Policy Mixology: Finding the Right Dosage
- The articulation of fiscal and monetary policy in dealing with the inflation shock is crucial. We welcome a generalization of measures breaking the relationship between wholesale and retail energy prices. The United Kingdom (UK) may provide another “lab experiment” though: the market is ready to “cut some slack” for governments dealing with the current crisis, but visibility on the future fiscal consolidation is necessary.
In the absence of clear forward guidance, single data prints can make big differences to monetary policy decisions. Last week’s data flow came with divergent signals for the Federal Reserve (Fed) and the European Central Bank (ECB). In the United States (US), some tentative deceleration in wages and a rebound in labour market participation should steer the Fed towards a 50 basis points hike at the next meeting, rather than another 75-bps move, barring a nasty surprise on inflation next week. In the Euro area, another acceleration in core inflation in August may well have convinced the Governing Council to hike this week by 75 bps – our new baseline. They would “rip the band aid” and bring the policy rate faster in neutral territory.
The policy mix has become a key issue. Germany has announced another fiscal programme to mitigate the impact of the surge in energy prices. In our view, focusing fiscal action on breaking the relationship between wholesale and retail energy prices is the optimal avenue, since it allows some cooperation with the central bank: it may “artificially” dampen the actual inflation shock, but this may help keep inflation expectations anchored. From this point of view, what we know of the European Union (EU) plans on the electricity market reform is reassuring.
Meanwhile, the UK is providing another interesting “laboratory experiment”. Liz Truss – widely expected to have won the Tory leadership race – is for now focusing on general tax measures to mitigate the energy price shock after it occurs. More fundamentally, beyond short-term support, her fiscal plans are quite spendthrift. This is met with quite some market pressure, as investors expect the Bank of England to be forced into even more tightening to deal with the fiscal push. Markets are ready to “cut some slack “on governments for their immediate action, but they want to be convinced consolidation will be the priority when the crisis is over. In the EU, it’s the fiscal surveillance framework which is supposed to provide this visibility. We explore here a German proposal for its reform.