The ECB and the Fed

By: Charles Wyplosz, Graduate Institute of International Studies

While the Fed lowers its interest rate to take to negative territory in real terms, the ECB goes in the other direction. It would seem that one of them is badly wrong. Of course, this is not necessarily the case if conditions are different, and they are. In fact, both are making reasonable bets, which both can come to regret.

 

The economic slowdown is deeper and wider in the US. After all, the financial crisis started in the US housing market. The bubble had become pretty sizeable and the fall must be commensurate. Mortgages have been extended like nowhere else and delinquency, still on the rise, is impressive. A maze of small specialized boutiques have played the securitization game unrestrained, cynically peddling flexible rate mortgages and promptly offloading them. It may be that, in the end, many people will end up owning a house that was previously out of reach, but the casualties are enormous. Many of the largest US banks have been caught apparently unprepared by the turnaround, which is amazing. After all, it had been years that a bubble had been detected and that market analysts had predicted a turnaround. Worse, prices started to decline in 2006, nearly a year before the crisis erupted. Why these banks, and the credit rating agencies, failed to see the writing on the wall is a story that remains to be fully elucidated, but the fact is that a classic credit cycle unfolded in slow motion and was allowed to unfold in the full view of apparently unfazed supervisors. At any rate, today’s US banking system is in disrepair and credit conditions have tightened. Whether the interest rate is high or low is almost irrelevant in a situation where banks, now focused on improving their balance sheets, lend with extreme caution and parsimony. The negative real interest rates, even at long maturities, are not expansionary. Pretty much as the Bank of Japan in the early 1990s, the Fed has essentially lost the interest rate as a monetary policy instrument. They merely provide some breathing space for banks and other financial intermediaries.

 

This means that the Fed is not currently stoking inflationary fire, as many complain. It is another story whether implicitly bailing out the banking system is justified. Clearly, the Fed cannot let the system wither away. Why should it, on the one hand, provide ample liquidity against second-rate collateral and, on the other hand, maintain high real interest rate, especially as the Treasury mail checks to US citizens? Yet, the amazing reduction of interest rates in the wake of irresponsible bank behavior through a credit cycle leaves the painful impression that moral hazard is officially accepted as a fact of life. The Fed may note, however, that many banks have suffered severe losses and that their shareholders have seen some dilution of their assets as capital has been raised. The new Bagehot rule seems to be: banks are bailed out indirectly via low real rates and the ability of swapping toxic assets against liquidity while their shareholders take a beating and some top managers are made redundant. This is a soft rule, especially in view of the golden handshakes given to outgoing managers, following years of huge bonuses. The same soft treatment applied to Japanese banks has turned out to be harsher when, a decade later, they have emerged sharply diminished and highly cautious. But the punishment has been extended to the whole economy in the form of the Lost Decade, which may not be over nearly twenty years later. The new Bagehot rule may also prove to be adequately harsh if the large US banks shrink in the years to come. Somehow, however, one has the feeling that one concern of the US authorities is not to severely jeopardize the might of its financial institutions. Moral hazard used to be the result of too big to fail institutions; now it may be created by a form of industrial policy applied to too dominant to be abandoned institutions.

 

Across the Atlantic, the ECB has not faced similar challenges. While some large euro area banks have also suffered deep losses, none has been pushed into a corner. The main challenge of the ECB has been the freezing of interbank bank, followed by significant spreads. Thus monetary conditions have tightened as well, but not to the same extent, by a far margin. Indeed, until recently, credit growth has been respectable, just more selective. The long period of apparent ECB inertia has concealed this implicit tightening. In addition, growth has gently declined so far. The real question, therefore, is whether this slowdown is sufficient to tame inflation and whether it will last long enough to achieve the return to price stability. This is a particularly difficult question. No one knows how long the financial crisis will last, nor whether oil, commodity and food prices will recede. Nor is there any clear indication of how decoupled the emerging market economies, the world’s new engine of growth, will be. The ECB must make a guess, as good as it can, and bet on this basis.

 

The latest move, unfortunately, does not indicate what the ECB view is. Raising the interest rate suggests that the ECB believes that the slowdown is too moderate, but this is contradicted by the accompanying statement according to which no further increase is currently contemplated. The difference between last month 4% interest rate and this month’s 4.25% is too negligible to have any impact on the economy. No one would seriously consider that 4% is not enough and that 4.25% is just right.

 

A charitable interpretation of the ECB’s action is that it is symbolic. Symbolic steps would then join code words and verbal admonition into the central bank’s rich toolkit of non-actions. We can only hope that this tool works, for the remaining options are not palatable. Should inflation become entrenched, the ECB will have to raise the interest rate. Given the lags involved, it would then have to do so promptly and forcefully, to 5% and beyond, thus making a mockery of its current “no bias” position. Should instead the slowdown be protracted or turn into a recession, the ECB would have to reverse itself, a potentially embarrassing move. So far, therefore, looking strictly at its actions and overlooking its non-actions, the ECB has done well. Given the considerable level of uncertainty, one can disagree with the ECB’s underlying assessment of the economic outlook but no one can honestly claim that it is plainly wrong.

 

Central banks are going through a rough patch. Oil shocks are technically easy – prevent inflation from setting in – but politically delicate – allow for rising unemployment – to deal with. Financial crises are always delicate because they are always different, largely because lessons from the previous have been learnt. High food prices additionally complicate the picture. Facing different situations, the Fed and the ECB muddle through, each in its own way. They could have done it differently, maybe, but it is fair to say: “so far, so good”.

 

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