Inflation and Monetary Policy

The European Central Bank is now making the economic case for decarbonisation. Not as climate policy. As monetary policy. Frank Elderson, ECB board member, argues in the Financial Times that Europe's dependence on imported fossil fuels is a structural threat to price stability (👉 https://lnkd.in/eKWWjKbh). The data is damning: energy price shocks pushed euro area inflation to 10.6% in October 2022. Every geopolitical tremor in the Middle East shows up in European energy bills. And the ECB is caught in an impossible bind: tighten to fight inflation and deepen the slowdown, ease to support growth and entrench inflation. The solution is not better forecasting models or finetuned monetary policy. It is cheaper energy. Spain shows what is possible. Wholesale electricity prices in early 2024 were approximately 40% lower than they would have been had wind and solar generation remained at 2019 levels ( 👉 https://lnkd.in/edXgxh9q). Once the infrastructure is built, the energy itself is virtually free. Volatile global commodity markets simply become less relevant. Elderson is explicit: €660 billion per year in clean energy investment sounds large. But Europe already spends nearly €400 billion annually on fossil fuel imports, money that leaves the continent and buys geopolitical vulnerability. Analysis in the UK shows that for every pound invested in sustainable energy, benefits outweigh costs by a factor of 2.2 to 4.1 ( 👉 https://lnkd.in/emEXVfiw). This is precisely what I argued in my piece for Triodos a few weeks ago: Europe's crisis response has been backwards. We keep treating energy dependence as a shock to manage rather than a structural problem to fix. (👉https://lnkd.in/ehFqA6iY) The ECB cannot decarbonise Europe. What it can do is name the conditions: keep the ETS, mobilise capital toward renewable capacity, strip out fossil fuel subsidies, and stop confusing cheap fossil fuels with affordable energy. If people need help with energy costs, target it: don't suppress the price signal that drives the transition. The cheapest energy is the energy we no longer have to import.

📊 Exciting new research from the European Central Bank (ECB) sheds light on how banks are pricing climate risk in their lending practices! 🌿 In their working paper, Carlo Altavilla, Miguel Boucinha, Marco Pagano, and Andrea Polo combine euro-area credit register data with carbon emission information to uncover fascinating insights into the intersection of finance and climate change. 🏦 The study finds that banks are indeed factoring climate risk into their lending decisions. Firms with higher carbon emissions face higher interest rates, while those committed to reducing emissions enjoy lower rates. Interestingly, banks that have publicly committed to decarbonization goals (through initiatives like Science Based Targets initiative) are even more aggressive in this pricing strategy. 💶 But here's where it gets really intriguing: the researchers uncovered a "climate risk-taking channel" of monetary policy. When the ECB tightens monetary policy, banks not only increase their overall credit risk premiums but also amplify their climate risk premiums. This means that during periods of monetary tightening, high-emission firms face a double whammy of increased borrowing costs and reduced access to credit compared to their greener counterparts. The authors argue that while restrictive monetary policy may slow down overall decarbonization efforts, it inadvertently creates a more favourable environment for low-emission firms and those committed to going green. 🌍 These findings are crucial for understanding how the financial sector is adapting to climate change and how monetary policy interacts with climate-related financial risks. It's also clear that the greening of finance is not just a trend, but a fundamental shift in how risk is assessed and priced in our economy. #ClimateFinance #SustainableBanking #MonetaryPolicy #ECB #GreenEconomy #ClimateRisk

