ECB and Fed take opposing view on fiscal strategy

The European Central Bank eased monetary policy last week, albeit not enough to please markets. But the US Federal Reserve is widely expected to raise short-term rates next week.

This divergence between the most important central banks is likely to prove significant. Does this make sense for each in view of their own mandates? And what complications might such a divergence create for the world?

At first glance, the answer to the first question is straightforward: yes. The Fed and the ECB ought to be following different policies because their economies are in such widely different places.

As Janet Yellen, Fed chairwoman, said last week, the US economy has enjoyed a sustained recovery since the Great Recession. The unemployment rate has declined from a post-crisis peak of 10 per cent to 5 per cent. The annual rate of core consumer price inflation – excluding food and energy – is also close to (though below) the target of 2 per cent. It seems reasonable, given all these facts, to argue that the US economy is growing at well above potential rate and is close enough to full employment for tightening to begin.

The euro zone is in a very different place, as Mario Draghi, ECB president noted in another significant speech in New York last week. The euro zone has not enjoyed a strong recovery from the Great Recession and the subsequent euro zone recession. On the contrary, in the second quarter of this year, real domestic demand was still 3.5 per cent lower than pre-crisis.

From its peak of 12.1 per cent in early 2013, the unemployment rate has fallen only to 10.8 per cent. As Mr Draghi stressed, the ECB is failing to achieve its mandate of price stability, as it defines it: a rate of CPI “be­low, but close to, 2 per cent”. In October, year-on-year core CPI was just 1.1 per cent and the headline rate just 0.1 per cent. Indeed, year-on-year core inflation in the euro zone has been below 2 per cent since March 2013.

To deliver on their mandates the central banks ought to be behaving differently. But this does not mean what they are about to do is right. This is partly because their mandates are different. It is also because both are too conservative.

First, the Fed. Here are four reasons why the case against raising rates is still strong:

• There is no sign of significant inflationary pressure – the strength of the dollar will also keep inflation in check;
• If the Fed were pursuing a symmetrical policy, inflation should be above 2 per cent as much as below. In fact, core inflation has been below 2 per cent most of the time since the end of 2008;
• There is a real risk that the tightening will have a bigger negative effect on the economy than expected, particularly if it is seen as the first of many moves (however gradual). Given this, the risk that the interest rate will be brought back hard against the zero lower bound in the next (possibly quite imminent) recession is substantial;
• Last and most important, while unemployment is low, so is the participation rate. There is a good chance that, if the economy is run "hot", more workers will be pulled into the labour force. It is possible, too, this would accelerate investment and productivity growth, keeping inflation in check. So the risks of tightening exceed those of waiting.

Risks

Some will argue that delay risks further destabilising the financial system. This view is problematic. If the monetary policy that stabilises supply and demand in the real economy destabilises the financial system, the problem lies in the latter. It must be dealt with forcibly and directly.

The ECB, meanwhile, disappointed the markets. This is not of itself important; its job is not to please markets but to stabilise the euro zone economy. Still, it merely lowered the deposit rate 10 basis points, extending quantitative easing (QE) at an unchanged €60 billion a month, by six months, to March 2017. This simply does not qualify as decisive action.

In his New York speech, Mr Draghi seemed to recognise this. He made three fundamental points. Today’s aggressive policies are working; the loosening last week was significant; and “there cannot be any limit to how far we are willing to deploy our instruments, within our mandate, and to achieve our mandate”.

The points are reasonable. Even so, the ECB should have announced it will continue with QE until it hits its inflation goal. The unnecessary weakness of the euro zone economy has gone on too long.

Whatever the drawbacks of the decisions of the two central banks, the big picture is clear. The US is years ahead of the euro zone in its recovery and is, in consequence, at a different stage of the monetary policy cycle. It is likely the divergence will increase modestly in the next few years. The Fed is also likely to diverge increasingly from the Bank of Japan (BoJ), which will remain ultra-loose, and the People's Bank of China, which is loosening (albeit from a tighter starting point).

To return to the question of the potential complications of such a divergence, it is likely to reinforce the strength of the dollar, which in turn, would worsen the difficulties of dollar-denominated borrowers. Yet it would also be risky to extrapolate the divergence too confidently. The Fed may find the US economy is not as strong as it believes, particularly given the strength of the dollar. If so, the tightening might be small and brief.

While good reasons do exist for the divergence, experience reminds us of the danger of overconfidence. The BoJ has now had near-zero short-term rates for two decades. It also raised rates, modestly, in 2000 and in 2006 and 2007. It was forced to reverse. The Fed should note this sobering precedent.

– (Copyright The Financial Times Limited 2015)