“To govern is to destroy, to destroy the parasites, to destroy one’s own troops, to destroy the enemy” said Shang Yang.
The enemy is the inflationary spiral. It is Karl Otto Pölh’s toothpaste, to use the words of the President of the Bundesbank, which “once out of the tube, cannot go back in”. The weapon is the rise in interest rates towards their neutral point; a very theoretical level at which the economy stops overheating and full employment and price stability become compatible again…
Before taking over the presidency of mankind’s economic destiny, leading them to the nirvana of this state of platonic harmony where monetary policy is neither accommodative nor restrictive, central banks must first go through the painful phase of tightening financial conditions. As Janet Yellen says: “you can’t break inflation without a recession”. You have to blow the economic cold to fight the fire.
By quenching the liquidity they have poured in so abundantly, central banks are first destroying the bubbles they have indirectly encouraged to emerge. On the equity markets, the most expensive stocks are being massacred through a violent compression of their multiples: the GAFAs are giving up 1,000 billion in capitalisation in 3 days. The destruction of crypto-currencies, whose market capitalisation has collapsed by 60% in a few days, does not move the FED either. What does it matter if 40% of investors are now losing on their digital assets… They are parasitic assets in the eyes of those who have the legitimate monopoly to mint the official currency or “fiat”. The revenge of the dollar on bitcoin, prophesied until 2021 still as the instrument of protection against the inflationary effects of the imprudent policy of the FED, has begun… The major “fiat” currencies (Euro, Sterling, Yen) are also devaluing and approaching, or even, like the Swiss franc, reaching parity with the greenback. At $1.04, the euro is more or less at the same level as the “cable” (GBP/USD) in 1985. Indeed, at that time, the pound also tested parity with the greenback, far from the $2 that prevailed until Bretton Wood. At that time in the US, Volcker was taming inflation. Growth was strong. US bond yields, in a booming economy, paid better than Gilts: capital flight was bleeding the UK currency in the midst of an economic slump. In many ways, the situation on both sides of the Channel was reminiscent of 1985: inflation was higher than in the US, growth lower, and bond yields lower than treasuries. The BOE has just admitted that at 10%, inflation is out of control and that the British economy is already heading towards recession. Its room for manoeuvre is therefore limited. Rates can only go up so much. When the economy collapses, the BOE will be forced to ease off.
Unfortunately, in a context of shortages of energy, agricultural raw materials or semi-finished goods, there is no indication that the rise in rates and the recession will have an effect on inflation. The pound has thus lost 10% against the dollar since the beginning of the year, with the euro following suit at -9% and approaching parity. On the old continent, too, basic goods are becoming scarcer. Stock-outs of flour and oil are appearing in supermarkets in the eyes of consumers who are feeling the effects of rising prices.
There is no improvement on the energy front: for the first time, the war in Ukraine has physically reduced the flow of gas to Germany. 3% of imported volumes have disappeared.
After the car manufacturers, Safran and Thalès, which are already suffering from the lack of Russian titanium, fear that they will soon have to shut down certain production lines. New orders to industry are turning around. The European economies, especially Germany, could come to a halt and go into recession in the second half of the year.
It is this stagflationary spectre that is weakening the Euro. The feeling that imported inflation will not stop with the recession, the mistrust of a central bank that lags behind the others. While most central banks have started to act, some with the ambition to go further than the neutral rate, the ECB is still hesitating.
The euro is therefore suffering, its weakness increasing imported inflation. Worse still, energy shortages and rationing in the event of a total halt to gas supplies may raise the existential question of the value of a currency that does not allow access to the most basic resources.
In 2020, the ECB and governments did everything possible to avoid the employment damage of “whatever it takes” confinements.
This year, whether she acts or not, we must face the facts: the ECB’s policy will claim victims, among its own troops, among the states of the South, among companies with a high level of debt, among the most fragile consumers, among the middle class, which will probably be trapped between the erosion of its purchasing power and the contribution to solidarity and to the record public debt.
Christine Lagarde will have to come to terms with the bitter idea that governing sometimes means destroying
Thomas Planell, Portfolio manager – analyst at DNCA. This article was finalised in May 13th, 2022.
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