European Headwind: ECB Policy and Fed Normalization

The euro area crisis five years on

It has been five years since the epicenter of the global financial crisis that erupted in late 2008 moved from the United States across the Atlantic. Since then, while the U.S. economy has enjoyed recovery with steady growth, the euro area economy has languished, going through a double dip slump and currently at risk of falling back to an unprecedented triple dip recession (see Figures 1 and 2). The mismanagement of the euro area crisis has converted a relatively small and potentially easily manageable fiscal problem that originated in Greece (a state representing merely 2% of euro area GDP) into a systemic crisis for the euro area as a whole. On average, real GDP has moved sideways, but the mismanagement of the crisis has led to substantial declines in some member states. The resulting economic dislocation has threatened the very existence of the euro area, generating recurrent questions about the long term viability of its construction.

Headwind from Europe has been one of the key factors behind the extraordinary accommodation pursued by the Fed over the past five years. In light of the continuing risks that the euro area crisis poses to the global economy, European headwind will likely remain a key factor in shaping the normalization of Fed policy. Policy actions in the old continent over the past few years have contributed to the benign outlook for inflation in the United States. Had policies contributing to growth and stability been pursued in the euro area, the global economy would have experienced faster growth and the accumulated policy easing in the United States would have proven overly inflationary. At present, risks continue to hamper the prospects of the European economy. In the October 2014 World Economic Outlook, the IMF concluded that the euro area faced a 40% chance of returning to recession over the next year and a 30% chance of deflation. Another downturn in Europe would be a major drag for the global economy. In light of the interconnectedness of the global economy, the pace of Fed normalization is intimately related to developments in the old continent. ECB policy decisions, and their impact on the euro area economy, are key drivers for assessing Fed policy.

Read the full report here.