Tug of War

3^rd February 2008

The Malta Independent on Sunday

Bankers who work for central banks are generally very serious people, serious to the point of being boring. It is therefore not often that one has an opportunity to witness a tug of war that is going on between the main central banks of the world, that is, the Federal Reserve Bank of the United States and the ECB of the euro countries.

On the contrary, it is more normal for the two main central banks of the developed world to co-ordinate their actions in order to re-enforce their effectiveness, as they did last month when they flooded the financial system with short term liquidity. They worked together with others to lubricate the world financial system that was stalling as banks started hoarding liquidity to cushion the stress of the losses they had to book on their exposures to the US mortgage securities.

So what is leading to a situation where the Federal Reserve is in crisis mode, slashing down interest rates and loosening monetary policy by taking urgent measures announced outside the scheduled calendar of meetings for this purpose, just as the ECB continues to talk hawkishly about tightening monetary policy more than it already is?

Some history would help readers to understand what I am talking about. In the aftermath of the 11 September 2001 events and the consequent economic shock resulting from the bursting of the technology stock bubble in 2000, the Federal Reserve Bank reduced interest rates to a floor level of one per cent. The ECB moved its rates in sympathy but kept its floor level at two per cent.

As the economies emerged from the recession, the Federal Reserve started raising interest rates in June 2004 and 17 consecutive quarter point rises took the rates up to 5.25 per cent. The ECB, on the pretext that it had not taken the rates as low as the Federal Reserve, started moving EUR interest rates up in December 2005 in a series of non consecutive quarter point rises, which took rates to four per cent by June 2007.

So, as at June 2007, interest rates in the US were 5.25 per cent and in the euro area they were four per cent. Then a hurricane hit the financial markets on both sides of the Atlantic. The world financial markets started to seize as inter-bank money markets stopped functioning properly. Banks switched suddenly from an aggressive mode to a very defensive one as the defaults on US mortgage payments started to soar, spreads between corporate bonds and safe haven Treasuries widened and the market for mortgage and asset backed paper in the US disappeared almost overnight.

In an effort to ease the lock jam of the financial markets that risked pushing the economy into a recession, the Federal Reserve shifted to a rate cutting mode and in the space of the last six months cut rates in four consecutive instalments for a total shave of 1.75 per cent, reducing them from 5.25 per cent to 3.50 per cent.

In the same period, the ECB held steady and only caved in to the extent of cancelling the quarter point interest rate increase that was pencilled in for September 2007. But today interest rates on the euro are still at the four per cent level, where they were last June.

In a globalised world it is difficult to imagine that Europe can avoid the economic consequences of a sharp US slowdown or outright recession. So what economic justification can there be for interest rates in Europe, which were 1.25 per cent lower than those of the USA as late as last June, to now be 0.50 per cent above them? There is also the clear prospect for this gap to continue to increase as US rates seem destined to fall further just as the ECB continues to dismiss any possibility that it could be forced to consider reducing euro interest rates at any time in the near future.

They can’t be both right. Either the Federal Reserve is panicking beyond reason and being too aggressive in cutting interest rates by over-estimating the risks of recession, or the ECB is too complacent and is showing the consistency of those re-arranging the chairs on the deck of the Titanic denying that it had hit an iceberg which would send it to the bottom of the ocean.

If time will prove that the Federal Reserve is panicking and the ECB is right in showing a steady hand, which in the long term will enhance its credibility as an effective inflation fighter, we will in due course witness a much stronger European economy as the US will continue to use monetary policy to inflate and deflate bubbles in boring succession.

If on the other hand the Federal Reserve will prove that it has acted timely to avoid a recession just as the ECB continued with its rigid policies, ignoring clear signals of a slowing economy, which, on its own, will roll back inflation pressures, we will witness a quick emergence of the US from the current slowdown while the European economy will be constrained by the weight of an over tight monetary policy.

As fully fledged members of the euro system we did not have to wait more than a few weeks to come to the point of practical realisation that our economic growth is largely dependant on monetary policy decisions taken by the ECB, which cannot be expected to be too sensitive to the needs at ground zero at Valletta, Nicosia or Ljubljana.

Never before has the ECB faced a situation where there is such a narrow margin between exiting from this situation either as heroes or as fools of consistency. Either with a crown as the most credible central bank on earth or with egg on its face, as it will have to eat its words and follow the Federal Reserve in crisis mode.

Essentially, the decision of the ECB is uncertain. If the administrative staff, mostly moulded in the former Bundesbank tradition, continues to call the shots the ECB will sit out the situation. If the majority rule applies, considering that the southern Europeans now have a majority round the ECB board table, we could soon see the ECB backtracking with its tail between its legs. The entry of Malta and Cyprus into the euro could tip the vote balance at the ECB.