect on the economy. Decisions now must be taken thinking about future inflation, i.e. the 3% in Dec and lower in 2024 2/

The battle of Cocos. Swiss authorities made a mistake with consequences and potentially a host of court cases. They wiped out $17 billion of Additional Tier 1 bonds ( or Contingent Convertible Bonds or Cocos).These were invented after the 2008 crisis to shore up banks’ capital 1/ Cocos are perpetual bonds (traded in the market though) that can be wiped out if the capital of a bank comes below a certain percentage around 6%. They earn a higher interest while alive and that was the incentive to get an easy capital equivalent tool without voting rights. 2/

UBS acquires Credit Suisse by slightly more than $2bn! Shareholders lose 70% relatively to the market value on Friday. In 2009 CS market cap was $90bn, in 2018 still $50. What a machine of massive value destruction! ft.com/content/ec4be7… 1/ Switzerland stays with a Bank that initially has assets of more than 200% of GDP, a risky proposition (too big to fail or to save) However, the downsizing of CS is going to be significant. Sales of parts of CS business to be expected, dismissals etc.2/

The Swiss CB provided 50 bn in liquidity to Credit Suisse and partially calmed down and the ECB felt reassured to go ahead with the announced 50 bps hike. However, they didn’t ignore the banking sector turbulence that is due to the hiking campaign of all CBs. 1/ But the ECB cut all references to “still several increases needed” or “we have to stay the course” used in many previous meetings. They decided to “ reinforce” the data-dependence for assessing the future inflation outlook. Important flash estimate of inflation on the 30th Mar 2/

The US authorities weekend interventions on the SVB case were successful. Markets started to correct somewhat Monday’s negative reaction. Stocks, particularly bank stocks, recovered a bit today and the US regional bank stocks increased a lot. Yields increased. The VIX came down… twitter.com/i/web/status/1… One interesting point about the SVB is that seemingly the bank was complying with the applicable regulations. It had a large low-risk long-maturity governmental type of securities, mostly in the legal class of “held to maturity” (no mark to market) and Basel liquidity ratios… twitter.com/i/web/status/1…

Huge surprising reaction of markets to the SVB failure. Unexpected long memories from the banks predicament in the 2007/9 crisis. Peak rate now priced in approaching 3%!, tumbling from 4%. Markets pricing that the FED will not hike next meeting ! …1/ US 2Y bond yields tumbled 90 bps, (equal to 1987 ) saying that the FED will stop hiking (not true). 10 Y bond yields also down a lot VIX from 24 to 30. MOVE (for bonds) from 129 to 141. Bank share prices going down everywhere. 2/

There is high uncertainty in assessing the US economic situation. The dominant views are: 1) there won´t be a recession and even a “no landing” while inflation will attain target; 2) there will be a soft landing with a possible but unlikely very mild recession. 1/ With few supporters, there is a third possibility that the recession will come later and be deeper than anticipated. I think that this view is possible but dependent on the FED overdoing tightening, which right now seems likely. The risk seems to be similar for the Euro Area. 2/

The FED increased rates by 25 bps and Powell had a transparent press conference acknowledging that “for the first time we can say disinflation has started” and although he emphasized that 2 more hikes are “probably necessary” a decision on that will come only in March 1/ Powell acknowledge the recent data but tried to take a risk management stance, saying that it is premature to declare victory and that he does not envisage rate cuts this year. However, he said that if inflation would decline quicker than they think, they would adjust policy 2/

Some more details on the ECB decisions to hike 50bps and start QT in March by 15bn a month were expected and would not have moved markets. The surprises were the forward guidance: "rates will still have to rise significantly" and the justifying controversial forecasts 1/ The controversy refers mainly to the 2024 inflation prediction of 3.4% that in the Sept. projections was 2.3%. The price of energy, food and other commodities have been the big contributors to the high inflation in the EA, contrary to the US where Services (wages) are stickier 2/

Bad news for Euro Area prospects.The ECB decisions, language and forecasts,point to an excessively hawkish policy that will aggravate the coming recession unnecessarily.The expression“rates will still have to rise significantly”is grounded on controversial inflation forecasts.1/ As mentioned at the ECB site, December (and June) forecasts are coordinated by National CBs whereas in the other quarters ECB staff does it. So, the 2023 inflation prediction jumps from 2.3% in September to a whopping 3.4% in today’s forecasts, pushing the 2.3% to 2025!. 2/

Another bid decrease of US inflation from 7.7% to 7.1%. Inflation-linked swaps are pointing to inflation at 3.4% in May and some market literature put it at 2.5% in August. The IMF recently forecasted 3.5% for the whole year (from 8.1%in 2022) which implies levels around 2% 1/ The present reduction cannot be due to recent monetary policy moves that take time to produce effects. It is mostly due to the expected dissipation of the supply shock effects. A longer “transitory” is on. Question: why would the FED continue to hike after tomorrow’s +50bps? 2/

Phillip Lane´s blog posted a rich data set used by the ECB to diagnose inflation: “a combination of rising strong in generating inflation in food, goods and services sectors over 2021-2022.” It´s mainly energy 1/
ecb.europa.eu/press/blog/dat… Various measures of core inflation have to be examined to identify the best indicator of what might be the persistent component of inflation. All of them, alas, are under the influence of indirect effects of energy inflation (variation of energy prices that will abate in 2023)2/

The ECB went for a 75bps hike (I was for 50bps). That difference doesn't matter so much, but what concerns me is what was announced, what it can mean for the rest of the cycle, and the underlying monetary policy views. My concerns can be assembled into four points 1/ 1st, the need to consider the coming recession; 2nd, the recognition that Mon. Pol. is inevitably forward-looking and not just dependent on current data; 3d, on averting misuse of specific forward guidance about rates; 4th, avoiding misinterpretations of the Taylor principle 2/

The German Government principles for the review of the European fiscal rules have now defined what will be the future of the SGP. bmwk.de/Redaktion/EN/D… In a positive note, the annual reduction by 1/20th (or 5%) of the debt ratio excess over the unchanged 60% is eliminated 1/8 After the debt increase caused by the pandemic it was unreasonable to keep such a rule. The other positive point is the additional (slight) flexibility in the temporary allowance for a higher public investment level, albeit keeping the MTO target for the structural deficit. 2/

The ECB delivered a good compromise by front loading a bit the path of rate hikes against an unanimous decision to introduce a new tool to explicitly target excessive unfounded fragmentation of sovereign yields, thus ensuring a smooth transmission of monetary policy. 1/ The conditions for eligibility to use such a tool are balanced: compliance with fiscal rules; debt sustainability; absence of severe macro imbalances and “Sound and sustainable” macroeconomic policies, including complying with commitments under the EU recovery fund.2/