The headquarters of the Federal Reserve and the ECB. (Photo credits: Federal Reserve-BCE)
Inflation, monetary policy … what role do central banks play in general, and in exiting the crisis in particular? We often compare the behavior of the Fed and the ECB to contrast them. For Jean-Paul Pollin, however, the two institutions have important points in common.
Fed and ECB are federal institutions and, despite minor differences in their operational framework, their instruments and methods of intervention are the same (they set and control interest rates). However, in recent years we have observed real divergences between their policies which seem to be due to four main reasons.
1 / We have frequently insisted on the differences between their mandate. While the ECB is supposed to act only to ensure price stability, the Fed also has the mission of raising employment to its “maximum”: in this connection, we are talking about a dual mandate. But in reality the text concerning the ECB is not as clear as the presentation we make of it. Because it specifies that the bank must also contribute to the other objectives defined by the Union Treaty: full employment, economic and social cohesion, etc.
It is in fact the posture and the practice adopted by the bank, during its first ten to fifteen years which could lead to believe that its task only to anchor in the duration the rate of inflation around 2 %. This led to its weak reactivity as well as some surprising decisions (the rate hike of July 2008 in particular). Moreover, the fall in inflation combined with the flattening of Phillips’ relationship today makes the pursuit of this single objective incongruous. This justifies the “strategic conversion” that the bank is in the process of making.
2 / Another well-known difference is that the Fed, unlike the ECB, is not statutorily independent. This does not prevent the American monetary authorities from keeping a wide margin of maneuver, in particular because they generally have real credibility based on skills attested by prestigious academic and professional backgrounds in the field. In fact, Donald Trump’s vituperations against Jerome Powell (whom he himself named) did not have a significant influence on the decisions of the Fed. But it is at least required to explain itself, and if possible to lead, its action in coherence with the overall macroeconomic policy.
The ECB, for its part, enjoys a strong independence because of its statute, but also because it can hardly be criticized, or constrained, by the 19 executives of the zone often expressing divergent positions, nor by the supranational level endowed with few powers. That said, independence may have virtues, but in this case it has the disadvantage of hampering good coordination of monetary and budgetary policies.
3 / The peculiarities of the euro zone also complicate the task of the ECB compared to that of the Fed. Because it must be admitted that the area of the Monetary Union, unlike the US economy, is still not an optimal monetary area. Due to the asymmetry of the cyclical shocks that affect the partner countries, the weak circulation of labor and capital between these countries, the weakness of the federal budget … So that if the ECB makes its decisions based on the data aggregated over its entire area, it will allow local imbalances that are dangerous for the stability and unity of the Union to subsist (or worsen). And if, on the contrary, it takes local situations into consideration while sparing the extremes, it will lose reactivity. The short history of the Union has already provided examples of these two scenarios.
4 / Finally, and this is not the least of its properties, the Fed’s policy has an undeniable impact on the financial balances of foreign economies. Recent empirical work has shown in particular that US rates significantly affect the development of long rates in both advanced and emerging economies. This is explained by the importance of the American financial system, and by the dominant international role of the dollar. This is why the financial markets, in Europe and elsewhere, are following Jerome Powell’s words more closely than those of ECB officials. For the latter, this is indeed a constraint on the design and effectiveness of its policy. Come to think of it, this is probably where the essential difference between the two central banks lies.