GO
Loading...

Fed and ECB: Spot the difference

Janet Yellen enters the opening reception of the Jackson Hole Economic Policy Symposium in Jackson Hole, Wyoming August 21, 2014.
Reuters
Janet Yellen enters the opening reception of the Jackson Hole Economic Policy Symposium in Jackson Hole, Wyoming August 21, 2014.

People expecting "market guidance" from the U.S. Federal Reserve (Fed) proceedings last week at Jackson Hole, Wyoming, got nothing. That is as it should be. The Fed communicates its policy intent through open market operations.

Here is what the Fed is telling us.

The Fed's policy interest rate – the federal funds rate (the only interest rate it directly controls) – traded at 0.08 percent last Friday, significantly below its 0.25 percent target and was roughly identical to the 0.10 percent observed a year earlier.

The monetary base – the only aggregate directly controlled by the Fed (because that is the liability side of its balance sheet) – last Wednesday (August 20) was 20 percent above its year-earlier level, marking an average monthly expansion of $44.8 billion since the beginning of the year.

Read More Fed's Charles Plosser on 'risky' policy, watching wages

And with all that monetary largesse, the Fed reported in the middle of last week that it kept a mind-boggling $2.7 trillion in banks' excess reserve deposits – the funds banks can readily lend -- a 27 percent increase from the year before.

These numbers show that the Fed is an open book. But that, apparently, is not enough. Some people want the Fed to tell them when it will turn the leaf.

They are, of course, asking the impossible, because the Fed itself does not know. And when the Fed says, as it did last week, that its next policy change will depend on employment and price inflation, the statement is branded as bland and useless. But how can it be anything else when the Fed – like all the short-term forecasters – is searching for evidence relevant to its policy decisions?

Fear wrong policies, not America's secular stagnation

Curiously coinciding with the Fed's annual conference is a revival of the declinist debate asserting that the U.S. economy is structurally in an irretrievable stagnation.

Under these conditions, the declinists argue, the monetary policy cannot lift the economy and keep it on a steady and sustainable growth path. And there is worse, they warn: Instead of creating economic growth, the monetary stimulus then just creates all sorts of bubbles, leading to financial crises and further declines in the effectiveness of easy credit policies.

Read More Yellen's balanced approach, soothes doves, encourages hawks

But all is not lost. Some of the purveyors of the idea of America's secular stagnation suggest that the government may be able to restore the ability of the monetary policy to help create more output and employment.

There is no policy blueprint here, but the reference to government policies clearly implies that taxes, public spending and regulatory changes can be used to increase the economy's growth potential through better infrastructure, competitive markets and a more qualified and efficient labor force.

In other words, what is needed is a better balance and coordination between monetary and fiscal policies.

That is what has been missing in the U.S. for some time. Indeed, the expansionary monetary policy has been working against a sharply restrictive fiscal stance that saw budget deficits declining from 11 percent of gross domestic product (GDP) in 2009 to less than 3 percent this year.

Read More Yellen: Getting closer to Fed objectives, but still hard to gauge labor market slack

As far as I could see, the Fed had nothing to say about that last week.

ECB wants growth-oriented fiscal policies

But the European Central Bank (ECB) did. In remarks at the Fed's Jackson Hole symposium, the ECB's President Mario Draghi reminded the euro area governments of what they could (and should) do individually, and as a group, to stimulate the economic growth and employment creation.

And that was not the usual exercise where the central bank passes the buck to the government.

With the euro area economy stagnating in the first half of this year, Mr. Draghi restated the ECB's readiness to introduce further measures of monetary stimulation, but he also invited the governments to support their domestic demand through growth-oriented fiscal policies while remaining within the agreed budgetary limits. This politically coded message implies tax cuts with declining public spending; it also refers to structural reforms to create more efficient public services and more flexible labor and product markets.

Italy's new government has tried this. The plan looked good on paper and even got a rare praise from Germany. Unfortunately, the declining growth seems to have invalidated the original budget calculations. Rome is now turning to Brussels and Berlin to ask for a euro area stimulus and for more time to meet budget commitments.

France is on the same policy path. And it is also on a clear collision course with Germany. France's Economy Minister, Arnaud Montebourg, wants a radical departure from a policy of tax hikes and spending cuts in a recessionary economy. Ominously, he went a step further last week by saying that the French Socialists cannot align themselves on the "extremist" fiscal policies of "Germany's right-wing parties."

That does not sound good. But the ECB's advocacy of growth-oriented fiscal policies may support the French and Italian quest for a cyclically appropriate policy mix in the euro area.

The ECB could also put Germany on the hook. The idea (discussed by Mr. Draghi in Jackson Hole) is that an acceptable euro area fiscal stance can be achieved through better coordination of national fiscal policies. That would imply more expansionary demand management policies in low deficit countries (such as Germany) and a shift toward restraint in countries experiencing high budget deficits.

Read MoreDraghi says ECB stands ready to adjust policy further

Expect interesting times in the euro area. The ECB will be in the middle of it.

Investment thoughts

The Fed's policy statement in Jackson Hole last week reflected the view that America's economic output, labor market conditions, price inflation and a restrictive fiscal stance warranted a continuation of expansionary monetary policies. The extent and timing of the policy change were left open because the Fed needs evidence that new developments in any of these variables would require an appropriate policy response.

The ECB's participation highlighted the fact that coordinated monetary and growth-oriented fiscal policies were needed to support a sustainable euro area economic recovery.

Absence of such policy coordination in the U.S. leaves the Fed to carry alone the burden of economic stabilization. That affects the speed and the intensity of monetary stimulation.

Investors, however, should not take seriously arguments that the U.S. is condemned to structural stagnation, and that the Fed's easy credit conditions will merely result in financial bubbles.

The U.S. economy will be front and center in forthcoming Congressional and presidential elections. Domestic and geopolitical pressures will knock the heads together (i.e., the Congress and the White House) to clear the roadblocks to faster growth. Meanwhile, the Fed will hold the fort – alone.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.

Follow the author on Twitter @msiglobal9