Monetary Muddles

The Fed as a role model?

This role isn't easy to grow into. Source: Handelsblatt

Since last month, when the European Central Bank announced its gradual pullback from an ultra-relaxed monetary policy, Europe has taken a greater interest in the policy of the US Federal Reserve, and not just because Jerome Powell was appointed its next chairman. The Fed changed course some time ago and, apparently, with some success – even if America’s inflation rate isn’t quite where it wants it to be. Should the ECB pursue a similar policy in the euro zone, given it seems to be working so well in the US?

As nice as this sounds, it could be more difficult than we think. Unlike the Fed, which is concerned with inflation and nurturing growth and employment, the ECB pursues three distinct objectives. Apart from price stability, the ECB strives to keep financial markets on an even keel, aided by its supervision of the euro-zone’s 120 largest banks. Third, since 2010 the ECB has been locked in a battle to preserve the euro, even if the central bank doesn’t draw attention to its efforts.

In fact, as former Nobel Prize winner Jan Tinbergen would have put it, the ECB has only two instruments, monetary policy and financial market supervision, at its disposal – meaning it has one independent instrument too few. This is also called the Tinbergen problem.

Phasing out the ECB's easy monetary policy could endanger financial stability and the very foundations of monetary union.

If the ECB took its mandate literally, it would pursue the twin aims of price and financial stability ahead of preserving the euro zone. But is that price too high? Abandoning the primacy of price stability could directly undermine the credibility or even the independence of the ECB, especially in political terms. Finally, and this would probably be the easiest for the ECB, it could abandon the goal of financial stability and simply leave that to European regulators, effectively giving up a key policy instrument.

But this is not the ECB’s biggest problem. Unlike in the US, phasing out the ECB’s easy monetary policy could endanger financial stability and the very foundations of monetary union. For some of Europe’s major commercial banks suffering from meager profits, a cycle of near-term interest-rate hikes could add insult to injury.

In future, companies in the euro zone – previously enthusiastic about expanding their bond issues, because the ECB remained a potential buyer – will also have to accept higher market rates and lower prices on debt capital. In an era of globalization and tougher competition for goods and services, it remains to be seen how well these companies will finance themselves.

This seems all the more difficult because Europe, unlike the US, is not exactly a stronghold of “super champions” such as Microsoft, Google, Facebook or Amazon, whose powerful market positions reap exorbitant profits and render them relatively immune to shifts in financing conditions.

Frankfurt – Cloud City
ECB policy in a fog. Source: Getty

The threat to the euro zone is serious. Phasing out the current government bond purchases could raise questions over the viability of the euro zone if the region’s debt-laden countries fail to put their public finances in order, despite the time the ECB “bought” them by keeping monetary policy ultra-loose. If that happens, interest rates for their government bonds will rise sharply again.

Although some euro-zone countries chided by the European Commission have cut their deficits, there is much to suggest that the fiscal “improvements” have to do with economic recovery and are not sustainable. Instead of curbing spending, some governments have backtracked to giving big sweeteners to the electorate.

This is why the ECB could be tempted to stretch the time horizon for its planned change in monetary policy. But this, in turn, could raise the risk of speculative bubbles forming in financial markets. Even now, the ECB’s balance sheet has bulged much more than the Fed’s, leaving the Europeans in a position that is less than enviable.

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