Notes for an interview with an Italian TV chain on the Fed and the ECB

The Fed’s Challenges Under Warsh: A More Complex Environment Than for the ECB’s.
I believe it is useful to look first at Kevin Warsh’s early weeks at the Federal Reserve, as the developments in Washington are currently more complicated than those in Frankfurt. Warsh, in particular, finds himself in a far more precarious position than Christine Lagarde at the ECB.

Key Challenges for Warsh at the Fed:
1. Original Sin of Trump’s nomination: The president’s push for lower rates, his disregard for Fed independence, and his lack of respect for institutional norms (renewed attempt to fire Lisa Cook) continue to cast a long shadow on Warsh’s chairmanship of the Fed.
2. Communication Breakdown: The absence of clear guidance by Warsh has left markets and other policymakers in a state of uncertainty.
3. Task Forces and Distrust: The creation of task forces, headed by external people, signals a lack of confidence by Warsh in the Fed’s existing personnel and structures. This is in contrast with the high reputation of the institution.
4. A Divided FOMC: The Federal Open Market Committee is increasingly fractured, with divergent views on policy direction.
5. Balance Sheet vs. Interest Rates: Warsh’s idea that balance sheet reductions can do the work of rate hikes does not convince many economists and leaves the market perplexed.
6. AI, Productivity, and Lower Rates: Warsh’s conviction that the potential for AI-driven productivity gains could ease inflationary pressures and allow lower interest rates is empirically and theoretically uncertain.

Unprecedented €/¥ FX Interventions: A Test of € Institutional Maturity
The Fed’s recent intervention in the foreign exchange market—selling euros to support the yen at the Treasury’s behest— is unprecedented. This action, apparently taken without prior coordination or communication with the ECB, raises questions about its efficacy. In addition, it contravenes long-standing traditions of fairness and openness in central bank relationships. Yet, it also signals a maturity of the euro: notwithstanding the U.S. unilateral action, the euro did not suffer. Technically, the intervention was feasible and smooth, and the lack of fallout suggests a shifting dynamic in global currency markets.

Interpreting July’s CPI and the Fed’s Restrictive Path
July’s CPI data came as no surprise—it was widely anticipated. However, the critical takeaway is that U.S. inflation has now exceeded the 2% target for over five years, yet Warsh has offered little precision on the Fed’s intentions. The market is evenly split on the possibility of a September rate hike to 4%.
The FOMC is deeply divided, and Warsh may find himself in the minority, as the Bank of England Governor has on occasion.

Labour Market Weakness: A Shifting Risk Balance for the Fed
Recent signs of weakness in the U.S. labour market potentially complicate the Fed’s calculus. For now, these signals are, however, limited:
• Unemployment remains historically low.
• The slowdown in job creation is moderate.
Thus, the inflation-employment trade-off has not yet tilted decisively toward prioritising employment over inflation.

Geopolitics and Oil: A Large but Smaller-Than-Expected Impact
The recent oil price pressures, driven by the Middle East crisis and the challenges of reopening the Strait of Hormuz, have had large but less dramatic effects than feared. This is partly due to:
• Reduced Chinese imports of oil and gas.
• Structural shifts toward lower fossil fuel dependence.
• Workaround for Hormuz.
• Market desensitisation to news, as good and bad news (e.g., Trump’s statements) alternate rapidly, muting reactions.

Europe’s Independence from the Fed: A Growing Divergence?
The ECB is gradually decoupling from the Fed’s influence:
• The USD/EUR exchange rate no longer plays a dominant role in Eurozone inflation, which is now more driven by wage dynamics.
• U.S. policy uncertainty (fiscal and monetary) compels the ECB to focus more on domestic European developments.

The ECB’s Scenario: Rate Hikes in 2026, Cuts in 2027?
The market is betting on further ECB rate hikes in 2026, followed by cuts in 2027. How credible is this?
• Inflation in Europe is better controlled than in the U.S. (3-4% in the U.S. since early 2023 vs. 2-3% in the EU since early 2024). Still, after 5 years, it is significantly above the target.
• Growth in Europe is weak but shows signs of resilience:
o The services PMI rose to 51.7 in July (from 49.4 in June).
o The composite PMI increased to 52.0 (from 50.0 in June).
o Q2 2026 Eurozone GDP grew by +0.44% QoQ, exceeding expectations (with Ireland contributing +0.15pp).
o Q3 2026 growth is estimated at +0.2%.

A September rate hike by the ECB is highly probable.

Bond Markets: Italy and Greece Outperform the U.S.
Surprisingly, the Treasury departments of the two most indebted countries in the €-area have to pay less than the US treasury to convince investors to lend them money: the 10-year yields on Italian (BTP) and Greek bonds are significantly lower than those of U.S. Treasuries notwithstanding their hefty convenience yield, (Italy at ~4%, Greece at 3.82%, vs. U.S. at ~4.7%). This reflects:
• Credit improvements in Italy and Greece.
• More favourable inflation and exchange rate expectations compared to the U.S.
• But also underlying doubts about the dollar and the US credit quality.
The stability of the BTP-Bund spread suggests that the rise in yields is a broader Eurozone phenomenon, not a country-specific issue.

The Biggest Undervalued Risk: A U.S. Triggered Financial Crisis
The market may be underestimating the risk of a U.S.-triggered financial crisis, driven by:
1. Unsustainable fiscal policy.
2. Monetary policy uncertainty.
3. Overvalued equity markets.
4. Early cracks in the dollar-based international monetary system.

While the probability of this event remains low, its potential severity is huge.