The latest Federal Open Market Committee minutes seem to have surprised market participants who were expecting the first rate rise to take place only in 2016. The “news” coming out of the US central bank after the September meeting suggested that the state of the world economy was still too risky to take the decision before the end of the year.
However, the grounds for the new messageare not entirely clear. The macroeconomic data and financial market situation have not changed much in recent days. It may be that the European Central Bank’s announcement a couple of weeks ago that monetary policy in Europe could be further eased in December made a difference. In a press conference on 22 October, Mario Draghi, ECB president, clearly indicated that various options had been considered by the central bank’s governing council, including a further reduction of the deposit rate, which is already at a negative level (minus 0.25 per cent), and an increase in the monthly purchase of assets under the quantitative easing programme.
Why should the ECB’s intention of further easing monetary policy have induced the Fed to anticipate its tightening?
There is a broad consensus that QE tends to become less and less effective over time, particularly when interest rates have reached the zero lower bound. The combination of sustained purchases of government bonds and the negative interest rates on deposits that banks hold at the ECB has certainly lowered the burden of debt for eurozone governments and facilitated deleveraging for households and companies. But there are also side-effects. Savers and pensioners are increasingly worried about the diminishing returns on their investments, and may be induced to save even more, which produces recessionary consequences for the economy. Furthermore, the low cost of debt is reducing pressure on governments to reform and to consolidate public finances.
The main channel of transmission of QE to the real economy has been the exchange rate. The euro fell against the dollar from 1.25 a year ago to slightly above 1.05 in early March when the QE programme started. Thereafter, the exchange rate moved back to around 1.10 and showed an appreciating trend each time the Fed decided to postpone the first rate rise. The weakness of emerging market economies has also fostered an depreciation of their currencies. In trade-weighted terms, the euro has appreciated by about 4 per cent since the summer.
The strengthening of the European currency in recent months represents a risk for the fragile eurozone recovery and for the prospects of inflation moving back towards the ECB’s target of 2 per cent. The ECB’s announcement at the last governing council meeting is clearly intended to make the markets aware that unless the euro falls back to levels close to parity against the dollar, monetary expansion will be stepped up. Markets seem to have fully understood the message as the euro has fallen from about 1.14 to the dollar to below 1.08 since then.
How does this affect the Fed’s decision? Everybody expects the dollar to strengthen when US rates rise, be it in December or early next year. However, the appreciation would be even stronger if it was the result of a combination of a Fed tightening and an ECB easing. If the Fed were to wait for the ECB to ease before it raised its key interest rate, the impact on the dollar exchange rate would be much larger. Once it had decided to cut the deposit rate or to step up its asset purchases, the ECB would not easily reverse its decision, just because the Fed had raised its rates. The Fed would de facto lose degrees of freedom and the pace of its tightening would become dependent on what other central banks would do.
By anticipating the first rise in December, the Fed may hope that the ECB will reconsider its intention of further easing. The depreciation of the euro resulting from the US rate rise would do part of the job for the ECB.
Indeed, this scenario may actually not displease the ECB. A weakening of the euro that would follow the Fed decision could be sufficient to maintain an adequate monetary accommodation for the eurozone, and might make further measures unnecessary. Difficult discussions about the pros and cons of QE could be postponed, and the unpleasant public display of dissent would be avoided.
It sounds almost too good to be true.
Lorenzo Bini Smaghi is a former member of the executive board of the European Central Bank and currently visiting scholar at Harvard’s Weatherhead Center for International Affairs and at the Istituto Affari Internazionali in Rome