Lagarde has seen the light … finally – Opinion Han de Jong

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Opinion Han de Jong

Today at 15.55

I’m not a big fan of ECB President Christine Lagarde. But now she’s written a blog (at least she’s on it) that I really like. If you want to read the text yourself, it can be found here: Monetary policy normalization in the euro area (

The reason I like the blog post is that it shows a good understanding of the situation we are in. I actually mean to say that I agree with the content. But really, I would say that I am glad that the ECB is finally “on my line”.

I like to summarize the main points. The economy is reopening, but we are not going back to the same pre-pandemic situation. Lagarde lists three types of shocks that greatly affect or have affected the economy. The first type concerns shocks due to logistical disruptions that have led to price increases on raw materials, both materials and other industrial inputs, as well as food. The second kind of shock relates to what has happened to the total demand for goods and services in the economy and production, e.g. supply and demand. These shocks have led to high price increases on industrial goods. The third set of shocks concerns the opening of the economy, leading to a significant shift in consumption patterns with fewer goods and more services. Due to staff shortages, this is leading to high inflation in the service sector.

According to Lagarde, less than 20% of all components of the eurozone inflation basket rose faster than 2% a year before the pandemic. Now it’s apparently 75%.

She then notes that supply chains can change for geopolitical reasons. This makes the global economy less efficient and leads to structurally higher inflation at least for some time. The war-accelerated ‘green transition’ will have the same effect.

Finally, Lagarde notes that inflation expectations have risen. She adds that the ‘right tail’ of the distribution of expectations has become wider. This means that the risk of much higher inflation than desired has increased.

Lagarde concludes that the extremely lenient pre-pandemic monetary policy is no longer appropriate. After all, that policy was aimed at boosting inflation and inflation expectations, which were judged to be too low. It is no longer necessary. Therefore, Lagarde informally announces a normalization of the policy. In July, the ECB will stop buying bonds and interest rates will definitely rise. At the end of the third quarter, we will then avoid negative interest rates. The ECB should have come to this realization much earlier, but still: Hallelujah!

Incidentally, the ECB would not be the ECB if Lagarde did not dampen expectations of interest rate hikes either. ‘Gradualism’, ‘freedom of choice’ and ‘flexibility’ remain keywords. So do not expect a high interest rate on your savings account.

Maybe less financial damage
The world economy is still being thrown up and down by various shocks, and the predictability is therefore very limited. It is difficult to assess how the war and sanctions will affect the European economy. I’m not at all sure we can avoid a recession. Now you can argue that a recession is not so bad because we have an overstretched labor market, and a (limited) rise in unemployment may actually be a good thing. But yes, it is still annoying when people lose their jobs or see their business get into trouble.

In any case, the latest confidence indicators do not indicate a recession in the eurozone so far. The preliminary figures for the so-called purchasing manager indices show a small decrease for both the manufacturing and service sectors. The total figure fell from 55.8 in April to 54.8 in May. It’s a pretty healthy absolute level. The influential German Ifo index even rose: 93.0 in May after 91.9 in April. The graph shows that the outbreak of war led to a significant weakening of the expectation component, but that this has not yet resulted in a corresponding decline in the assessment of the current situation. In fact, according to the Ifo survey, German entrepreneurs rate actual economic development in May more positively than they did in April: 99.5 to 97.3.

Source: Refinitive Datastream

In the US, the combined purchasing managers’ index fell from 56.0 in April to 53.8 in May. Economic growth also downgraded slightly in the first quarter: -1.5% (annualized) against previously reported -1.3%. The Atlanta Federal Reserve is preparing a series, GDPNow, that seeks to quantify current growth based on various indicators. This GDPNow is now at + 1.8% for the second quarter. So it does not exactly stop.

American recession?
The question this raises is whether the US economy can end up in recession anyway. The combination of purchasing power eroding inflation, the sharp rise in interest rates and the increased uncertainty caused by the war may work in that direction. On the other hand, the yield spread between ten-year and two-year government bonds has been 0.2-0.4% for a long time. In the past, recessions have all been preceded by a yield curve inversion, more specifically by a situation where the effective return on two-year securities has been higher than for ten-year securities.

