Monetary Policy Views Continue to Diverge
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The divergence in the economic policy outlook of the United States and that of Europe is quite striking given that the economic forecasts for the two economies are quite similar. The International Monetary Fund’s World Economic Outlook forecasts modest increases in output in the U.S. and Europe in 2011, with most of the incremental world GDP growth expected to come from emerging economies. Debt overhangs facing U.S. households and European peripheral governments will limit growth in expenditures from these sources going forward, while overall credit growth is likely to be constrained by questions about the banking system and the impact of financial regulatory reform. Yet despite many commonalities, the U.S. and Europe have embarked on fundamentally different paths with respect to both fiscal and monetary policy.
During the crisis the policy response was nearly identical on both sides of the Atlantic. Central banks slashed policy rates, increased liquidity facilities, and expanded eligible collateral for refinancing operations. Elected officials reduced taxes and increased outlays on a massive scale to provide the economy with record amounts of fiscal accommodation. But as 2009 came to a close, major differences began to emerge. The Europeans, as represented by policymakers at European Central Bank (ECB) and Bundesbank headquarters in Frankfurt, emphasized fiscal consolidation, monetary stability, and structural reforms to enhance competitiveness. U.S. policymakers chose instead to focus on demand management, including fiscal stimulus at home and in current account surplus countries, fresh rounds of monetary accommodation at the first hint of trouble.
Today, European policymakers like Bundesbank President Axel Weber argue that “there is no alternative to the rapid and credible consolidation of public finances” and a return to normal monetary policy. At the same time, U.S. policymakers like Federal Reserve Chairman Bernanke lay the groundwork for another round of quantitative easing, while Congress failed to even produce a budget in 2010, let alone pass legislation to address the fiscal deficit that stands at 9% of GDP. As members of the ECB governing council openly fret about the mispricing of risk caused by continued intervention, the Fed seems prepared to pursue another round of easing with the expressed intent of changing the relative pricing of risky assets.
On Friday, the Labor Department reported that the U.S. economy shed 95,000 net jobs in September. Job losses for July and August were also revised upwards by a combined 15,000, placing net job losses over the third quarter at 110,000. Perhaps even more troubling, the Labor Department reported that the “U-6” unemployment rate – workers without a job and working part time for economic reasons – increased to 17.1%, which was higher than the 17.1% reading recorded a year earlier.
Despite the unexpected weakness of the labor market, the U.S. equity markets actually all rose in response to the news. The explanation for this counterintuitive move was probably best stated by investor David Tepper, who explained on CNBC that Federal Reserve policy had made the stock market a one-way bet: either the economy improves, which would result in higher corporate earnings and higher stock prices; or the economy would continue to falter, which would lead the Federal Reserve’s Open Market Committee to pursue more “quantitative easing” to boost asset prices more generally, which would also increase stock prices. The expectation of additional money printing in response to the bad labor news pushed the Dow Jones over 11,000 on Friday.
The Fed’s commitment to print more money to buy financial assets was outlined in Chairman Bernanke’s August 27 speech at Jackson Hole. There, Chairman Bernanke explained that the Fed believed that previous quantitative easing – the creation of new money to finance the acquisition of $1.5 trillion in Treasury notes, mortgage-backed securities (MBS), and agency debt – significantly improved economic and financial conditions. Specifically, Mr. Bernanke argued that these asset purchases eased financial conditions through the “portfolio balance channel,” a technical phrase used to describe a process by which the central bank pushes investors into riskier assets. When the Fed prints money to buy Treasury securities, the seller of that Treasury note uses the proceeds from the sale to invest in a corporate bond, for example, which causes the seller of the corporate bond to move into corporate stock. Equity market participants clearly agree that quantitative easing boosts asset prices: since the time of Chairman Ben Bernanke’s Jackson Hole speech, the S&P has increased by over 10.5%
Consider the difference between current Fed policy and the ECB approach to the Greek sovereign debt crisis in the spring. Whereas the Fed seems concerned only with the downside risks associated with insufficiently stimulative policy, members of the ECB governing council emphasized the risks attached to overly aggressive action, even in the context of what many feared to be an existential crisis for the common currency. The ECB was under enormous pressure to provide a supportive bid to the market by acquiring Greek debt outright below some price threshold. Rather than rush ahead with this strategy, the ECB waited to allow national governments – i.e. elected officials – to devise a response to the crisis. As a result of the apparent brinksmanship, European governments were able to get the Greeks to accept cuts to public expenditure that would have been “unthinkable” had Frankfurt adopted a more accommodative posture.
