The Bear and the Turtles

Key Points

• We explore the macro constraints to a re-armament effort in Europe. Russia would struggle. It may be an acute awareness of these challenges ahead which explains Moscow’s tough approach now. 
• While this keeps us behind some prominent sell-side calls, we make the case for a cautious approach by the Fed after the March lift-off.

Judging by the public warnings of the US and UK governments, tension with Russia over Ukraine is not abating and may even get paroxysmic this week despite continuing diplomatic efforts. Beyond the impact a further escalation would have on the short-term European outlook, we explore the macroeconomic constraints around a likely re-armament race in Europe. While the current gap in military spending between Russia and the EU looks glaring when expressed in share of GDP, it reverses when looking at the absolute levels. The likely demographic and economic trajectory in Russia will make it very hard for Moscow to keep up with the EU countries if, in a delayed reaction to Russia’s assertiveness, they decide to bolster their own defense spending.  It might be Moscow’s very awareness of these demographic and economic challenges ahead which may explain why Russia is ready to go quite far now to protect its influence in Ukraine, which is sees as crucial to the “strategic depth” which has traditionally been a focus of Russian military doctrine. In a nutshell, Moscow would rather have an indirect confrontation with the West before its economic vulnerabilities start impacting its defense capabilities again. Yet, by confronting the West now, Moscow may actually accelerate a re-armament race which it will have a very hard time winning.

Inflation surprised to the upside again in the US in January, but the reaction from the Fed has not been unanimous. While James Bullard called for raising the Fed Funds rate by 100 basis points by July, San Francisco Fed President Mary Daly expressed her support for a prudent approach after the March lift-off. We think the cautious approach makes sense. The very recent weakness in consumer spending may reflect the decline in purchasing power as the combination of strong job creation and robust wage growth is not fully offsetting the rise in consumer prices and the end of the income top-ups by the government. Hawks will probably argue that the release of excess saving  - mostly held in checking deposits - back into consumption would keep demand on a unsustainable pace without a significant and quick monetary tightening, but no model can properly explore these opposite scenarios because the US economy has never found itself in a similar position. This would argue for a prudent approach to the pace of rate hikes by the Fed, with a lot of the “learning by doing” which Mary Daly advocates to get the right quantum of tightening. For now, we keep our forecast of four 25 basis points hikes in 2022, which leaves us behind some prominent sell-side calls.