Postcards from Old Europe – Policy Traction

Last week’s installment saw me try to do some Fed-watching, this week sees me hop back to the other side of the Atlantic to briefly examine the differing effects of monetary policy in Europe and the US.

The difference revolves around the efficacy of the so-called monetary policy transmission mechanism in the EU vs. the US. One of the key questions in this regard is “how quickly does a change in short term interest rates influence the rates that are being paid by borrowers in the economy as a whole?” It stands to reason that monetary policy would be almost worthless if a cut or hike in interest rates didn’t actually change anything in the real world.

A recent study by the OECD was nice enough to examine the difference between the “traction” of monetary policy in the US and Europe and came to the conclusion that monetary policy is a less effective tool in the Euro-Area than it is in the US.

The main reasons for this discrepancy can be found in the answer to the question posed above. US capital markets are larger, deeper and more competitive than the European capital market(s). Take mortgage lending for example: the US has transformed a formerly regional market for mortgages to a national market by way of securitizing loans and entire loan portfolios. This has made the mortgage rate much more responsive to changes in market rates than in times past where rates were much more “sticky”. Increased competition amongst lenders has led to aggressive marketing of new products and lower costs as well. This has in turn enabled consumers to actively use credit products to unlock equity tied up in their homes thereby exposing them to any change in rates (whether this is always wise will remain to be seen).

Another difference between the US and Europe lies in the fact that bank lending (vs. financing via capital markets) constitutes a much larger source of finance for companies in Europe than in the US. As banks tend to behave very much in line with the business cycle, i.e. expand lending in good and decrease lending in bad times, any policy response will have to be greater in Europe to dampen the effects of bank’s behavior.

If we take a step back and look at the entire picture we can see than other factors play a role as well. Markets for labor and goods are the place where we usually observe inflation in the first place. If these markets are highly regulated and/or inflexible we shouldn’t expect inflation rates to change quickly. This description fits Europe pretty well.

What does it all mean? If you have an economy with flexible markets and quick transmission of monetary policy the central bank will find that monetary policy is a very effective tool. An economy with rigid markets will find that policy rates will not change as often as inflation is much slower to react to any change in interest rates. This smoothing of the rate cycle may sound good, but it actually robs a central bank of one of the main tools to kick-start a recessionary economy.

Europe has been feeling the effects of sticky prices in labor markets for a while now, companies are not prepared to employ people if the economy doesn’t start looking better and the economy isn’t going to start looking better until more people have a job. The central bank knows that changing rates won’t do much to solve this dilemma so the focus should be upon making markets for labor and products more flexible. We’ll just have to see if there is real political will behind this goal.

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