“Water water everywhere, nor any drop to drink.” I first heard The Rime of the Ancient Mariner recited by a famous actor while in grade school. That image came to mind as I thought about the deluge of data we are about to get. It will fall short of quenching our thirst for information on the economy, and is adding to the argument to pause on rate cuts by the Federal Reserve. The October CPI cannot be backfilled due to a loss in survey information. The same goes for the Household survey, which is used to calculate the unemployment rate, and is chock-full of data on how well the labor market is performing for all kinds of workers. The November surveys will be done late and could have holes. We were already imputing 40% of the CPI in September due to staffing shortages at the Bureau of Labor Statistics; many field offices that collected data have closed. The Fed is left with a dueling instead of a dual mandate and a scarcity of new data to give clarity on the direction of inflation and the labor market. Chairman Jay Powell warned that a December cut was “not a foregone conclusion” for this very reason. The warning followed a contentious October cut. The CPI for September came out cooler than feared. But price hikes became more dispersed, showing up outside of areas affected by tariffs in the service sector. Making matters more complicated are record tax refunds, which will hit in ealry 2026. That is a double-edged sword as we saw during the pandemic. Fiscal stimulus cushions the blow of higher prices, while fueling inflation. Proposed rebates on tariffs would increase those risks, while adding to deficits. We cannot sustain full employment without price stability. Any short-term gains in employment due to rate cuts could be quickly wiped out by resurgent inflation. Further muddying the waters is whether the weakness in the labor market going forward is structural - due to aging demographics, curbs on immigration and innovation - or cyclical. Structural losses are harder to reverse via rate cuts. Financial conditions for large companies, which are announcing major layoffs, remain extremely easy. That means additional rate cuts run the risk of stoking more inflation instead of employment. Inflation is corrosive and hits 100% of the population, while unemployment hits only a few percent of the population. Both are bad - they are worse together. We have not had to deal with both since the 1970s. The Fed mistakenly cut too much back then, which is informing their decisions today. The Rime of the Ancient Mariner is a story of redemption and penance. The Fed’s reputation on inflation needs redeeming. The penance is slower cuts in rates than most would like. A pause in December is likely. The trajectory of rate cuts thereafter will depend on more complete data on the economy and shifts in Fed leadership. Moral of the story: A loss of data leaves us thirsting for more and has left the Fed with no risk-free policy choices.

Fed Holds Rates Steady, Signals Two Cuts This Year—But Uncertainty Looms The Federal Reserve kept interest rates unchanged, with its closely watched dot plot now implying a median of two rate cuts by year-end. At first glance, that may sound dovish. But a closer look at the details suggests a more cautious tone beneath the surface. Compared to March, more Fed officials are now penciling in fewer rate cuts, indicating growing divergence within the committee. Meanwhile, the Summary of Economic Projections reveals upward revisions to both inflation and unemployment forecasts—largely due to the impact of tariffs. That shift points to a more hawkish tilt, not a more accommodative one. Adding to the uncertainty, the recent spike in oil prices—driven by geopolitical tensions—is clouding the inflation outlook and complicating the Fed’s policy path. While the Fed’s projections offer insight into its current thinking, their usefulness has diminished in a trade environment shaped by tariffs at levels not seen in decades. Combined with a still-evolving post-pandemic economy, these dynamics make a near-term pivot unlikely until there is more clarity on both trade policy and inflation trends.

Navigating the Federal Reserve’s Tightrope: A Delicate Balancing Act or an Imminent Misstep? Arguments can be made that we have observed the Federal Reserve's skillful navigation through economic uncertainties, notably during the challenging times of the COVID-19 pandemic. Initially criticized for maintaining loose monetary policy, the Fed's actions successfully averted a deflationary bust. However, recent developments raise a critical question: Is the Fed sleepwalking into a policy error? The Federal Reserve's recent hawkish tilt has stirred concerns among market participants, notably evident in the pronounced bear steepening of the yield curve. The surge in both the 2/10 and 5/30 yield curves signals a tightening of U.S. financial conditions, impacting long-term investments like mortgages and corporate debt. These rate increases pose potential challenges to economic stability. The current economic landscape is characterized by unprecedented uncertainty regarding the trajectory of U.S. GDP. Divergent growth projections, ranging from the optimistic 4.9% by the Atlanta Fed to the more conservative estimates by the NY Fed and private forecasters, contribute to this ambiguity. This uncertainty is compounded by a rapid decline in U.S. nominal GDP growth rates, a trend inconsistent with projected policy rates. Persistent inflationary concerns persist despite external factors beyond the Fed's control, such as shutdowns, strikes, and energy prices. The crucial question arises: Is the recent hawkish tilt a premature response that could jeopardize the delicate balance achieved in the past three years? The Fed's current outlook of a 'soft landing,' implicit in its latest projections, appears incongruent with the recent hawkish tilt. This dissonance leaves investors pondering the possibility of a more challenging economic landing or a swift Fed pivot. Considering the Fed's historical reluctance to tighten and the evolving economic landscape, a pivot seems increasingly likely. Upon closer examination, it becomes evident that the Fed may have already made critical missteps. The belief in the 'Fed Put' as an omnipotent safety net led to market complacency. Downplaying the persistence of inflation created an environment where businesses and investors acted as if inflation was transitory. Now, the question shifts from the potential for a policy mistake to whether the Fed can effectively rectify these prior errors. The tools at the Fed's disposal are blunt, and historical performance suggests caution is warranted. Sophisticated investors must stay vigilant as the Fed's communication strategy will play a pivotal role in guiding market expectations. A potential pivot in communication, followed by liquidity adjustments and interest rate changes, could be on the horizon. Navigating these complexities requires flexibility and a keen awareness of the evolving economic landscape, essential for weathering potential storms on the horizon. What do you think?

