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The Fed and the ECB: Moving at different speeds in the same direction

  • U.S. bond markets see rising inflation and public debt
  • Bond vigilantes may soon be forcing the Fed's hand
  • The ECB sees deflation, tight fiscal policies and political contingencies
Janet Yellen speaks with Mario Draghi at the Jackson Hole economic symposium in Wyoming.
Bradly Boner | Bloomberg | Getty Images
Janet Yellen speaks with Mario Draghi at the Jackson Hole economic symposium in Wyoming.

The U.S. and the euro area economies — nearly one-third of global output — are currently continuing to grow at a pace which is not causing inflationary capacity pressures in labor and product markets.

The Federal Reserve and the European Central Bank are, therefore, maintaining an exceptionally easy policy stance, while envisaging gradually rising credit costs to reflect (a) an expected improvement of cyclical conditions, (b) fiscal policy changes, (c) trade balance effects on growth and employment, and (d) vastly different political circumstances in the U.S. and in Europe.

Based on the preliminary estimates for the third quarter, the U.S. economy grew in the first nine months of this year at an annual rate of 2.2 percent, marking a considerable acceleration from a 1.4 percent growth during the same period of 2016.

Predictably, that has led to the strengthening demand for labor. The jobless rate declined to 4.2 percent in September from 4.9 percent a year earlier, leading to an increase, over that period, of real average hourly earnings by 0.7 percent.

The U.S. cost and price inflation picture looks benign. The core consumer prices rose 1.7 percent in the year to September, the personal consumption expenditure index (PCEI) has stabilized at an annual rate of 1.4 percent in the three months to August, and the unit labor costs in the first half of this year increased 0.3 percent from the year before.

Still, it seems that these numbers don't look reassuring to those at the Fed fretting about the inflationary impact of "tight labor markets."

Bond markets forcing the Fed's hand

The concern about a strong demand for labor is technically correct, but that is merely a politically-neutral expression about the inflationary dangers of the expected fiscal policy easing.

Yes, the Fed and the bond markets are worried about the impending fiscal stimulus. The announced personal and corporate tax cuts are expected to raise household spending and business investments, representing 80 percent of the U.S. economy. That clearly harbors a substantial inflationary potential the Fed would have to deal with.

Bond markets are doing that already. They are repricing the rising government debt because they apparently don't believe the tax-cutters' claims that accelerating economic growth will raise enough revenues to offset $6 trillion in proposed tax cuts.

It sounds like the bond market vigilantes are telling us that America's fiscal position is already too uncomfortable to even contemplate tax cuts of any magnitude. This year's federal budget deficit shot up 14 percent from 2016 to $666 billion, reaching 3.5 percent of GDP, while the gross public debt continues to tick above $20.4 trillion, or 105.4 percent of GDP.

So, the bond markets are taking the lead. And the Fed will have to follow suit as the yield curve continues to steepen in the weeks and months to come. Keep the fingers crossed that the Fed will have the time, and the possibility, to operate a gradual process of rate hikes.

The ECB is in a very different position. The euro area economic growth has picked up to 2.3 percent in the second quarter of the year, but the monetary union is still struggling with an average unemployment rate of 9.1 percent, ranging from a historically low 3.6 percent in Germany to 17.1 percent in Spain and 21 percent in Greece. Two of the area's large economies, France and Italy, are stuck, respectively, with 9.8 percent and 11.2 percent of their active civilian labor force out of work.

ECB's 'whatever-it-takes' mode

The euro area's price stability looks good. The current core rate of inflation stands at 1.2 percent — substantially below the medium-term target of 2 percent — prompting the ECB's statement last week that "an ample degree of monetary stimulus remains necessary."

The fiscal policy is the other big difference compared with the U.S., and an important reason for the ECB's "ample degree" of credit easing. France, Spain and Italy — accounting for one-half of the euro area GDP — have to maintain a restrictive fiscal stance. France and Spain are required to bring budget deficits down to 3 percent of GDP, and to balance the books in the next few years, while Italy has to reduce its public debt down from a colossal 158 percent of GDP.

As an aside, one may also note that the ECB's monetary easing will help to keep the euro's exchange rate at a level that could stimulate strong export sales in countries suffering from weak domestic demand. This year, for example, an estimated $400 billion surplus on net exports of goods and services will make a positive contribution to the area's growth and employment.

The economic fallout from serious political instabilities in the European Union is another problem that makes a big difference for the settings of American and European monetary policies.

Spain now not only has to deal with difficult fiscal and structural policies, but its minority government is also facing a serious challenge to social peace and territorial integrity. Things have already gone so far that the depressive economic impact of the Catalonian quest for independence will transcend Spain's 12 percent share of the euro area's economy.

There is no telling indeed where the contagion of Catalonia's separatist movement will stop in Europe's complicated political landscape. Italy's regional problems, for example, have been exacerbated. Similar to the case of Catalonia, the rich regions of Lombardy and Veneto, and probably Piedmont, want to keep their fiscal revenues for themselves instead of sending the money to Rome and to the perennially underdeveloped Mezzogiorno (Italy's poor southern regions).

Germany's federation has not been threatened yet, but, who knows, the rich and conservative Bavarians apparently cannot stand the idea of sharing a coalition government with the leftist Greens. And the Bavarian concerns seem to be spreading to the German Christian Democratic Union (CDU). Ominously, even the erstwhile supportive center-right media are now asking: Where do we go with Chancellor Angela Merkel?

The German coalition talks are going nowhere, that's for sure. The new elections are looming, and the union between the CDU and the Christian Social Union in Bavaria now sounds like it could be looking for a new leader.

Investment thoughts

The Fed's balance sheet, and its money market operations, are showing no rush to a policy change. That's the way it should be, because there are no urgent problems calling for a precipitous new course, and there are still substantial uncertainties with regard to the U.S. fiscal policy.

But the U.S. bond markets are not held back by those concerns. They see rising public debt and budget deficits, they are much less sanguine about the inflation outlook, and they are asking for higher yields to buy and hold public debt instruments. They are driving a steepening yield curve that may soon force the Fed's hand.

The ECB is dealing with different economic and political events. The euro area economy is growing, but the labor market slack is still huge, all inflation indicators remain subdued, the fiscal policy is in a tightening mode, and the fallout from political instabilities could seriously affect consumer spending and business investments. The ECB, therefore, plans on a prolonged period of "ample monetary stimulus."

Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He 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 Business School.

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