2014 may well end up being summarized as having been an arm-wrestling match between Janet Yellen and Mario Draghi. Simply rereading the declarations of each would be sufficiently convincing of this. For the Chairperson of the Fed, the robustness of the American economy will lead to a reduction, meeting after meeting, of the volume of assets purchased. Then, next fall, when the number will have fallen to zero, the Fed will set a schedule (6 months?) to begin raising interest rates.
On this side of the Atlantic, the discourse is different. During the last monetary policy committee meeting, Council members unanimously considered that the ECB’s monetary policy was restrictive, even with a benchmark rate of 0.25%. Consequently, it was necessary to implement a more accommodating strategy.
The ECB confirmed this policy change during the semi-annual meeting with the IMF and World Bank in mid-April. It would initially lower its key interest rate, without giving any more details about a possible negative rate for deposits for the moment. The second phase would involve the purchase of financial assets with maturities up to 10 years. A very diverse range of assets would be purchased, primarily with long maturities to keep in line with the Eurozone’s financing arrangement.
Thus, the economic situation in 2014 is divided into: Americans who wish to adapt their monetary policy to a more sustained growth in activity and the Europeans whose monetary strategy must remain accommodating or become even more so. In the Euro Area, activity is not very dynamic and unlikely to put pressure on productive capacity. The specter of deflation haunts Eurozone investors, not American.
This divergence in economic trajectory is due to the jolts suffered by the US and Europe, but also to the manner in which economic policies were implemented.
The graph illustrates that for the 2009/2010 period, each economy reacted similarly, reflecting the introduction of a stimulus plan on a large-scale. Every developed or emerging country contributed to the global economy’s recovery.
The separation occurred afterwards. It is very obvious on the graph. The US economy continued to rise while the Eurozone’s ground to a halt. This interruption in 2011 is behind the current configuration.
This change in trajectory must first be understood. Three reasons are attributable to Europe, two to the US.
Three Reasons Attributable to the Euro Area
1 –The Need to Implement a More Coherent Strategy for the Euro Area.
The Greek crisis in 2011 and its repercussions first and foremost highlighted the institutional weaknesses of the Eurozone’s structure. It was unable to respond in an autonomous manner to a specific negative shock. There were no instruments to ensure its own regulation. This flaw was in large part repaired with the implementation of the European Stability Mechanism, a governance treaty and banking union, as well as by the ECB, which has gradually taken on the role of last-resort lender, not necessarily consistent with its initial status. Thus, the Eurozone gained autonomy, a major factor.
2 – Budgetary Policies Were Very Restrictive, Especially in Southern European Countries
Activity in Spain, Italy or even Portugal was heavily influenced by these strategies that were overly taxing and rapidly restrictive. The sustainability of certain situations was not guaranteed but these measures were nonetheless implemented despite domestic demand being depressed. That could only result in recession. These measures weighed more durably on domestic demand and impacted directly the demand addressed to companies.
3 –The Third Reason Lies with Monetary Policy
While the Fed had maintained its intervention rate at very low levels since end-2008 and agreed to do so for a very long time, the ECB did not lower them as much and raised them in April and July 2011. Just as activity was beginning to recover, the ECB toughened its stance against unlikely inflationary pressure.
All these factors led to uncertainty about the durability of the monetary construction in place and the Eurozone’s ability to return to growth. The weak institutional environment and restrictive economic policies dealt a serious blow to the fragile recovery taking hold in 2010. These factors have dissipated and since spring 2013, growth has slowly began to return.
Two Reasons Attributable to the US
1 – Household deleveraging occurred rapidly. Accelerated household indebtedness had been the cause of the crisis and so it needed to be reduced in order to give consumers room for maneuver. At the same time, the US Treasury accepted a larger deficit to offset lower household demand as a result of said deleveraging. The third phase of the process saw the Fed accept a significant amount of Treasury issues by buying them over the course of various Quantitative Easing operations. This helped dissipate risk over time. Here, the Fed played the role of last-resort lender.
At this point, the difference from the European strategy is striking.
2 – The second reason is a supply shock. The use of shale gas and oil slashed production costs and created new production conditions.
Apart from the management of the Euro Area crisis, which is a major factor, the methods adopted to facilitate macroeconomic adjustment are not comparable on either side of the Atlantic. Consequences can be perceived: the US economy will record nearly 3% growth this year, while the Eurozone’s will be close to 1%.
As the US economy has resumed a more typical profile, the Fed has every reason to progressively adjust its monetary strategy. Recently, rates at the short-term end of the yield curve have moved. The long-term part of the curve has already been adjusting since May 2013, since Bernanke implied the shift in monetary strategy by the US issuing institution. Janet Yellen gave some indication of when interest rates could rise, probably from summer 2015. No doubt investors’ expectations will gradually become more aggressive regarding changes in American rates and on the shape of the yield curve.
This trend will necessarily spill over towards the Euro Area yield curve. Interest rate spreads by maturity are already widening, but the gap could increase further. This would avoid excessive constraints on the Eurozone economy.
It is also for this reason that the ECB must implement new monetary policy measures. If nothing is done, it is the Fed that will set the tone and pace. The Euro Area needs more time and for that the ECB must be more proactive. The Eurozone’s other stakeholders – consumers, entrepreneurs and governments – must also play a part in implementing systems that foster more autonomous growth. For this is where the real issue lies. The economy is globalized but everyone must find a way to be a bit more autonomous. The ECB must be involved but cannot provide the solution alone.