Budget, monetary policy... The match is on!

It is rather unusual for a President of the French Republic to openly criticise European monetary policy. A guardian of monetary orthodoxy, the European Central Bank’s (ECB) mandate is well known by all: to keep inflation close to 2%, regardless of budgetary policy. And yet, this past Monday, Emmanuel Macron stated: “It concerns me to see many experts, and decision makers in European monetary policy, explain to us that European consumer (?) demand must be sharply reduced in order to better contain inflation. We must be very cautious about this.” 

Such an analysis is wholly justified by the European economic situation, as the Continent could be in recession in 2023. But while inflation is largely due to external factors, is aggressive monetary tightening justified?

Indeed, the ECB, which as usual remains in step with the Fed and does not dare to stray from its path (on this subject, see “Central Banks: Freed from Desire”), is preparing to raise its key rate by 75 basis points while starting to reduce its balance sheet. Emmanuel Macron emphasised – rightly – that the European case differs from that of the United States: when, in an overheated economy, the US must deal with high domestic inflation, inflation in Europe currently stems mainly from the energy crisis, with consumers already suffering from rising costs. In this case, could such monetary tightening, belatedly adopted, be an error of monetary policy? Delayed action by the ECB could indeed risk leading to financial instability, raising the spectre of 2008 and 2011, and threatening some pension funds and the real estate sector.

The day after the President’s article was published, the full-page interview with François Villeroy de Galhau in the Financial Times appeared as a scathing response to Macron’s critique. It was a stunning statement from the Governor of the French central bank, who commented – also in an unusual manner – on the budgetary policy…of the United Kingdom!

Insisting on the importance of the coherence between budgetary and monetary policy, Villeroy pointed out that it was the UK’s unfunded £ 45 billion tax cut that led to a sharp increase in rates, which in itself a key driver of financial instability. Unlike Emmanuel Macron, the member of the ECB’s governing council expressed concern about fiscal expansion and noted that “If you have a monetary policy with an anti-inflationary stance and there are doubts about whether your fiscal policy will fuel inflation, then you may get caught tina  vicious circle.”.[1]

In direct response to Emmanuel Macron’s critique, the governor reminded of the importance of the central bank’s independence and criticised budgetary stimulus plans that could lead to higher inflationary risk and, potentially, interest rate hikes. That is a key source of bond market stress that, as we have seen, has the power to cause the downfall of governments.  Not often do we witness such a sharp exchange between central bankers and governments has rarely been seen in developed countries. It illustrates the beginning of an arm-wrestling match that could end poorly.

Between inflation and recession, the ECB has made a choice in line with its mandate - it will continue to tighten rates and its credibility depends on this. Confronted with galloping inflation, governments have, for their part, renounced budgetary orthodoxy. To avoid recession, they will continue to support consumers. This unprecedented situation carries the primary risk of driving interest rates even higher. Indeed, with a lower demand for debt (as central banks reduce their asset purchases) and an increasing offer (due to unfunded measures), the risk of an upward spiral is ever present. It means that what happened in the UK could, in theory, also take place in Europe, unless a compromise is found and governments and central banks get on the same page. Otherwise, it is the market that will be the magistrate of this conflict carried out via the press. And the ECB will have to act as a matter of last resort by purchasing debt.

The assertion of independence can sometimes lead to disastrous results.


[1] “If you have a monetary policy with an anti-inflationary stance and there are doubts about whether your fiscal policy will fuel inflation, then you really risk nurturing a vicious loop.”

  • Nicolas Forest
    Nicolas Forest
    Chief Investment Officer

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