There are three divergences in the art of central banking. The most obvious is between the monetary tightening expected in the United States and the loosening expected in Europe. A second divergence is between the prudential oversight of the banking system and the conduct of macro-economic demand stabilization – particularly quantitative easing. A third divergence is between the communication of forward looking policy intentions and the practice of monetary policy decision-making. Each of these divergences acts as a constraint on the conduct of monetary policy; the juxtaposition of all three increases the risk of significant market volatility.
The divergence between the United States and Europe is easy to explain. Although recovery in the U.S. economy is not dramatic, it is nonetheless sufficient to lift underlying conditions toward normalcy. Specifically, unemployment is back down to pre-crisis levels and employment growth is starting to increase the labour force participation rate. More important, the last batch of jobs numbers suggest that the employment being created is moving up the value chain. These are good jobs with significant skills requirements. Therefore it is unsurprising that we are starting to see upward pressure on wages. For the open market committee of the U.S. Federal Reserve System this creates an opportunity to lift its policy rates away from the zero lower bound. It will not do so quickly, but it is definitely headed in that direction.
By contrast, the European Central Bank (ECB) is looking to loosen monetary conditions even further. The reason is the weakness of domestic inflation and the danger that inflation expectations will anchor at a level that is too low to allow for a sustainable recovery. Commodity prices continue to drag down inflation in the broad index; more troubling, as ECB President Mario Draghi noted in remarks to the European Parliament recently, is the weakness of core inflation. The challenge is to forge an effective response. The ECB’s main policy rate is already very close to zero and the deposit rate is negative. Meanwhile, the ECB’s quantitative easing program has another ten months to run. Hence the speculation is that the Governing Council will act to push deposit rates down even further into negative territory or to extend or expand the quantitative easing program; it may even do both.
The difficulty for the ECB is to translate these actions into macroeconomic activity. This is where the tension between prudential oversight of the banking system and macroeconomic stabilization becomes apparent. European regulators are pushing banks to build up their capital buffers and to use more (and better) collateral to underpin transactions. Such policies slow down the pace of banking activity. They also put the banks in competition with the ECB to purchase high quality (collateralizable) assets. This explains only part of the difficulty that the ECB is having with its accommodating monetary policy. As both bankers and central bankers are quick to point out, the weakness of European credit markets is more pronounced on the demand side than on the supply side. Nevertheless the monetary transmission channel is not working effectively.
That leaves the exchange rate as the principle mechanism for stimulating Europe’s economy. Each time the ECB loosens monetary policy, the euro falls in value relative to other currencies like the dollar. The hope is that this decline in the value of the euro will enhance the competitiveness of European exports. To the extent that works to bolster manufacturing and service sector activity, the effects should spill over into new borrowing and lending. Of course Europe’s gain is a loss for the rest of the world because the rise in net exports is also a fall in net imports from abroad. Therefore the question is whether Europe’s reliance on the exchange rate channel is only temporary or something more permanent – transforming the euro area into another China or Japan as a giant export-led growth economy.
With all this activity, there is plenty of reason for controversy over monetary policy on both sides of the Atlantic and also in those central banks like the Bank of England that find themselves caught in between. The governors of the U.S. Federal Reserve worry that they might act too soon and so choke off recovery or too late and so reignite inflation. The members of the ECB’s Governing Council have the opposite concerns. The Bank of England’s Monetary Policy Committee members have similar preoccupations but worry also about how they will be affected by decisions taken in Washington and Frankfurt. Within this context it is hard for policymakers anywhere to announce what policy will look like in the short to medium-term with any high degree of commitment. Nevertheless it is possible to shape expectations in the markets and so to influence the level of activity today, in advance of any actual decision. That is why central bank governors are so often in the news.
This talk policy is a powerful substitute for action. Nevertheless, it has the perverse effect of constraining monetary policymakers to live up to expectations. Once policies are ‘priced in’ by market participants, any disappointment of expectations has macroeconomic consequences because those same actors have to reposition themselves (buying and selling assets) once they learn that a promised policy action will not be forthcoming. This is good news for those policymakers who are skilled at shaping expectations because they are able to change the relative cost of a policy action before a decision is made. This is how Fed chair Janet Yellen has strengthened the presumption that the Open Markets Committee will vote to tighten rates; it is how Mario Draghi has strengthened the presumption that the ECB’s Governing Council will deepen its policy of accommodation; and it is how Bank of England governor Mark Carney reined in both hawks and doves on the Monetary Policy Committee to keep interest rates unchanged.
The problem is that policymakers are binding themselves to future action at a time when they need to respond flexibly to a complex and changing pattern of macroeconomic interdependence. This is where the three different forms of divergence in central banking interact. The divergence in monetary policy commitments across the Atlantic is going to strengthen any exchange rate implications of a change in policy by the ECB even as the divergence between prudential oversight of banks and macroeconomic demand stabilization is slowing down the monetary transmission mechanism and forcing the ECB to focus more efforts on influencing the exchange rate. The unanswered question is whether the exchange rate channel remains effective as a source of macroeconomic stimulus – particularly when governments in other countries like China and Japan respond to the effects of change in the euro-dollar exchange rate. The risk of significant volatility in markets influenced by these dynamics is high.Follow @Erik_Jones_SAIS
This essay was originally published on ‘MNI Euro Insight’. The edited version can be found here.