Briefly Comparing the Fed and the ECB

The ECB has moved toward forward guidance but they have been careful not to press too far ahead, I suspect because they wanted to get Weidmann on board. Here are two recent comments on ECB policy and some of my own.

First, Marc Chandler from last week when the ECB moved to forward guidance (emphasis added):

The ECB took an unprecedented step today. Part of its mantra has been that it does not pre-commit. Today it did. It indicated interest rates will be the same or lower for an extended period of time. Draghi, when pressed, chose not to define extended period, except to note that it does not mean six or twelve months.

Sometimes ECB officials are surprised by the market’s reaction, but not today. Interest rates fell. The implied yield on next year’s Euribor futures contracts fell 8-11 bp, while the yield on the 2015 contracts fell 12-13 bp. Even further out, the 2-year yields fell 5-7 bp in Germany and France and 14-16 bp in Italy and Spain. As one might expect,the reaction was more muted at the long end of the curve. Benchmark 10-year yields were off only slightly in the core, and 5-8 bp lower in Italy and Spain. Portuguese bonds continue to recover from the dramatic losses as more appear to be coming around to our view that an early election is not the most likely scenario.

The euro fell to new lows since late May near $1.2880.

And today the ECB told us about dovish comments from Jörg Asmussen that:

“Mr Asmussen aimed to confirm the unanimous decision of the Governing Council on forward guidance that covered an ‘extended period of time’… No guidance was given as to the exact length of this period of time and it was not Mr Asmussen’s intention to do so.”

Michael Steen at the FT sums it up this way:

What, if any lessons can we draw from this? I’d suggest the following:

  • The bank really wants to keep its forward guidance as soft as possible for the time being, with maximum room to change course later on without there being grounds to accuse it of going back on its previous statements.
  • There cannot have been much discussion after the press conference internally otherwise Mr Asmussen wouldn’t, while apparently trying to repeat Draghi’s words, accidentally contradict them.
  • On the other hand, given the dire state of the eurozone economy, is it not a fair bet that rates will stay low for quite some time, like more than a year? This gets into the debate about whether the ECB’s forward guidance is actually all that radical.

Europe wants to be more responsible – and therefore less aggressive – than the United States on both fiscal and monetary policy. The real point of the Draghi and Asmussen commentaries are that the ECB now feels the pressure to ease because of economic conditions in the core and in the periphery. Yet, Europe cannot be seen resorting to the aggressive tactics of the Americans. That’s how I see it.

On monetary policy, the ECB is 50 basis points higher than the Fed. But the ECB is also into negative real rate territory just like the Fed. The ECB has expanded its balance sheet a lot, just not as much as the Fed (charts from Feb 2012). And the ECB’s balance sheet did shrink somewhat earlier this year (pdf here). The whole European Central Banking System’s balance sheet is now 15% smaller than it was at this time last year. And with rate easing, we see yet again that the ECB is following the Fed’s lead but chooses to try to be more hawkish. Asmussen hinted at serious dovish rate easing but was called out for it.

My conclusion is that European policy makers recognize the need for easing in both fiscal and monetary policy to counteract private sector debt deflation and the lack of public sector monetary sovereignty. But the existing economic paradigm only allows Europe to go so far. When Europe looks to America, time and again, it wants to be more responsible and less dovish. Over the medium term, that is going to mean lower growth. And I expect this paradigm to hold for years to come. Will it ever lead to longer-term outperformance? I doubt it given the cumulative output loss from debt deflation in the periphery. Just look at the size of the shrinkage in the euro system’s central banking balance sheets. Even so, it will be a very long time before we find out.

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