Emmanuel Macron throws down inflation gauntlet to ECB

French President Emmanuel Macron

When government spending collides with central-bank rate hikes in the face of rampant inflation, markets take fright. That’s the lesson for UK Prime Minister Rishi Sunak after the implosion of his predecessor’s “Trussonomics” bazooka of energy aid and tax cuts. A more austere path beckons.

The euro zone has dodged this turmoil, which gives an idea of where the real economic radicals sit these days. But an inflation standoff looms there too as governments express frustration with the tightening path of the European Central Bank. France’s “Macronomics” suggests such dissatisfaction has a point.

France should, in theory, be a poster child for the kind of loose spending that has markets panicking over deficits. It emerged from Covid-19 with a debt-to-GDP ratio of 113% and a budget deficit of 7%, higher than the euro-area average, having pulled out the stops to protect jobs.

Keen to avoid a repeat of the 2018 Gilets Jaunes protests over a higher cost of living, French President Emmanuel Macron’s administration has spent 24 billion euros ($23.9 billion) since late 2021 to cap consumers’ energy bills. This will be extended next year for the princely sum of 45 billion euros.

However, France’s headline inflation rate of 6% is currently the lowest in the euro area — well below Germany’s 10% and the UK’s 10.2%. Inflation at 6% is still objectively high and has eroded purchasing power, of course, but think tank OFCE estimates that government energy support will shave 2 percentage points off inflation this year for a GDP gain of almost 1%.

The International Monetary Fund expects France to grow faster than the UK and Germany next year. French yields have not spiked UK-style, partly because policy unpredictability is low.

The point here is not to celebrate France’s price controls on energy. They are not a free lunch and are funded by the public purse. The Macron administration is trying to target them more effectively and plans to increase the price cap to 15% next year from 4%.

But France demonstrates that more spending to shield households can curb headline inflation without causing market turmoil. It also suggests interest rates might not be the most effective way to tackle energy-driven inflation. Even if core inflation excluding energy is picking up, Nicolas Goetzmann, strategist at Financiere de la Cite, says high energy prices are still clearly filtering through, with a five-to-six-month lag.

Hence why Macron is sending an unusually vocal message to the ECB, which is set to deliver another big 75 basis-point hike. He warned in an interview with Les Echos against monetary authorities “shattering demand” to contain inflation. And after meeting Macron, new Italian Prime Minister Giorgia Meloni launched her own broadside against Frankfurt, calling looming rate hikes a “rash choice.”

Nobody wants to see intensifying conflict between fiscal and monetary authorities, not least after the Trussonomics mess. But there’s a case to make that central bankers will face their own limits in an energy-driven inflation shock.

Europe’s economy is not overheating like the US’s. Double-digit inflation in the UK suggests a combination of deteriorating terms of trade and Brexit’s impact on the labor market; while in Germany, the scale of recession is such that a massive energy aid plan is in the works. It’s not clear higher interest rates would solve this without a brutal hit to demand and consequences for financial stability.

The impact of driving down euro-area inflation from almost 10% to 2% through central-bank tightening is something markets still have not adjusted to, says Carmignac analyst Michael Michaelides.

What Europe needs more than aggressive rate hikes is true coordination. Rather than expect all countries to test the market’s willingness to fund energy-support plans, European Union members should borrow jointly and invest in targeted aid for those vulnerable to high energy prices, as well as infrastructure projects that will boost growth and increase energy supply.

Martin Moryson, economist at DWS, says even after the turmoil of Trussonomics, more joint EU energy investments would pay off.

This will mean finding more coordination between governments and central banks. Indeed, Bank of Spain boss Pablo Hernandez de Cos this week called for more investments using pandemic-style recovery funds and fiscal rule reforms. Trussonomics has failed, but the real inflation test begins now.