Postcards from Old Europe – A tale of two (central) banks

The recent decision by the FOMC to hike the Fed Funds rate to 1.25% was widely reported and commented on. All the noise surrounding the Fed’s decision may have drowned out the fact that the European central bank, the ECB, decided to leave interest rates unchanged yesterday.

Both central banks are facing distinct challenges. While the Fed is confronted with an expanding economy and rising inflation, the ECB is looking at a much less vibrant economic situation. Growth in Europe is still sluggish while inflation remains stubbornly high at a level above 2%. But criticism abounds on both sides of the Atlantic.

Many Fed watchers feel that the US central bank is behind the curve in raising rates. They see the recent price data as a clear signal that inflation is rearing its ugly head again and will continue to rise. This camp would have liked to see a more substantial rate hike and a quick return to a more neutral Fed Funds rate.

I have two problems with this line of reasoning – the first is that I believe much of the recent rise in prices can be attributed to firms capturing pricing power. Monetary and fiscal measures contributed to increased consumer demand which was met by low inventories and scaled down production. Companies were able to use this scenario – coupled with the much publicized rise in commodity prices – to raise prices whilst slowing building up supply. This being one of the reasons that job gains took so long to materialize. As more and more supply comes online we could very well see price momentum abating – what the Fed called “transitory” its recent statement.

My second difficulty with the behind the curve argument is that I’m not all that sure what the “neutral” Fed Funds rate is. Rates of around 3% keep getting tossed around by commentators – this being based on the historical Fed Funds rate. I don’t really believe that the past can be a very good guide here. The reason being that the inflation backdrop was totally different in the past 20 years than it is today. Central banks have achieved something akin to price stability by ways pushing disinflationary policies over the past two decades. Now that they’re there , they have to figure out how to remain there.

This paradigm shift will in my opinion have to involve the acceptance of the fact that an economy will continue to have inflation as the business cycle turns expansionary. Using the first sign of a rise in prices to brutally hike rates reminds me of the German saying “Mit Kanonen auf Spatzen schiessen” (Shooting cannonballs at sparrows). We should bear in mind that the recovery is not a done deal. Recent data has shown that momentum is moderating and that there is still much slack in the economy. The current administration may just manage to actually create a few jobs by election day but I’m sure that a goodly number of unemployed people will still ask themselves when the recovery will finally reach them.

So the Fed will continue to remain vigilant and administer rate hikes in homeopathic dosages. The ECB is facing a rather different challenge. While the US economy is expanding on the back of strong domestic demand, the Eurozone is still dependent on exports to provide any sort of economic growth. Consumers still prefer saving to spending and there is no real sign that this will change in the near term. The pace of structural – especially labor market – reform is still slow. The current ECB statement puts it this way

A second issue we have discussed in depth over recent weeks has been the need to clearly step up the pace of structural reforms in the labor and product markets. In this connection, the Governing Council expressed concern about growth in euro area labor productivity having been on a downward trend since the mid-1990s.


A relatively smaller proportion of the working-age population participates in the labor market, a higher proportion of those participating is unemployed and those who are employed work, on average, far fewer hours per year than elsewhere. Hence, there is a need for further policy changes in the euro area that underpin the labor supply and its utilisation and thereby raise the medium-term growth prospects, so as to preserve average living standards in the face of an ageing population.

In the face of these challenges the ECB will – in my opinion – refrain from raising rates this year as well as most of next year unless something extraordinary happens.

The ECB is – at least for the time being – in a somewhat better position than the Fed. There are not all that many critics around Europe who are demanding higher rates and raising the prospect of runaway inflation. But that’s small comfort against the backdrop of low overall growth in Europe. To end on a positive note: we Europeans shouldn’t feel all that bad about ourselves. Recent studies have shown that simply comparing GDP per head isn’t all that helpful in asessing well-being!

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