One factor that is remarkably often overlooked in such considerations is what happens to public finances. Well, it’s nothing short of spectacular what’s happening there, as can be seen immediately from the following chart. The federal government budget deficit is currently declining at an unprecedented rate. This, of course, has everything to do with the fact that the support and stimulus measures of the last two years are not repeated and with the strong labor market. Between March 2021 and April 2022 (ie thirteen months), the deficit fell from 18.6% of GDP to 5.0% of GDP. It is inevitable that this will put a very strong brake on GDP growth. The good news is that this fiscal tightening will not continue at the same pace. I am therefore still reasonably optimistic about the United States that a recession can be avoided there, or at least that they have a better chance of doing so than we in the eurozone.

Source: Refinitive Datastream

Double plaster on the stock market?
This is of course very relevant to the stock market. It has gathered rake harvesters this year. So far, the fall in share prices has been mainly driven by rising interest rates, which have hit price earnings. A recession would also hit corporate profits. A ‘second push’ in the stock market would then make sense.

The profit margin is currently high. A macroeconomist like me prefers to look at macro figures that can be found in the national accounts. In the first quarter, corporate profits fell slightly both in dollars and as a percentage of GDP. No need to panic, but the following chart makes it clear that the margins are historically high. Anyone who believes in ‘mean reversion’ can easily conclude that there is at least more ‘downside’ than ‘upside’.

Source: Refinitive Datastream

Turkish inflation is getting out of control
Something completely different. Turkish President Recep Tayyip Erdogan is not happy with Sweden and Finland as potential NATO countries. The Turkish citizens, I imagine, are much less satisfied with the monetary policy that Erdogan is advocating. Erdogan has an unconventional view of inflation. While a large majority of economists believe that high inflation can be combated with interest rate rises, Erdogan believes the opposite. Interest is a cost item for companies. The lower the interest rate, the lower the cost and the lower the inflation. In addition, low interest rates encourage investment that increases production capacity, which reduces inflationary pressures.

Erdogan’s vision is currently being tested. During 2021, the central bank lowered interest rates while inflation rose. Unfortunately for the Turkish people, this crazy experiment is currently running completely out of control. In April, inflation was 70 per cent. Despite this, the central bank maintained its official key interest rate at 14% this week. The lira is under intense pressure and is roughly halved in value over a year. Add to that the rising energy prices, and there is a good explanation for the rise in inflation. To reverse the trend, the central bank is buying lira for dollars in the foreign exchange market. Over the past two weeks, foreign exchange reserves have fallen by about $ 6 billion (to about $ 60 billion).

Source: Refinitive Datastream

The question is how it affects Erdogan’s position. Citizens are quite willing to suffer financial pain, but if it gets too bad, they rebel. In South America, political leaders who let inflation get out of control have often been forced to step down under pressure.

par ugers pause
I take a couple of weeks off from my written comments (and also from my spoken comments at BNR). And I’m glad I can do it with some positive messages.

The first is that ECB President Lagarde has posted a blog post that is worth reading, though my summary may also be sufficient. The inflation outlook is very different from that of the pandemic, and although much is uncertain, the current circumstances and outlook no longer justify a monetary policy aimed at boosting inflation and inflation expectations. We will get rid of the damn negative interest rate in a few months.

Various confidence indicators are optimistic that the battle for the economy due to the war, sanctions, etc. may be (slightly) less negative than previously feared.

The US economy is currently producing mediocre GDP growth figures, but an extremely spectacular reduction in the government deficit is playing an important role. Public finances will not continue to negatively impact the economy much longer. I think there is a good chance that the United States will be able to avoid a recession.

Finally, it is worth looking at Turkey. Inflation there is completely derailed by the monetary policy that Erdogan enforces. Of course, that does not fit with good news. The Turkish citizens are hard hit by this. This could significantly weaken Erdogan’s position. Whether it’s good or bad news is up to you.

Han de Jong

Han de Jong is a former chief economist at ABN Amro and now a resident economist at BNR Nieuwsradio, among others. His comments can also be found on

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