En (La)Garde: ECB President Reveals What Happens Next

By Michael Every of Rabobank

Yesterday saw a major upside surprise in the US Empire PMI (+10 vs. -18 expectation), which seals a May 25bps Fed rate hike and opens the door to chatter of more.

Indeed, Fed-speak underlined the US economy is ‘doing just fine’ with rates at 5%. That’s the usual ‘small picture’ stuff of most market commentary.

However, ECB President Lagarde yesterday gave a very big picture speech (‘Central banks in a fragmenting world’) that dwelled on the usual subject matter found here.

Indeed, it was so significant that I am going to reprint almost all of it:

“The tectonic plates of geopolitics are shifting faster. We are witnessing a fragmentation… into competing blocs, with each bloc trying to pull as much of the rest of the world closer to its respective strategic interests and shared values… All this could have far-reaching implications across many domains of policymaking…[and] for central banks….

In the time after the Cold War, the world benefited from a remarkably favourable geopolitical environment. Under the hegemonic leadership of the US, rules-based international institutions flourished, and global trade expanded. This led to a deepening of global value chains and, as China joined the world economy, a massive increase in the global labour supply. As a result, global supply became more elastic to changes in domestic demand, leading to a long period of relatively low and stable inflation. That in turn underpinned a policy framework in which independent central banks could focus on stabilising inflation by steering demand without having to pay too much attention to supply-side disruptions. But that period of relative stability may now be giving way to one of lasting instability resulting in lower growth, higher costs and more uncertain trade partnerships. Instead of more elastic global supply, we could face the risk of repeated supply shocks.

Recent events have laid bare the extent to which critical supplies depend on stable global conditions… In response, governments are legislating to increase supply security, notably through the Inflation Reduction Act in the US and the strategic autonomy agenda in Europe. But that could, in turn, accelerate fragmentation as firms also adjust in anticipation. Indeed, in the wake of the Russian invasion of Ukraine, the share of global firms planning to regionalise their supply chain almost doubled –to around 45%– compared with a year earlier. This “new global map”… is likely to have first-order implications for central banks.

One recent study based on data since 1900 finds that geopolitical risks led to high inflation, lower economic activity and a fall in international trade… ECB analysis suggests similar outcomes may be expected for the future. If global value chains fragment along geopolitical lines, the increase in the global level of consumer prices could range between around 5% in the short run and roughly 1% in the long run.

These changes also suggest that a second shift in the central bank landscape is taking place: we may see the world becoming more multipolar… After 1945, the USD became firmly ensconced as the global reserve currency, and more recently, the euro has risen to second place. This had a range of –mostly beneficial– implications for central banks. For example, the ability of central banks to act as the “conductor of the international orchestra” as noted by Keynes…

But new trade patterns may have ramifications for payments and international currency reserves. In recent decades China has already increased over 130-fold its bilateral trade in goods with emerging markets and developing economies, with the country also becoming the world’s top exporter. And recent research indicates there is a significant correlation between a country’s trade with China and its holdings of CNY as reserves. New trade patterns may also lead to new alliances. One study finds that alliances can increase the share of a currency in the partner’s reserve holdings by roughly 30 percentage points. All this could create an opportunity for certain countries seeking to reduce their dependency on Western payment systems and currency frameworks…

Anecdotal evidence… suggests that some countries intend to increase their use of alternatives to major traditional currencies for invoicing international trade, such as CNY or INR. We are also seeing increased accumulation of gold as an alternative reserve asset, possibly driven by countries with closer geopolitical ties to China and Russia. There are also attempts to create alternatives to SWIFT… These developments do not point to any imminent loss of dominance for the USD or EUR… But they do suggest that international currency status should no longer be taken for granted.

We have clear examples of what not to do when faced with a sudden increase in volatility. In the 1970s, central banks… failed to provide an anchor of monetary stability and inflation expectations de-anchored – a mistake that should never be repeated for as long as central banks are independent and have clear price stability mandates. So, if faced with persistent supply shocks, independent central banks can and will go ahead with ensuring price stability. But this can be achieved at a lower cost if other policies are cooperative and help replenish supply capacity.

For example, if fiscal and structural policies focus on removing supply constraints created by the new geopolitics –such as securing resilient supply chains or diversifying energy production– we could then see a virtuous circle of lower volatility, lower inflation, higher investment, and higher growth. But if fiscal policy instead focuses mainly on supporting incomes to offset cost pressures… that will tend to raise inflation, increase borrowing costs and lower investment in new supply… Insofar as geopolitics leads to a fragmentation of the global economy into competing blocs, this calls for greater policy cohesion…behind a strategic goal…

Achieving the right policy framework will not only determine how our economies fare at home, but also how they are viewed globally in a context of greater “system competition.”

…For Europe, long-delayed projects such as deepening and integrating our capital markets can no longer be viewed solely through the lens of domestic financial policy. To put it bluntly, we need to complete the European capital markets union. This will be pivotal in determining whether the euro remains among the leading global currencies or others take its place.

Central banks also have an important role to play here – even as protagonists. For example, the manner in which swap lines are used could influence the dynamics of major international currencies…. We have already seen the PBOC set up over 30 bilateral swap lines with other central banks to compensate for the lack of liquid financial markets in renminbi. How central banks navigate the digital era –such as innovating their payment systems and issuing digital currencies– will also be critical for which currencies ultimately rise and fall.

So, we need to be ready for the new reality that may well lie ahead. The time to think about how to respond to changing geopolitics is not when fragmentation is upon us, but before. Because, if I may paraphrase Ernest Hemingway, fragmentation can happen in two ways: gradually, and then suddenly. Central banks must provide for stability in an age that is anything but stable. And I have no doubt that central banks will measure up to the challenge.”

In short, *the ECB president* says we are seeing fragmentation into competing geopolitical blocs, which is structurally inflationary; rival FX architecture is emerging; trade invoicing and swap lines are key; Western fiscal policy must be expansionary on the supply side or into defense; monetary policy needs to work with it for “strategic goals”; central bank digital currency might be needed; and the bloc that does state capitalism/mercantilism best will win the “systemic competition.”

All of this was predicted here as far back as 2015-16, but ignored by markets focusing on what they thought mattered more – which was themselves. Now, En (La)Garde!