The twin focus of officials in Frankfurt was on limiting moral hazard and restoring competitiveness to the Greek economy. ECB officials – including Bundesbank President Axel Weber – were under no illusions about the potentially catastrophic consequences of a Greek sovereign default. But the strategy to take this outcome off of the table sought to address the “deeper causes” of the crisis and ensure that pain was apportioned equitably so as to deter future fiscal mismanagement, or encourage other European governments to seek their own bailout. Ultimately, the ECB did make outright purchases of sovereign debt and it continues to do so in some quantity today, but these interventions have always been sterilized (did not increase the monetary base) and were performed in the context of a European Financial Stability Facility constructed by fiscal authorities to eliminate the potential for default on these obligations.
Policymakers in Frankfurt not only seem to have a better sense of the symmetric nature of the risks central banks face, they also seem to show more confidence in market outcomes. The message sent from the Federal Reserve Board of Governors suggests that market outcomes will inevitably disappoint absent more aggressive and ambitious monetary stimulus. The message from Frankfurt seems to be quite the opposite, given the focus on fiscal consolidation and price stability. Though Brussels has and continues to flirt with myopic restrictions on free capital flows and counterproductive limitations on instruments that allow investors to hedge their sovereign default exposure, policymakers in Frankfurt seem, on the whole, to be far more concerned about the way policy can distort market processes.
Axel Weber, in particular, has been vocalabout the need to consider the “possibility of the recovery taking place in a more dynamic way than currently expected.” The lessons of the 2001-2005 period in the United States would seem to go unlearned if policymakers do not account for the ways overly accommodative monetary policy can aid in the mispricing of risk. As Professor Weber has argued, “the time horizon relevant to monetary policy decisions should not be too short.” Inordinate focus on near-term growth can lead directly to runaway inflation in the general price level, or inflation in asset markets (bubbles). At the same time, steps taken by fiscal authorities to boost demand could be counterproductive if they increase expectations of tax increases or threaten fiscal solvency. That is why Professor Weber advocates a “frontloaded credible consolidation strategy” to reduce public debt levels and maintain market confidence.
Weber’s essential message is to trust market outcomes, not pervert them. If governments would deliver price stability, prudent fiscal policy, and “deregulated product and service markets”, they could count on private sector entrepreneurs, innovators, and financiers to do the rest. Part of this confidence in market outcomes could be based on recent German experience. From 2001-2007, Germany went through a period of tepid real wage growth brought about by painful labor market and pension reforms. These market-based reforms increased employers’ flexibility with respect to wages and working hours. The deregulation and reduction in public outlays was so successful in terms of rationalizing production costs and enhancing productivity that Germany was accused of “excessive wage moderation” – which allowed the country to become hypercompetitive at the expense of other nations. Market-based reforms that lowered inflation and improved public finances were somehow viewed as “cheating” because the German government wasn’t doing enough to force its households to spend more.
Again, the contrast with the U.S. should not be ignored. Whereas the Bundesbank establishment worries about monetary policy’s contribution to the mispricing of risk, the Fed pursues the “portfolio balance channel,” which is basically a fancy name for pushing investors into risky assets. As Professor Weber speaks of German consumption activity as “comparatively stable, therefore supporting the economic growth process” New York Federal Reserve Bank President William Dudley blames the “sluggish recovery in consumer spending” for the economy’s troubles and advocates effective interest rate cuts by printing money to “help smooth the adjustment process by supporting asset valuations.” (More examples abound.)
The divergence in views between the world’s two most important central banks is unfortunate given the extraordinary economic and financial linkages between the U.S., Europe, and broader world economies. The hope is that economic growth accelerates, which would lessen the need for more aggressive monetary policy measures and foster consensus on the pace at which central banks should remove the extraordinary accommodation of the past few years. Unfortunately, that is not the forecast. The fear is that policymakers could actually find themselves further apart in twelve months’ time.
Christopher Papagianis is the Managing Director of e21 and was Special Assistant for Domestic Policy to President George W. Bush.