In March, the United States Federal Reserve kept its main interest rate on hold, while the European Central Bank cut its main interest rate to zero. The moves confirmed what investors already knew: the American and European economies still have plenty of weaknesses. But despite appearances, the Fed and the ECB are on track to end their expansionary monetary policies.
In keeping interest rates on hold, the Fed showed it is aware that the American economy is relatively solid, but growth remains less than satisfactory. It understands that there is no reason to expect growth to accelerate in the near future. The ECB, for its part, has cut its main interest rate to zero. It makes no bones about the European Union’s economic weakness, which in some countries is reaching critical levels. As usual, the focus is on public finances, banking and youth unemployment.
Unless growth in the EU picks up significantly (and it will not), these pressing problems will become more acute, while monetary policy will remain a poor substitute for structural reform. Mario Draghi, president of the ECB, deserves credit for stating clearly that easy money cannot work miracles. On the other hand, one might wonder how long he can maintain such a generous policy – one that will intensify throughout this year and next.
Predicting how central bankers will act is a difficult exercise, especially when they have seemed to proceed according to the necessities of the day rather than pursue a clear strategy. However, some guiding principles have emerged in the last few weeks. These could help us understand what kind of monetary scenarios might emerge over the next couple of years.
Fed changes tack
The macroeconomic data shows the U.S. economy has stabilized. Gross domestic product is growing at about 2.5 percent annually, below what would be expected for a rebound out of recession. Despite record low unemployment figures, the data on the size and quality of employment is hardly exciting. However, neither issue is proving a major source of concern for the American public. The more sophisticated information tends to be overlooked, and the monetary authorities seem ready for a change of tack.
Unless a major downturn hits, the Fed will soon stop using low interest rates to sustain growth and feed money supply, which is currently rising at about 5.5 percent per year. The more the economy stabilizes and the need for emergency intervention recedes, the nearer the end of expansionary monetary policy. Three consequences will follow.
First, investors will pay less attention to the Fed’s decisions than they have in the past. Investors realize that a new crisis is not imminent, and that interest rates will slowly rise throughout this year and next. Stock markets should not be influenced by major economic news and volatility should subside. Political tensions will now drive the broad picture, while the health and performance of each company will determine the value of its shares. In particular, since the slow rise of interest rates has already been factored in since early 2015, it will not make a major difference, not even for companies that are heavily indebted.
Second, a firmer, more consistent stance from the Fed will help the dollar eventually bolster its role as reference currency. The dollar had recently lost some of its luster, but it can recover quickly if the Brexit saga worsens and if Chinese economic policymaking becomes more confused. We can expect a gradual strengthening of the dollar/euro exchange rate, which might actually drop below $1.05 before the end of the year. Dollar-indebted developing countries will feel the pain, and high-yield bonds will become synonymous with a high risk of default.
Third, higher interest rates will put the U.S. government under heavier pressure to reduce the budget deficit, (now at about 2.5 percent of GDP) and contain public debt (about 103 percent of GDP). This will be good news for the U.S. economy, since the burden on future generations will ease, and for the world, which will not be required to finance increasing American profligacy. It will also help many large dealers who are already overburdened with U.S. treasury bonds.
ECB’s tight spot
Mario Draghi is in a much more difficult situation than his American counterpart Janet Yellen. On the one hand, he tends to lend a friendly ear to Brussels, doing whatever it takes to bail out governments and avoid enforcing bail-in procedures on financial institutions that agreed to support public debt and corporations’ bad investments.
On the other hand, he keeps repeating that his actions have no effect on growth. One wonders whether Mr. Draghi could take advantage of a Brexit by forcing his political masters to reconsider how the EU operates. He could also use it to clarify the role of the ECB, which was certainly not designed to finance government indebtedness and subsidize large corporations by buying their bonds.
The current policy provides an incentive for countries to delay structural reforms – the opposite of what Mr. Draghi is preaching. By pushing interest rates to zero it is also wreaking havoc on millions of European pensioners’ savings. They had hoped to have enough returns from relatively safe assets; now they are being forced to live off their capital or engage in risky investments.
However, none of this is crucial in the debate on the role of the euro. After all, a large share of the euros created each month are just being transformed into bank reserves at the ECB itself. This does not feed debt or inflation. The key question is how long the ECB will continue this strategy. The turning point will likely take place sooner than expected. In fact, it will probably come before the end of the year, after the dust after Brexit has settled, once the Greek problem resurfaces and when EU authorities take on a number of countries who continue to flout the rules.
When these factors converge, the ECB could announce that while quantitative easing will continue until the end of 2017 as promised, it will gradually be phased out. Banks and governments would have about one year to do what it takes to avoid bankruptcies, partial defaults and a public outcry.
Mr. Draghi might soon find that the collapse of the European private pension system is worse than the deepening public-debt crisis, and that a return to healthy financial markets is more important than giving breathing room to irresponsible politicians. In the past, the ECB has done much more than it should have. It is now free to show some nerve.
Seeds of change
Economic conditions in the U.S. and Europe are sowing the seeds of major change in monetary policy. While decisions by the Fed and ECB in March seem to indicate a continuation of expansionary monetary policy, the tide seems to be turning. If that happens, Europeans will experience a new period of instability. The silver lining is that this time it will be for a good cause.
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