Monday, September 10, 2012

Europe, the ECB, and the Fed

Greece, Spain, Portugal, Italy, and France are lost causes from an economic point of view. All have very rigid, state-regulated labor markets which have resulted in uncompetitive levels of labor costs and high, long term, structural unemployment. I see nothing on the horizon which is likely to change this political choice made by these countries. Monetary policy can't alter this situation one iota.

But monetary policy can have big short run effects on nominal GDP and national income, largely by changing business expectations about the profitability of investment in plant and equipment going forward. To have such effects central banks must convince the markets that they are determined to achieve levels of GDP growth consistent with declining or low levels of unemployment (where "low" means what is possible in a rigid labor market).

Central banks do this by promising to grow their balance sheets as necessary and/or by setting short run interest rates at appropriate levels. Nowadays short term rates are so low that this second policy instrument is not of much use. But in either case the central bank must promise to achieve targets for either nominal GDP growth or for average inflation over the business cycle.

How does the European Central Bank's latest policy announcement shape up against this criterion? The essence of the new policy is to buy the short term sovereign bonds of failing EU governments provided they promise to meet International Monetary Fund austerity criteria. This aspect of the policy will have the effect of reducing the "safe haven" demand for euros while making other financial assets attractive. This by itself has the same effect as would an expansion of the ECB balance sheet and has to be regarded as a positive development in the short run.

But in the same statement the ECB promised to "sterilize" its purchases of short term bonds by selling other balance sheet assets - probably dollar denominated assets - so has to keep the size of its balance sheet steady. This is a very dumb move because once the "flight to safety" has been stemmed there will be no further net stimulus to nominal GDP growth going forward. Therefore the monetary boost being provided by the ECB policy is limited and of a relatively short run nature.

From this I conclude that since the ECB is in effect promising to support the Euro by sterilization of its bond purchases the  outlook for the euro priced in dollars in bullish. But is the outlook for European stock markets also bullish? Not so much.

Next Thursday the Fed will announce the results of its latest policy meeting. The markets expect concrete steps towards an easier policy. This is why the weak US employment numbers today had no effect on the  market - they only bolster the case for further easing.

If the Fed does ease this will also support the euro and provide a short run boost to US and European stock markets. If the Fed fails to ease as expected I think the market will take it very badly.

1 comment:

Graph1159 said...

Is it possible that the Fed is waiting to see the outcome of the presidential election before deciding what to do next with monetary policy?