Can the Fed and the ECB stand the election heat?

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The focus of this article is on the likely policy response of these two central banks as households and businesses continue to adapt their spending and saving behavior to expected election outcomes in the U.S. (November 8, 2016), France (May 2017) and Germany (September 2017).

The title of this article is in no way hinting at an implicit belief that the current Fed and ECB leaders are influenced by political pressures in the conduct of their monetary policies. The unequivocal presumption of their independence and integrity stands.

The Fed and the European Central Bank (ECB) manage directly nearly one-half of the world economy. But that is only part of their de facto policy remit, because the dollar and the euro are the world's key transaction and reserve currencies. That means that these two central banks' effective policy domain extends to global demand, output, employment and the real purchasing power of dollar- and euro-denominated assets.

Obviously, the Fed's and the ECB's primary responsibility for these core policy variables is to their national constituencies. Others simply have to adjust.

Here is an example of how the perceived changes in some of these variables recently caused the Fed to modify its policy stance, despite strong protests from the rest of the world.

Signaling its clear intent to gradually move toward less accommodative policies, the Fed withdrew $267.7 billion of money market liquidity in the three months to January. Global asset markets swooned. But then the Fed reversed course in February. It has since added back nearly $100 billion to its monetary base and stabilized its asset holdings at $3.9 trillion.

Tell them: "You're fired!"

What happened? The Fed realized that the U.S. economy still needed help, and that large and sustained liquidity withdrawals would be premature. A number of domestic and external considerations were at the center of the Fed's decision.

First, there is the issue of the policy mix. The Fed knows that it has to keep pushing hard against the headwinds of a restrictive fiscal policy, because the U.S. has to run a growing primary budget surplus (it currently has a deficit of 1 percent of GDP) to stop and reverse the expansion of America's public debt (about 111 percent of GDP at the moment).

The Fed is also getting no help from structural labor market policies. There are still 15.6 million people (about 10 percent of the labor force) without stable full-time employment. Labor supply is declining (i.e., there is a low and falling labor participation rate), and more than a quarter of the people out of work are part of the long-term unemployed.

And then there is a depressive impact of our foreign trade deficit. That is taking nearly a percentage point off the growth of our domestic demand as Washington continues to struggle with free-loaders whom untutored analysts take as great contributors to global economic growth. Like most myths, this one is dying hard: These world growth champions are living off the rest of their trade partners. They are still complaining about Fed's policy intentions, even though their manna coming from the U.S. was running at an annual rate of about $700 billion in the first quarter of this year.

Central banks in focus for markets this week

So, there it is: The Fed is trying to offset downward growth pressures from (a) restrictive fiscal policies, (b) large foreign trade deficits and (c) structural labor market problems. These are the policy challenges the Fed will be facing in this election year - and for some time to come.

Working against all these odds, the Fed has done a good job. It has single-handedly guided the U.S. economy along a stable 2.4 percent growth path over the last two years. That is almost an entire percentage point above America's physical limits to growth.

Fire your economic advisers, Mr. Trump. The current Fed leadership – whom Mr. Trump apparently would like to fire -- has nothing to do with the lingering effects of the financial crisis we are still fighting. The seeds of that disaster were sown at the time when the Fed was running a federal funds rate of 1 percent between June 2003 and June 2004 to speed up an economy already soaring at an annual rate of 3.5 percent (remember what was happening in November 2004?), and when the referees were taken off the playing field in the years prior to the financial crisis in 2008.

The good news is that even if America's next chief executive were to change the Fed's current leaders, the Fed and the dollar would still be there – hopefully in good hands and stronger than ever.

Insults flying across the Rhine

That is much more than one can say about the ECB and the euro in the run-up to French and German elections in May and September of next year.

At the moment, about 40 percent of the French electorate – consisting of "souverainistes" and far right and left political parties – wants an exit from the euro and the EU. Calling them just "Euro skeptics" is a misnomer. Their virulent opposition to sovereignty transfers to the European Commission is a cover for terminal Germanophobia and an unbearable hurt of a proud nation being trampled upon by the European institutions serving its (erstwhile) arch-enemy.

Unfortunately, that is not a figment of anybody's paranoia. The German mismanagement of the financial crisis and of the chaotic migrant waves is now at the heart of the French-German discord.

The latest flare-up is as recent as last week. In a display of an incredibly offensive behavior, the German Chancellor Merkel told an audience of the French School in Berlin last Tuesday (May 3) that "I shall try to contribute to making other (French) political sources more powerful than the Front National ..." As a reminder, the Front National (FN) is a far-right anti-EU French political party currently polling at about 30 percent, and projected to compete in the second round of French presidential elections in May of next year.

And here is the answer from FN's President Marine Le Pen: "This serious statement is an outrageous and humiliating interference in our internal affairs that is confirming a cruel truth: France's submission to Germany."

Now, to round of the political spectrum, here is what Jean-Luc Mélanchon, the leader of the French radical left, and a presidential contender in next year's elections, tweeted on December 7, 2014 about Chancellor Merkel's hectoring: "Maul zu, Frau #Merkel ! Frankreich ist frei. Occupez-vous de vos pauvres et de vos équipements en ruines!" (Shut up, Mrs. Merkel ! France is free. Take care of your poor people and of your crumbling infrastructure!").

The French "souverainistes" anti-EU parties are right-of-center; they are aristocratic, more polite and surprisingly young, judging by the people in their mass rallies. But, as Brexit people would say, they want their country back.

Market reaction to today's Fed meeting will hinge on these two words

Germany is not short on invectives either, and its unraveling social consensus is equally serious. The xenophobic anti-everything Alternative for Germany (AfD) has soared from virtually nothing to about 15 percent of the popular vote in one year. Turkey's indignant refusal last Friday (May 6) to accept the EU conditions to hold Germany-bound refugee waves will be another godsend to AfD. That could also be a coup de grâce to Berlin's teetering governing coalition.

Chickens come home to roost. Immense suffering caused by Chancellor Merkel's cruel imposition of fiscal austerity on sinking euro area economies, and her disastrous immigration policies, seem to have pushed the EU and the euro area into an irretrievable tailspin.

Investment thoughts

The Fed will continue to support the economy by focusing on growth, employment, price stability and the soundness of America's financial system. Both presidential candidates would be well-advised to refrain from attacks on the Fed. Upon reflection, they will probably do that because there are no votes in Fed-bashing.

The ECB will continue its excellent work in supporting the euro area economy until ….

The tragedy is that the monetary union – a crowning achievement of nearly 50 years of wisdom, valor, pain and sacrifices -- may be gravely compromised anytime between May (French elections) and September (German elections) of next year, or immediately thereafter. That bitter end could even come sooner if, as seems likely, a deeply humiliated and destabilized Turkey were to unleash on Europe an unstoppable wave of migrants, refugees and who knows what else.

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