Bretton Woods 2.2?

Given the number of Fed speakers arguing for an early lift-off for rates amid more bad news on US consumer prices, we have brought forward our expectation of the first hike to March. That the Fed is increasingly ready to act fast to “nip inflation in the bud” is clear. However, calibrating the appropriate quantum of hikes which will be needed to bring inflation back to target is going to be tough for the central bank. Some of the current excess demand will probably spontaneously disappear given the change in the US fiscal stance, but the extent to which some of the past stimulus currently stored in the households’ savings overhang will ultimately support spending is impossible to predict. Meanwhile, some of the supply-side constraints will recede. Central banks always operate under uncertainty, but the lack of visibility is still unusual for the beginning of a tightening phase. This will trigger volatility.

As higher long-term interest rates are also part of the Fed’s arsenal given their insistence on the reduction of its balance sheet, it’s tempting to look for factors which could counteract the impact of the monetary policy stance on the bond market. A resumption of the old “Bretton Woods 2.0” model is mentioned, with re-emerging large current account surpluses in China being recycled into purchases of Treasuries. We are not convinced. We think the policy agenda in Beijing is inconsistent with a large structural surplus in the medium-term. We also believe the Chinese official sector will continue to try to diversify away from dollar-denominated assets. Finally, Chinese financial flows have changed. The official sector is intermediating a smaller share of “excess dollars” in China. Private entities are playing a larger role, and they will probably behave like any other profit-seeking investor and wait to see if US yields have sufficiently risen before moving their currently massive deposits into bonds.

While the European bond market is affected by some contagion from the US, at least the monetary policy status quo prevails. This week we explore the discussion of the impact of the green transition on monetary policy by ECB board member Isabel Schnabel. We don’t share her optimism of the capacity of fiscal policy to redistribute a lot of the transition costs – which has a strong bearing on the ultimate impact on inflation and monetary policy – but she opened a key debate with her speech. However, this question is not for immediate consumption, which is consistent with quite a lot of “wait and see” at the ECB this year.