The end of the “Great Tuning” for the policy mix

The era of policy mix, in which monetary policy is that tax cooperate with each other, supported so far by one low inflation and from coordinated responses to international crises, it is ending. The big fiscal expansion is behind us and its drag effects will wear off. The upcoming budget deficit reductions will go hand in hand with the decrease in household savings and corporate profits, which have already begun to come under pressure. In fact, if it is true that companies have so far been able to pass on the increase in production costs to consumers, above all because household savings have been high, this phase is also over and now it is expected. salary negotiations and increased pressure on corporate margins.

From a monetary standpoint, we are seeing the end of the very low-cost money season as the central banks they find themselves in the uncomfortable position of having to raise rates to drain liquidity in a period of looming stagflation. Policy makers are likely to maintain some kind of “benign neglet” and tolerate inflation a little higher than their targets to preserve growth. Monetary policy interventions have long been justified (and overly commented on). However, there is no point in looking at monetary policy in its own right. On the other hand, little has been said about the budgetary issues. This means that investors have missed a fundamental link: the question today concerns the role of monetary policy interventions in the overall policy mix. In perspective I see three possible policy mix scenarios, with markets reacting differently to each of them. The question at stake will be to optimize the growth / inflation trade-off at a time when most markets remain overvalued.

The first scenario involves fiscal expansion and complete normalization on the monetary front. This option is tricky, as normalization inhibits fiscal room for maneuver. L’rising interest rates make large public debts unsustainable and limits the room for further action, which may be needed to avoid triggering a recession if monetary conditions are too tight. The main risk in this case lies in the timing and coordination needed to prevent monetary authorities from turning off the taps too quickly and tax authorities to intervene too late. For this reason, there should be a consensus on both sides. The result could be a “Volckerian” victory that eliminates inflation (by sacrificing demand) or stagflation. For the markets, this would imply a further correction for risky assets, in particular for stocks that are more sensitive to interest rate dynamics.

The second scenario involves some fiscal expansion, but central banks stay “behind the curve” in order to cooperate to accommodate the fiscal momentum. This is the best way to optimize the trade-off between growth and inflation and to organize a controlled slowdown in economies; however, inflation would continue to be high. In this case, some risky assets, notably dividend-paying equities and real assets, would deserve higher portfolio exposure to protect themselves from the threat of inflation.

Finally, the third scenario envisages a fiscal expansion with full cooperation and a monetary accommodative approach. This would inevitably lead to an un-anchoring of inflation expectations and leave investors with almost no place to take refuge other than liquidity and some real assets. This option can be considered as a financial regime such as that of the 1970s, characterized by inflation, nominal growth, market corrections of nominal rates and adjustments of all risk premia, with equilibrium valuations.

Although the narrative currently in vogue focuses on the first option, I think the second or third scenario is more likely. The fiscal area will be used to address in particular new factors important for the public good, such as the energy transition or social and strategic autonomy. Central banks will need to remain collaborative and adapt to these priorities. This is especially true in Europe, where the lack of effective and credible fiscal rules will have to be made up for on the monetary front. Furthermore, the perception by public opinion that the fiscal space is effectively unlimited is widespread (and originated by disinformation), such that it can be used without deteriorating the already inflated data of the debt / GDP ratio.

The worst case scenario is that of a real stagflation explosion. If little or nothing is done on the fiscal front, this automatically implies a tightening of the policy mix as a whole, reversing the trend of recent years. This could be triggered by political pressures, such as the fact that President Biden is already cornered. Ultimately, a recession and a sharp repricing of markets would be the obvious consequences.

* Chairman Amundi Institute