"Over the medium term, tariffs are set to have an unambiguously recessionary effect, both for countries imposing restrictions and those receiving them. The costs are particularly high when exchange rates fail to absorb tariff shocks, and some evidence suggests exchange rates have become less effective in this role." Piero Cipollone, Member of the Executive Board of the ECB, 29 April 2025. I posted recently about how the ECB wouldn't be happy (at least in private) about the disinflationary effect of the strength in the Euro since the tariffs were announced. Cipollone came out yesterday and made this point rather more explicitly than I had expected. As you can see, he's not exactly cheery about the outlook for growth either. Here's some more: "...the tariffs' global recessionary effects, which push down demand and commodity prices, as well as of the possible dumping of exports from countries with overcapacity. The short to medium-term effects may even prove disinflationary for the euro area, where real rates have increased and the euro has appreciated following US tariff announcements." Sounds like the ECB understand that tariffs will probably cause a recession and be disinflationary for the Eurozone (absent significant retaliation). The implication of this is that they should cut rates further (and further than is priced), to support growth, combat disinflation and try to weaken the euro (although that won't be an official target). Cipollone is perhaps one of the more dovish ECB members though. So here is Lagarde (generally the consensus builder) on 17 April: On tariffs/ disinflationary forces for the Eurozone: "we know that it’s a negative demand shock...no question about that" "there will likely be...some redirection and rerouting of goods that will be supplied by markets that are subject to much higher tariffs...those goods could be rerouted to Europe." (She's mainly talking about China). "there is the appreciation of the euro, which we mentioned specifically in the Monetary Policy Statement, and there has been a significant decline in the price of commodities and particularly the price of energy." "an appreciation of the euro could put downward pressure on inflation" (this is pretty blunt.) On the other hand, on fiscal stimulus: "When you inject €800 billion in the economy, or near €1 trillion, it’s not a small feat. It’s a serious impulse and it has a serious effect, certainly on growth, and to be seen on inflation". On the neural rate: "the neutral rate...is a concept that works for a shock-free world...And anybody in this room who thinks that we are in a shock-free world would, I suggest... have their head examined." (They can cut below "neutral"). On the rate outlook: "The consequences will differ depending on which part of the world you stand (in). And that really justifies the fact that monetary policy decisions are not going to be the same the world over." I think European investors might want to consider bunds.

As illustrated by this Bloomberg chart, the price shock emanating from the Middle East War has shifted market expectations toward a "higher-for-longer" rate environment across nearly all systemically important central banks. (The outlier remains the Bank of Japan, which continues to inhabit its own paradigm—though less so recently. However, identifying the changed rate trajectory is merely the opening act of the analysis.) The current situation represents more than a simple price shock; it also involves a "second-round" adverse demand shock. Beyond these immediate economic effects, there is the lingering risk of spillovers into financial instability. All of this underscores the uncertain outlook: central banks will be navigating a series of judgments which, I suspect, will likely (or should) be adjudicated by a single, sobering question: "Which is the least unrecoverable mistake we can make?" The answer to this question is less complicated for single mandate central banks, such as the BoE and ECB, than it is for the dual-mandate Fed. #economy #markets #centralbanks

