Europe faces potentially the worst of all worlds from aggressive tariff policies announced and planned by US President Donald Trump. An American inflationary upsurge and severe restrictions on world trade could produce an unpalatable mix of euro depreciation and a revival of price pressures amid further economic stagnation.
The US measures against Canada, Mexico and China could disrupt the European Central Bank’s campaign to ease monetary policy, lowering further already slender chances of a decisive European recovery from the second half of the year onwards.
Trump’s effective declaration of a trade war counters the impact of relatively good news on the inflation front expounded on 31 January by François Villeroy de Galhau, governor of the Banque de France, at an OMFIF meeting organised at State Street Global Advisors’ London headquarters.
He declared his support for ‘agile pragmatism’ in adjusting monetary policy as ‘victory over inflation is now in sight’. He outlined the chances for fresh interest rate cuts if, as expected, European inflation (at present around 2.4%) falls to the 2% target by the summer.
‘The direction of the travel is clear: our monetary policy will go from restrictive towards neutral… We should be sustainably around our 2% inflation target by this summer.’
Germany heads to the polls
All eyes are on the political position in Berlin as Germany prepares for a landmark election on 23 February. Friedrich Merz, leader of the Christian Democratic Union, the probable new chancellor, will face difficulties in putting together a workable coalition. He is under pressure both in Germany and internationally to reform the constitutionally anchored ‘debt brake’, which puts a cap on new public sector borrowing.
The need for a German and European fiscal stimulus has been increased by worries over a further dent to European growth in the light of Trump’s tariffs. The Bundesbank has been working behind the scenes on a potentially constructive compromise solution.
But the chances of reaching an effective political consensus for a constitutional change have been impaired by infighting between the different parties likely to be part of his new coalition. These include the Social Democratic party, Greens and liberal Free Democrats – all part of the ill-fated ‘traffic light’ coalition of Chancellor Olaf Scholz, which collapsed in November.
The strong opinion poll performance of the anti-immigration, anti-euro far-right party Alternative for Germany (AfD), at present polling second after the CDU, greatly complicates the parliamentary arithmetic needed for a consensus on Germany’s future fiscal policies.
‘Everybody loses in this kind of protectionist trade war’
Speaking on French radio on 3 February, Villeroy de Galhau referred to better news on inflation. ‘Looking at the economic news, there are some rather positive elements, there is a recovery of purchasing power… however, the decision of Mr Trump to impose strong tariffs will increase economic uncertainty.’
He said Trump’s tariffs were ‘very brutal’ and would especially hit the motor vehicles sector. ‘Everybody loses in this kind of protectionist trade war.’
At the 31 January London meeting, the governor’s speech focused on the rise of long-term yields in the US and the euro area (though to a smaller degree in the latter) since the start of monetary easing cycles in both economies. He dismissed the notion that the unwinding of quantitative easing has driven up long-term yields, as quantitative tightening is passive, bounded and ‘completely predictable’ for market participants. Rather he pointed to ‘sovereign debt trajectories and the elevated global policy uncertainties’ as reasons for the latest upward move in yields.
Villeroy de Galhau stated, ‘In the US, the risk of future trade restrictions and possibly immigration policies keep uncertainty about the outlook and inflation high, directly affecting risk premia’. This has also resulted in contagion of European yields. One major difference is expectations for monetary policy, which have declined in the euro area but increased in the US. ‘Monetary policy perspectives could and should rightly decouple’ said the governor, given that the ‘the disinflation trajectory is more clear-cut and the macro outlook is weaker’ in Europe.
To that end, the governor argued that ‘victory over inflation is now in sight’. The next steps will probably entail further policy cuts as well as ‘adjusting while keeping our toolkit, which will be a focus of our interim strategy review’. This will be a key focus of an OMFIF discussion in partnership with the Frankfurt School of Finance and Management next month.
Watch the event with Villeroy de Galhau on demand.
Join Joachim Nagel, president of the Deutsche Bundesbank, for a lecture on the natural rate of interest on 12 February.Â
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