Overview: ECB And Fed In Similar Positions

The budget and monetary authorities reacted swiftly to the economic crisis that broke out in the US in late 2007. Interest rates were rapidly cut around the globe, notably in the developed countries. As it became obvious that the world was not only facing an economic crisis, but a financial one as well, numerous governments set up bank recapitalisation plans and economic stimulus measures. Private debt was partially transferred into public hands and part of banking risk into sovereign risk.

In the US, once banking sector recapitalisation was deemed credible, the Fed was able to come back to business as usual: ensuring price stability and full employment. In the eurozone, the absence of a supranational response to banking problems was one of the main factors that led the sovereign debt crisis. The ECB was asked to step in, but given the gradual, half-hearted political advances, its response was not as massive as hoped.

Refusing to finance individual states, the ECB focused on bank liquidity. Yet, once the integrity of the eurozone was called into question -- soaring intra-zone spreads were no longer due solely to differences in budget perspectives but also to convertibility risk -- the ECB had to shed its orthodoxy. Mario Draghi declared that risk premiums based on fears of the euro’s reversibility were unacceptable, and announced the launch of the OMT. Since then, spreads have narrowed dramatically. Compared to Germany, the spread on 2-year Spanish rates is now only a little over 200bp, down from a peak of nearly 700bp at the end of July 2012. In Italy, spreads have narrowed from more than 520bp to less than 150bp.

Today, the ECB is in virtually the same position as the Fed: it no longer has to combat systemic risk, but can focus on conducting monetary policy in a calmer financial environment. Although the risk of financial collapse is no longer at the heart of central bank concerns, there is nothing “normal” about current cyclical conditions. In the US, three years after the end of the recession, the output gap still refuses to narrow while both the UK and the eurozone have slipped back into recession. The first estimates of Q4 GDP growth in the eurozone will not be known before February 14th, but a contraction seems inevitable, especially since this trend has already been confirmed in Belgium (-X.X%), Germany (-0.3%), and Spain (- 0.7%).

Striving to restore their fiscal credibility, most of the developed countries adopted austerity measures that are straining household purchasing power. On the demand side, prospects are sluggish, while the supply side suffers from surplus capacity, resulting in higher unemployment, which in turn puts a further strain on the formation of revenues. In brief, looking beyond the effects of higher VAT rates and fluctuations in commodity prices (notably food and energy), which often respond to supply-side shocks, inflation is bound to remain mild. Consequently, the central bankers’ big worry right now is to reinvigorate the economy.


Given the lack of pricing pressures, it would seem that they have large rooms of manoeuvre. Yet the central banks of the developed world have all run up against the zero-bound constraint, which many have tried to circumvent by using non-standard monetary policies. The Bank of England (BoE), the Bank of Japan (BoJ) and the US Federal Reserve (Fed) turned to quantitative easing (QE): no longer able to cut short-term rates, they acted directly on the long end of the yield curve by purchasing government securities (and in the Fed’s case, mortgage-backed securities). In effect either periodically or continuously since 2010, these non-standard measures have failed to rescue these countries from a liquidity trap. As a result, central bankers have had to be creative, by coming up with specific new programmes such as the BoE’s Funding for Lending Scheme, or by trying to influence the formation of inflation expectations.

The BoJ recently doubled its inflation target from 1% to 2%. The Fed also tried its hand at influencing expectations by announcing that it would be more tolerant of inflation as long as the unemployment rate held above 6.5%: it temporarily relaxed its target for the personal consumption expenditure deflator to 2.5% from 2%. The next BoE governor, Mark Carney, also brought up the idea of changing the monetary policy framework to target nominal GDP rather than inflation.

The BoJ has not yet announced which measures it will deploy to support its new inflation target, and Mr. Carney will not replace Sir Mervyn King as BoE governor until June. In the US, no new measures were announced this week either. Yet the minutes of the 2012 FOMC meetings leave little doubt that its members intend to further reform their communication. In particular, after clarifying the conditions that would lead it to begin raising key rates again, the Fed should spell out those for scaling back the expansion of its balance sheet. As for the ECB, it has certainly gone as far as its German roots allow. Yet there is still a possibility that the OMT could be launched, and the refi rate, at 0.75%, could still be cut if needed.

BY Alexandra ESTIOT