Why are both the Fed and ECB still easing policy?

As for the ECB, rate hikes, at least in terms of the discount rate, seem set to start in the second half of the year and move onto key refi rate hikes from 2023. Photo: ECB Chairman Christine Lagarde.

Admittedly, the Fed is just about at the end of its quantitative easing program, and the ECB may well decide to finish earlier than the current plan for October. But even if net bond purchases were to stop today, we might still ask the question, why haven’t interest rates risen before now?

A simple Taylor Rule calculation that gauges where policy rates ‘should’ be puts the US rate at over 9% and the euro zone at over 6%. Of course, many doubt the validity of these Taylor Rule type measures, but, whether you believe them or not, there’s no doubt that the banks are taking huge risks right now.

As FOMC member Bullard noted last week, if you were to go back in time, the sort of inflation rates we are seeing right now would have often prompted the Fed to have made an inter-meeting hike by now, not continue with easing! The key question is whether things have changed so much that the sorts of monetary policy actions that might have been taken 20 or 30 years ago – like inter-meeting hikes – simply have no place today.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy said two above factors suggest things could be different. Inflation has been very low for a long time, and either as a consequence, or because of this, central banks appear to have good anti-inflation credibility compared to 20–30 years ago. Secondly, the source of today’s inflation – the pandemic – has led to a shortage of supply, not an excess of demand. The Fed can’t influence the former, and it seems pretty certain that supply will improve as the pandemic passes into history. So why tighten policy to reduce demand when excess demand is not the problem? These seem like pretty persuasive arguments, but we don’t have particular confidence in either.

On the former, Mr. Steve Barrow doesn’t doubt that central banks like the Fed have better anti-inflation credibility these days. But this only means that it might take a relatively modest amount of tightening to keep inflation in check. It clearly does not obviate the need for policy tightening to take place. On the latter, the source of inflation might be the supply constraints caused by the pandemic (plus energy price increases), but inflation can take on a life of its own and that’s exactly what’s happening with a wage-price spiral already in train in the US and likely in the euro zone as well. Just a look at last week’s US CPI figures shows how price pressures are broadening and no longer down to COVID-related factors.

In short, Mr. Steve Barrow would argue that it is crazy that the Fed and ECB are still easing policy right now, particularly the Fed. The longer this craziness goes on, the more it seems that both will have to catch-up with rate hikes and balance sheet reductions in the future. The market is clearly adjusting its expectations rapidly to try to take account of this prospect.

"It seems likely to us that the Fed will be hiking rates by 25 basis points at each meeting this year. A 50-bps hike has been talked about for the March meeting, or even an inter-meeting hike of 25-bps before then to try to restore credibility. We’d not rule it out either, but it is not our base case. And, while Fed Chair Powell has talked about being "nimble" and data-driven, we suspect that, when push comes to shove, the Fed won’t be either. Instead, rates are more likely to rise in a steady way, much like in the last two rate-tightening cycles. Asset reductions are likely to take place in the background, with the Fed keen to keep the reductions on autopilot in order to avoid undue volatility. As for the ECB, rate hikes, at least in terms of the discount rate, seem set to start in the second half of the year and move onto key refi rate hikes from 2023. The need for urgency here is not as pressing as at the Fed. But while the prospect of wider interest rate differentials between the US and the euro zone might hold out the prospect of a lower euro/dollar, we feel that the Fed has a much bigger credibility problem which will counterbalance the help the dollar receives from higher rates," Mr. Steve Barrow said.