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Hawks and Doves Series

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By Riccardo Russo.

Donald Trump has eventually been elected President of the United States. In Europe, German hawks keep criticising the ECB which, according to Reuters, would be ready to implement an ad hoc OMO for Italian bonds, in case the outcome of the referendum made returns skyrocket.

How will the election of Mr Trump affect the FED’s policy in the next months?

There are two dilemmas: the first one is if Mr Trump’s behaviour will be consistent with a presidential attitude or with the candidate one he showed before the elections. The more he will act as a president, the more his attitude will be conservative. The more he will act as a candidate, the more he will take radical choices, including the possibility of pressing Mrs Yellen towards resignation. The second question is whether he will be more republican or democrat. Republicans are usually hawks, they don’t like lax monetary policy and have already pushed for normalization of interest rates and less discretion in the FED system. Still, we should not give for granted that Mr Trump will not assume a more democratic attitude. His economic agenda includes an increase in public spending for infrastructures. To finance such projects the government has only two possible ways: more taxes or more debt. If we consider Trump’s pre-electoral promises, going for higher taxes would not be electorally feasible: these expenditures would result in higher debt. Does a borrower prefer higher or lower interest rate? Of course, lower. In any case, the next crucial deadline is December, when Obama will still be president. Data show that the economic situation in the US is good. Unemployment is very low, inflation is increasing towards 2% and, on top of that, elections are over. The FED has no reason to wait and see. I guess the probability of a hike in interest rates in December is close to 1, Trump being willing or not.

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In our last meeting, you claimed the FED lacks a real strategy. Do you think the election of Donald Trump would change anything with this regard?

If she stays, I am not sure Mrs Yellen will change her overall attitude. She is an advocate of discretion who doesn’t like having her own hands tied.

Turning to Europe, Mr Schäuble harshly criticised the possibility of extending the QE beyond March. Is it actually so harmful to European saving countries like Germany?

Well, this does not really sound like something new. Also in Europe we have hawks and doves and usually Germans are considered to be hawks. We know that doves would like to have an even more aggressive QE, without constraints, calibrations of the OMOs and EU law clauses. Hawks are instead convinced the QE is already sufficient and that further steps would increase the risk of monetary and financial instability. Mario Draghi and his board are still in the middle but – at least – their clear mandate makes them stronger with respect to their American counterparty. The ECB does not respond to politicians and can resort to all possible tools to achieve its objectives, taking into consideration data and possible sources of uncertainty. An extension of the QE beyond March therefore is possible, but hawks countries may make it difficult by addressing the European Court of Justice.

Dealing with uncertainty, what may we expect from financial markets in the aftermath of the Italian referendum? Would the ECB intervene in case of turmoil?

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We first of all need to draw a distinction between the perspective of financial markets and the one of the real economy. They are not consistent. On the contrary, the more financial markets are developed, complex, and interconnected, the more their perspective will diverge from the one of real economy. When it comes to financial markets we are not speaking about months, not weeks, not days but seconds. Financial markets seek uncertainty, the real economy dislikes it. It is easy to understand that, the higher the uncertainty, the higher the possibility to bet. The referendum will be one more source of uncertainty. I guess we will have the same reaction we already experienced after the Brexit vote and the US presidential elections. Whatever the outcome, a jump, in one direction or the other. The lack of a clear message to investors would then lead to instability also in the months to come. The referendum will be a shock in the short term and a source of uncertainty in the medium one. The more likely this volatility will be deemed to threaten the path of inflation growth, the more Draghi will be likely to take further resolutions on the QE. Anyway, let me say that the most urgent source of potential instability concerns the European banking union. We still lack the deposit insurance: being in an incomplete banking union is the real systemic risk.

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