2️⃣ 0️⃣2️⃣ 4️⃣ Time for the Fed to embrace transparent forward guidance. In a candid assessment, Fed Chair Powell recently acknowledged that economic activity is decelerating, and inflation is receding more swiftly than expected. This is a pivotal moment for the Fed as it enters 2024 with a more balanced and pragmatic approach. It's time for the Fed to embrace transparent forward guidance, acknowledging that adjustments in 2024 will be essential, rather than reverting to vague allusions. This approach, while challenging, is crucial. Recent attempts by Fed officials to downplay Powell’s statement only serve to dilute his message, potentially undermining the Fed’s credibility. Instead, a clear narrative focusing on the desired pace and scale of policy easing could prove far more effective. This would help prevent excessive market euphoria and anchor Fed policymaking in a more forward-looking framework. Indeed, there are three reasons why the current market euphoria is excessive. Firstly, the Fed's commitment to a 2% inflation target remains unwavering. Any discussion of rate cuts will be intrinsically linked to positive developments in inflation metrics. Rate cut discussions will therefore be mechanically tied to encouraging developments on the inflation front. Since disinflation bumpiness is to be expected, current market pricing of early and rapid rate cuts seems misplaced. Secondly, economic activity will be largely influenced by ongoing cost fatigue and labor market trends. Cost fatigue is the reality that the cost of everything is much higher than before the pandemic, therefore weighing consumer spending and business investment – and leading to a massive disconnect between private sector sentiment and the underlying state of the economy. In turn, employment growth remains the main pillar to US economic activity. Surprising labor market resilience in the face of a historic tightening cycle confirmed our view that the value of talent has increased post pandemic. The question in 2024 will be whether cost fatigue or the value of talent dominate the business agenda in a context where the cost of credit remains historically elevated, but Fed easing is on the horizon. Lastly, reduced rate sensitivity in the business cycle suggests that even with the prospect of lower rates, immediate impacts on private sector investment might be limited. While the expectations of lower rates will undoubtedly prove stimulative for the deal market, it may not have an immediate and direct effect on private sector investment – rate insensitivity should be expected on the way down, just as it was a feature on the way up. In conclusion, the Fed stands at a crossroads. By articulating its commitment to a soft landing, contingent on its 2% inflation target, it can regain control of the monetary policy narrative. This approach would temper unfounded market optimism and set a course for measured and responsible economic stewardship.

