Fed and ECB: Kudos and problems ahead

Gary Cameron | Reuters

The Federal Reserve building in Washington.

The accelerating U.S. economy is on course to generate this year a trade deficit of $700 billion – about 4 percent of its gross domestic product (GDP) – which can be considered as America's net contribution to the growth of the world economy in 2014.

That remarkable achievement must be credited to the Federal Reserve's effective crisis management. Working against the headwinds of a sharply tightening fiscal policy, and the lingering problems in the financial system, the Fed has made it possible for the economy to bounce back from the widespread ravages of one of its worst financial crises on record.

The unusually long and fragile convalescence of the U.S. economy, and the huge losses of output and employment, reflect the severity of the crisis. And to understand the complexity of the Fed's task in overcoming the Great Recession and its aftermath, one should also note that the U.S. financial system returned to pre-crisis conditions only in the second half of last year. It took that long to get the banks' borrowing at the Fed (a distress signal for institutions that can't raise funds in private markets) down to levels seen in the months preceding the onset of the financial crisis in the second half of 2008.

This flashback is useful to remind ourselves of where we are coming from, while the markets and financial analysts exult at signs of a long-awaited cyclical upswing. They don't seem to think that the present euphoria may lead the Fed to take away the proverbial punch bowl sooner than generally thought. After all, the growth rate of 2.5 percent in the first three quarters of this year strongly suggests that the U.S. economy may have already hit the limits of readily available capital and labor resources.

Difficult steps ahead

Clearly, the Fed is facing a tough task of crafting an effective policy response. That is particularly difficult at a time, as is the case now, when the economy begins to accelerate. Under those circumstances, it takes an unusual ability – and a huge amount of luck – to correctly read the business cycle dynamics in order to administer an adequate amount of properly paced credit restraint to keep output and employment on a sustainable noninflationary path.

These difficulties are more easily understood by remembering the Fed critics' usual refrains. When they say "the Fed did too little too late," they accuse the Fed of letting the economy slip into recession. And when they say "the Fed panicked by doing too much too soon," they refer to Fed's premature rate hikes aborting the recovery.

Assuming that they are acting in good faith, the Fed's critics forget that they are demanding the impossible: An institution run by human beings endowed with perfect foresight.

Read MoreKeep an eye on the Fed's accelerating asset sales

Here is what that perfect foresight means. Instead of making a guess, the Fed would have to know exactly where the economy is at the time it designs and implements a policy change. And then, it would have to know exactly where the economy will be at the time when the policy change – acting through an ex-ante unknowable lag -- will hit the real economy.

Remembering these fundamental concepts in the theory of monetary policy makes me reluctant to criticize the Fed – the only major exception being the Fed's calamitous and unforgivable errors leading up to the financial crisis.

I will, therefore, pass one more time on Fed's criticism, but I will venture a hunch: It seems to me that the Fed should speed up the removal of a mind-boggling inflationary potential presented by its bloated balance sheet.

The latest numbers show that during the two weeks between November 26 and December 10, the Fed shrank its balance sheet by $56.3 billion. That brought the monetary base down to $3.7 trillion, a $315.1 billion decline from its peak of last August.

These liquidity withdrawals had no negative impact on U.S. money and capital markets: The federal funds rate remained well below its 0.25 percent target, and the yield on the Treasury's benchmark ten-year bond closed at 2.25 percent last Friday.

I expect to see the Fed accelerating asset reductions in the weeks and months ahead.

The ECB's broken transmission

The European Central Bank (ECB) is in a completely different situation as a result of the weak cyclical position of the euro area economy.

With the monetary union's growth rate of 0.9 percent in the first nine month of this year, and the bank loans to the private sector falling at an average annual rate of 1.3 percent in the three months to October, the ECB has to maintain its exceptionally loose monetary policy in the months ahead.

But the ECB needs no additional liquidity creation. The euro area markets are already swimming in liquidity. The problem is in an inadequate bank lending to businesses and households. Banks are gun-shy because of bad credit risks in a stagnant economy. Their balance sheets are also closely (maybe too closely) monitored by the regulatory authorities.

That means that the ECB's most urgent and important task is to fix its dysfunctional transmission mechanism between monetary policy and real economy.

The ECB's other problem is an apparent expectation of some euro area governments that the central bank will do the heavy lifting for them. True to form, Germans are issuing stern warnings to countries (France and Italy) accused of dragging their feet on structural reforms while pushing for even looser monetary policies. German taskmasters may have a point here because it does seem that advocates of greater liquidity are the ones seeking to avoid the political fallout from unpopular reforms.

Markets, however, should be under no illusion about the ECB's determination to support the euro area economy and the viability of the common currency as the pillar of Europe's economic integration. That is its mandate, and its pledge to do "whatever it takes" is no empty bravado.

Investment thoughts

U.S. equity markets are still one of the best bets around. Buying the market is over, but great values are available in an accelerating economy.

The euro area will continue to benefit from its expanding American export markets. That will help it to overcome some of the growing damage from (a) trade frictions with Russia and (b) an apparently increasingly difficult business environment in China that the Germans keep complaining about.

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.