Fed and ECB: monetary strategy convergence is not imminent

The current dynamics of monetary policies is fascinating. The US central bank, the Federal Reserve or Fed, has just announced implementation at the end of the year of a policy that breaks markedly with its strategy since December 2008. The Fed finally seems to be coming out of the financial crisis that kicked off in 2007/2008. Meanwhile, the European Central Bank (ECB) is sticking to its very accommodative policy on a long-term basis. The Eurozone is unable to let go of the monetary crutches it adopted after the 2008 and 2012 crises.

The two economic giants’ policies diverge in a number of ways:

Firstly, the US is way ahead in its economic cycle.
The recovery dates back to the second quarter of 2009, making it one of the longest cycles in the post-war period: the weakest but still one of the longest. However, it includes an unemployment rate close to that expected by the central bank.
In the Eurozone, the uptick in activity only truly materialized at the start of 2013, so the cycle is still very recent. The ECB has no reason to try to rein it in as this upturn needs to gain more momentum and become more self-sustaining. It is too early to see a turnaround in expectations on the interest rate profile across the board.

The inflation profile is not the same either.
At the press conference following the latest FOMC meeting on March 15, the chair Janet Yellen clearly indicated that the inflation target had been reached and that price trends would stabilize around the 2% target: sometimes above, sometimes below, but this was not a great cause of concern for the US monetary authorities.

Meanwhile at the ECB, inflation is still far from the 2% target, although it temporarily hit this level in February. This acceleration in inflation, which already slowed again in March with inflation at only 1.5%, was entirely due to the base of comparison for oil prices. Oil prices in the first quarter of 2017 (54.7 dollars), were much higher than the levels in the first quarter of 2016 (35 dollars), and this explains the positive contribution from energy and the sharp rise in inflation. However, this situation is set to disappear as prices are swiftly moving towards 2016 levels. The inflation rate will therefore converge towards the core inflation figure i.e. inflation excluding energy and food.
It is on this aspect that we see substantial divergence with the US. Core inflation there is slightly under 2% (1.75% in February) but below 1% in the Eurozone (0.7% in March). Europe is further behind in its economic cycle, so nominal pressure is therefore weaker.

The economic outlook is clearly and increasingly displaying why monetary policies are and must be disconnected. Statements from the two respective central bank chairs are crystal clear in this respect.
Janet Yellen thinks that targets have been reached and that it is time to normalize monetary policy. This will firstly involve a hike in interest rates, followed by moves to manage the Fed’s balance sheet, and this issue ties in with the idea that the Fed will definitely halt its financial asset purchases. We note that massive asset purchases severely inflated the Fed’s balance sheet, and total purchases increased from less than 6% of GDP before 2007 to 23.4% at end-2016. The Fed stopped its spending spree in this voluntary and direct way, but it still continues to receive revenues from this portfolio and income from the redemption of securities, and these profits are reinvested. The Fed is going bring this reinvestment to a halt. The amounts are quite substantial, with $425bn reinvested across 2017. The impact on the credit market is huge. So this change in strategy is a major shift.

What is new at this meeting is that we now have a date, as shown in the minutes of the meeting published on April 5.
The members of the Fed board of governors have been indicating for quite some time that there would be an imminent move towards this balance sheet management policy, focusing on the need to do so but without setting a date. The minutes reveal that it could happen before the end of the year. This information will shake up the market.

This date is interesting in itself as Janet Yellen’s term will come to an end on February 3, 2018. We cannot see Donald Trump renewing her term, so it is important to start monetary policy normalization before the end of Yellen’s term, in order to control her successor’s policy. We do not know who will replace her, but we can legitimately have doubts on the Fed’s independence beyond that date… Republicans in Congress have long been trying to restrict the Fed’s action and scope.

Meanwhile, at the ECB, Mario Draghi was very clear. Until such times as inflation is close to 2% and remains there sustainably, the ECB will maintain its accommodative policy. This will take some time, as an increase in core inflation requires a rise in salaries. The acceleration in the economic cycle will play a role as salaries in the Eurozone are flexible and move upwards when economic momentum accelerates. We can hope for pressure in 2018 or 2019 but not before, so the ECB really has plenty of time.
It can also be in the central bank’s interests to keep interest rates low as some countries would not be able to manage higher interest rates, such as Italy, where anti-euro sentiment is growing.

We hear talk of the need for the ECB to raise its key rates to avoid uncontrolled acceleration in inflation. This is amusing, as it is this same argument that these same very serious people applied to the Fed for years – the Fed was late and inflation was going to speed up and we had to act quickly. The central bank took the time it thought necessary and it was right to do so, as we are still waiting for the uncontrollable acceleration in US inflation. It is the same for the ECB… the argument is the same, the ECB is going to be late. This is an argument that holds no more water in the Eurozone than it did in the US.
The ECB should not and will not take this argument on board. Interest rates will remain low for quite some time yet in the Eurozone, even if the Fed changes policy. The ECB will be right to stick to its strategy.

Philippe Waechter – Chief economist – Natexis Asset Management