𝐓𝐨𝐩 𝐜𝐞𝐧𝐭𝐫𝐚𝐥 𝐛𝐚𝐧𝐤𝐞𝐫𝐬 𝐚𝐫𝐞 𝐧𝐨𝐰 𝐨𝐩𝐞𝐧𝐥𝐲 𝐚𝐝𝐦𝐢𝐭𝐭𝐢𝐧𝐠 that their traditional models have 𝐮𝐧𝐝𝐞𝐫𝐞𝐬𝐭𝐢𝐦𝐚𝐭𝐞𝐝 𝐭𝐡𝐞 𝐩𝐞𝐫𝐬𝐢𝐬𝐭𝐞𝐧𝐜𝐞 𝐨𝐟 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧. Once price growth exceeds a certain threshold (~3%), it no longer fades like a passing shock but becomes embedded in expectations, wage settlements, and corporate pricing strategies. The lesson of the 2020s is that inflation must be treated as 𝐬𝐭𝐫𝐮𝐜𝐭𝐮𝐫𝐚𝐥𝐥𝐲 𝐩𝐞𝐫𝐬𝐢𝐬𝐭𝐞𝐧𝐭 𝐫𝐚𝐭𝐡𝐞𝐫 𝐭𝐡𝐚𝐧 𝐭𝐫𝐚𝐧𝐬𝐢𝐭𝐨𝐫𝐲 — a reality that challenges the policy frameworks shaped during the low-inflation decades preceding the pandemic. One direct casualty of this regime change is 𝐜𝐞𝐧𝐭𝐫𝐚𝐥 𝐛𝐚𝐧𝐤 𝐟𝐨𝐫𝐰𝐚𝐫𝐝 𝐠𝐮𝐢𝐝𝐚𝐧𝐜𝐞. For nearly two decades, guidance served as a reliable anchor, shaping market expectations and stabilizing asset prices. That credibility has weakened. Policymakers are now torn between models that forecast a steady return to target and empirical evidence pointing to far stickier inflation. The outcome is a heightened 𝐫𝐢𝐬𝐤 𝐨𝐟 𝐩𝐨𝐥𝐢𝐜𝐲 𝐞𝐫𝐫𝐨𝐫: remaining too loose risks entrenching inflation, while turning overly hawkish risks financial stress and recession. This view was confirmed in a recent speech by Bank of England policymaker Catherine L Mann. She noted that UK inflation has exceeded the target for four consecutive years, with only a brief reprieve in 2024, and is likely to remain elevated for at least another eight quarters. Her conclusion is blunt: 𝘪𝘯𝘧𝘭𝘢𝘵𝘪𝘰𝘯 𝘱𝘦𝘳𝘴𝘪𝘴𝘵𝘦𝘯𝘤𝘦 𝘪𝘴 𝘨𝘳𝘦𝘢𝘵𝘦𝘳 𝘵𝘩𝘢𝘯 𝘳𝘦𝘧𝘭𝘦𝘤𝘵𝘦𝘥 𝘪𝘯 𝘣𝘢𝘴𝘦𝘭𝘪𝘯𝘦 𝘧𝘰𝘳𝘦𝘤𝘢𝘴𝘵𝘴 — 𝘸𝘩𝘢𝘵 𝘴𝘩𝘦 𝘤𝘢𝘭𝘭𝘴 "𝘱𝘦𝘳𝘴𝘪𝘴𝘵𝘦𝘯𝘵 𝘪𝘯𝘧𝘭𝘢𝘵𝘪𝘰𝘯 𝘱𝘦𝘳𝘴𝘪𝘴𝘵𝘦𝘯𝘤𝘦". Such statements highlight the growing lag between economic reality and official models. 𝐅𝐨𝐫 𝐢𝐧𝐯𝐞𝐬𝐭𝐨𝐫𝐬, 𝐭𝐡𝐢𝐬 𝐝𝐢𝐬𝐜𝐨𝐧𝐧𝐞𝐜𝐭 𝐜𝐚𝐫𝐫𝐢𝐞𝐬 𝐬𝐢𝐠𝐧𝐢𝐟𝐢𝐜𝐚𝐧𝐭 𝐜𝐨𝐧𝐬𝐞𝐪𝐮𝐞𝐧𝐜𝐞𝐬. Market prices still reflect expectations of a rapid reversion to low inflation, but this view is increasingly looking misplaced. Portfolio strategy must therefore adapt: prioritize inflation hedges, remain skeptical of dovish pricing, and reassess assumptions about central bank credibility. The practical response is to increase allocation to inflation-sensitive assets — such as commodities (excluding gold) and possibly inflation-linked bonds — while reducing exposure to long-duration government debt, which faces the greatest vulnerability to repeated repricing. Ultimately, if central banks are struggling to model the inflation dynamics of the 2020s, investors must ask 𝐰𝐡𝐚𝐭 𝐨𝐭𝐡𝐞𝐫 "𝐬𝐭𝐚𝐛𝐥𝐞" 𝐦𝐚𝐜𝐫𝐨𝐞𝐜𝐨𝐧𝐨𝐦𝐢𝐜 𝐫𝐞𝐥𝐚𝐭𝐢𝐨𝐧𝐬𝐡𝐢𝐩𝐬 𝐦𝐚𝐲 𝐚𝐥𝐬𝐨 𝐛𝐞 𝐛𝐫𝐞𝐚𝐤𝐢𝐧𝐠 𝐝𝐨𝐰𝐧 — from interest rate neutrality to the Phillips curve. The old compass that guided markets may no longer point true. #economics #markets #finance

Conquest Lost and Regained: American Inflation in 2020s" with Thomas J. Sargent is now posted: https://lnkd.in/eRtSTe-4 After the pandemic, inflation surged in the US. The Fed responded slowly. We use a model where the Fed sets policy by optimizing with a drifting coefficients model. The model tells how empirical evidence in the years preceding the pandemic shaped the Fed’s response & how outcomes were influenced by (1) a decline in inflation persistence, (2) a flattening of the slope of the Phillips curve, and (3) mismeasurement of real-time potential output. Our model captures well the decisions of the Fed, replicating the path of policy interest rates over the past 30 years. We show how both changes in beliefs and real-time uncertainty contributed to explaining the slow response to the inflation surge in 2021. We also show that the forecasts from our model align quite well with the subjective projections of Federal Reserve policymakers, who were projecting strong declines in inflation with minimal changes in interest rates throughout 2021-2022.