Here’s a simple test. ‘A’ is expected to grow 1.8% this year, has seen its economy reach its pre-crisis level of output and has seen core inflation rising (currently 2.2%). ‘B’ is heading for recession (growth seen -0.5%), remains nearly 2% below its pre-crisis peak in output and has core inflation steady at 1.6%.
Central bank ‘X’ has rates at 0.25%, has committed to keep them here for nearly three years and has indicated more QE may be on the way after two rounds already completed. Central bank ‘Y’ has rates at 1%, has not undertaken QE in the strict sense and has made no pre-commitment on rates, not even for a month ahead. Now just match the economy with the right central bank.
Of course, in this simplified and somewhat naïve approach, many would match the economy ‘A (US) with central bank ‘Y’ (the ECB). But it’s a way of illustrating the point that what is remarkable about last night’s raft of policy announcements from the Fed (greater pre-commitment, hints of more QE, further extension of maturities of the Treasury portfolio) is that they came at a time when the US is on a stronger footing than the eurozone and the focus of the world is on the risks that the eurozone poses to financial stability, both in Europe and beyond.
The riposte is that the ECB is constrained by its mandate, unable to undertake QE in the same way as the US (or UK) and that it has been bold in its provision of liquidity to the banking sector, most recently via the offering of 3-yr repos to banks. Naturally, this holds up to a degree but there is more that the ECB can do. In monetary policy terms, by lowering rates from 1.50% to 1.00%, all Draghi has done so far is unwind the mistaken rate increases of last year, rather than respond to the current slowdown and greater downside risks of the sovereign situation.
This is why more interest rate-cuts are needed. Lowering the policy rate to the 0.50% level would effectively push overnight rates near to zero, given the current liquidity overhang, but would also reduce the costs for banks borrowing from the ECB via repos (dependent on the average of the key rate), which is more important than market rates given that the ECB is rapidly becoming the market for inter-bank lending. But the Fed’s actions should also be a reminder that the ECB needs to do more and EU leaders need to explore other ways of allowing this to happen because, as the simple illustration highlighted, the ECB is appearing ever more out of kilter with the economic realities it is currently facing and is lacking in its ability to catch-up.
Simon Smith, Chief Economist